Triple threat for tech firms

Triple threat for tech firms

As a large number of IT and ITeS professionals bet their future on the industry and are getting used to average, annual hikes of nearly 20%, the party seems never-ending. The Nasscom-McKinsey report 2005 had projected IT-ITeS exports at $60 billion in 2010. And out of the nearly $40 billion revenue earned by the software and services sector in 2006-07 (expected to grow by 27% this year), exports contributed $31.3 billion.

The dollar moved from Rs45.87 on 30 June 2006 to Rs40.58 on the same date in 2007. It dipped below Rs39.5 in early October. The twin deficits for US economy —trade deficit and government deficit are the main reasons for this decline. And both show little signs of fading away.

The likelihood of dollar hitting Rs35 within a year is very real. A 10% depreciation in the dollar will result in a fall of 7-10% in the operating margins of all software companies, all other factors being the same. Unfortunately, all other factors will not remain same. They will make it worse.

The 10-year tax holiday under Sections 10A and 10B of the Income-tax Act and the exemptions under the STPI scheme for software exports are set to expire in 2009. These were meant to encourage the fledgling industry in the early 1990s. But it is no longer fledgling. The size of the IT industry is now close to $50 billion (including hardware and domestic software). It contributes 5.2% to the country’s GDP and has close to 1.7 million people working in it. These are signs of a mature industry.

In the last 10 years, it has created a lot of wealth in society, and a lot of resentment, too. Conventional industries, such as engineering, construction and petrochemicals, complain of a scarcity of talent and blame this on the high salaries—these comprise 40% of the costs of software firms thanks to their high profitability.

As we near 2009, calls from Nasscom and software companies for a renewal of exemptions will be met by strident opposition from various quarters. The possibility that the exemptions will be extended is unlikely. There’s more. Rising inflation and the war for talent has pushed up wages and overall costs are going up by 15-25% annually. But as billing rates are not going up in the same proportion, this will impose an additional burden on the margins of the players.

How will the industry deal with the triple threat of rising costs, end to tax exemptions and a strengthening rupee? The next three years will see a clear consolidation of the industry into winners, losers, and survivors.

Size matters and focus pays

The winners will be companies that manage to sustain the revenue and margin growth and deliver margins in higher teens in spite of the adverse circumstances. They would deal with the triple threat by a combination of high business volumes, a drive for higher productivity, smart currency hedging and business innovation. They will also exploit the concessions in the SEZ (special economic zone) route, wherever possible.

The IT services sector is commoditizing fast and, like any commodity sector, scale is the key. The kind of scale acquired by players such as TCS, Wipro, Infosys, Cognizant, HCL and Satyam will be a crucial factor in winning large outsourcing deals. The impact of the rising costs and rupee appreciation will be lower in the case of higher revenues.

Another set of winners will be the specialist vendors—those with a clear focus and strengths that can’t be easily duplicated. These players will not have the scale or the breadth but they will have the focus and depth in services. They will get their share of revenue and margins because of the leadership they show in their chosen areas.

Opportunists will die

The losers will post a negative growth in revenues and margins. These will typically be the generic and the body shopping companies, smaller captives and export vendors who work on very thin margins.

These companies coasted along on the wave of dollar-rupee arbitrage and adding four engineers in India for the cost of one developer in the US. The majority of the 8,000-plus software companies registered with STPI fall in this category.

Companies with revenues of less than $75 million and more than 80% exposure to the US will be especially vulnerable. They will either have to shut down or will be acquired by other firms.

Scraping through

Some companies will manage to barely stay afloat on the basis of their existing contracts. They will post flat growth in margins and revenues and will be characterized by mediocre management, lack of clear goals and vision. So, as a tsunami will hit it in late 2008, the software industry will enter a phase of rationalization. Some of the clear winners who succeed in the acid test may even take on global leadership in the 2010-2015 time frame.

Anirudh Joshi works out of Seattle, US, for a Bangalore-based technology company. These are his personal views. Comment at