Indian IT Services: Shaping Up for the Next Big PushPublished: February 24, 2011 in India Knowledge@Wharton
Earlier this month, newspaper headlines in India about US$5 billion worth of IT outsourcing orders expected from large U.S. banks brought cheer to the Indian IT services industry. In recent months, industry players have been expecting the return of good times, and this news reinforced their optimism. But experts say the US$60 billion industry needs to retool and reposition itself or it risks losing out on growth. According to Sudin Apte, principal analyst and CEO at research firm Offshore Insights: "Businesses in the U.S. and Europe have undergone dramatic changes. The paradigm at their end has changed and so have the needs and requirements from their technology vendors. If Indian IT firms want to stay in the game, they need to change, too."
Meanwhile, the country's top IT firms are close to shuffling positions. While Tata Consultancy Services (TCS) and Infosys Technologies continue to hold sway, Cognizant Technologies, currently the fourth-largest player, is threateningly close to unseating Wipro Technologies for the third slot. In the last quarter, Cognizant's revenues grew 45% to reach US$1.31 billion; Wipro was marginally ahead with US$1.34 billion in revenues from IT services. Also getting ready to join the club is iGate, which last month entered the billion-dollar revenue club after buying Patni Computers in a US$1.2 billion deal -- one of the largest acquisitions within the Indian outsourcing industry. Mahindra Satyam, the rechristened former No.3 Satyam Technologies, is bouncing back after a financial scandal orchestrated by its founder Ramalinga Raju nearly sent it into oblivion two years ago. A merger with Tech Mahindra, which will happen once the scam probe is complete, will boost its topline.
The business opportunity landscape for Indian IT services firms is also changing rapidly. Last year, in keeping with tradition, the industry won the bulk of its business -- 40% -- from the banking, financial services and insurance (BSFI) industry. Another 24% came from the so-called "emerging verticals" comprising healthcare, retail, media and utilities; a fifth from the high technology and telecom sectors; and the rest from manufacturing. But going forward, the biggest opportunities, according to the National Association of Software and Service Companies (Nasscom), will be in the emerging verticals, which are growing at 22% -- outpacing the rest by 1.5 times.
"These four verticals will emerge as growth engines by 2020," said B.V.R. Mohan Reddy, chairman and managing director of Infotech Enterprises, at Nasscom's annual Leadership Summit in Mumbai in February, one of the industry's premier events. "Eighty percent of the new opportunities will come from areas we haven't [yet] gone to," says Nasscom president Som Mittal. He sees public sector and defense also as high-potential sectors. Geographically, too, the industry faces changing opportunities. Last year, it won 62% of its business from the U.S., about 22% from the U.K., 12% from Continental Europe and 9% from Asia Pacific. But it is Asia Pacific that is growing the fastest at 24%.
Getting the House in Order
The industry is gearing up to take on the changing environment. On the day it announced lower-than-expected earnings for the latest quarter, Wipro let go of its co-CEOs Girish Paranjpe and Suresh Vaswani, both Wipro veterans of more than 20 years, with three years in the top job. (Wharton management professor Peter Cappelli had predicted that this would happen -- see Team Leadership at Wipro: Are Two CEOs Better Than One?) They were replaced by T.K. Kurien, a former General Electric executive who has played a key role in scaling many of Wipro's businesses over the past 10 years. "The joint CEO structure was one of the key factors that successfully helped us navigate the worst economic crisis of our times," said Wipro chairman Azim Premji in a statement. "With the change in environment, there is a need for a simpler organization structure."
Soon after Kurien took over, he realigned the organizational structure, with client delivery, sales and profitability tied more closely with industry domain-led strategic business units. "After the restructuring [effective April 1], decision making will be faster and customer satisfaction will be handled at the business unit level," Kurien told the media. Wipro is falling back on a tested model: TCS successfully underwent a similar restructuring some time ago.
Infosys recently brought together 500 of its top executives at a retreat to reportedly discuss sweeping organizational and business strategy changes, but it isn't showing its cards yet. "We have a strategy and action planning [meeting] every three to four years and it happens in December-January," Infosys CEO S. Gopalakrishnan told reporters at the time. "Once the strategy is finalized, we look at all the business aspects, including whether the structure is aligned to the strategy or not." But he did disclose that Infosys is investing in Europe, Australia, India, China and West Asia. It is also focusing on public services, utilities, healthcare and energy, and recruiting to build on its consulting practice. "We are looking at two themes in acquisitions -- geography-based in France, Germany, Japan and Australia; and in consulting and platform-based BPO," Gopalakrishnan said.
Soon after the appointment of Amitava Roy as the new chief operating officer at Tech Mahindra, Vineet Nayyar, managing director and CEO, reportedly said in an internal communication: "We are making other organizational changes to align ourselves to the demand of the market place, and we will be announcing the changes soon." Industry analysts say that similar activities are taking place across other IT firms in the country.
On a Hiring Binge
India's IT majors are also bulking up for when the recovery gathers momentum. TCS leads the industry with 187,000 employees, and plans to add 37,000 more people in two years. Infosys' Gopalakrishnan announced 26,000 new positions at his company, pushing the total new hires this year by the top five firms to 180,000. The industry already employs 2.54 million, and is expected to add 250,000 in 2010-11. The coming year (2011-12) will likely be a bumper one, with an estimated recruitment of 400,000 people. This could be the highest employee addition ever by the country's IT sector. What's more, Indian IT companies are hiring actively on U.S. university campuses this year against the backdrop of the Obama administration decrying the loss of U.S. jobs to India. They are also hiring senior talent locally in overseas markets.
Meanwhile, attrition last year ranged between 13% and 30% at the top 10 companies, according to Zinnov Management Consulting, an IT research and consulting services firm in Bangalore. Infosys is currently asking its nearly 128,000 employees for ideas on how it can retain them, as it battled attrition of 17.5% in the last-reported quarter
The industry's talent hunt extends to the corner office, with a slew of top-level departures in the past two months. MindTree's founder and executive chairman, Ashok Soota, quit in January -- reportedly after disagreements over performance issues. At Patni Computers, the promoter family (Narendra Patni, Gajendra Patni and Ashok Patni) have moved out after selling their 44% in the company to iGate. The biggest new face will be the successor to Infosys co-founder N.R. Narayana Murthy, who is set to retire as non-executive chairman and chief mentor in August when he turns 65. A team headed by Jeffrey Lehman has been tasked with the job of finding Murthy's successor. The industry buzz is that ICICI Bank chairman K.V. Kamath, who is an independent director on the Infosys board, is the preferred candidate.
The Takeover Track
There is action also on the takeover front. The first two months of 2011 have already seen 20 M&A deals by Indian IT services companies, compared to 120 deals in all of 2010, according to Venture Intelligence, a research services firm in Chennai focused on private equity and M&A deals. Deal values disclosed for 12 of those total US$1.645 billion, including iGate buying Patni (US$1.2 billion), Pearson buying TutorVista (US$127 milion) and Tata Communications buying BitGravity (US$100 million). "The IT and ITeS segment emerged as the second most active industry for deal making in 2010," says Arun Natarajan, founder and CEO of Venture Intelligence. Last year's deals include NTT Data's US$199 million purchase of Intelligroup, and comprised 55 outbound deals, 18 inbound and 47 domestic deals. "Size has started mattering to a certain extent," says Phaneesh Murthy, iGate's chairman who formerly headed Infosys' U.S. operations. "Many procurement departments [at client companies] believe that size and scale represent stability."
The past year has seen a pick-up also in client companies setting up captive BPO operations in India, according to Zinnov. The captive IT offshoring industry in India has grown from US$900 million in 2003 to an estimated US$3.4 billion in 2010, Zinnov says in a February report. This could cause worry for Indian BPO firms. British retailer Tesco saves more than US$100 million annually with its captive offshore unit in Bangalore, where it has 4,500 employees, says C.S. Chandramouli, director-globalization advisory at Zinnov. U.S financial services giant Wells Fargo is another active captive-unit operator. It set up a captive unit in Hyderabad in 2006 with 30 employees, and that has now grown to two units with more than 1,500 employees.
Pressure on Margins
There are other challenges, too. Analysts have for many years warned that Indian IT services firms will be unable to sustain their profit margins as their offerings get more commoditized. A recent Cognizant-commissioned report by research services firm IDG says that while last year's earnings reports generally show stable or improving margins among IT service providers (in India and elsewhere), "numerous factors conspire against sustained high-margin work." Operating margins (profit before interest, tax and depreciation as a percentage of sales) at the top Indian IT services companies have in recent years ranged between 20% and 40%, with marginal declines. Infosys, for example, enjoyed operating margins of 31.3% in 2008. In the latest quarter, this has fallen to 29.6%. Exchange rate imbalances and accelerating wage inflation are hurting margin growth at Indian IT services companies, according to the Cognizant-IDG report. "With multiple pressures and elusive price increases, [Indian] providers are looking for revenue streams that rely less on head count in anticipation of potential pressures on margins."
The biggest drawback that the Indian IT services firms face is in their ability to address the business needs of their clients, according to Ravi Aron, senior fellow at Wharton's Mack Center for Technological Innovation. "Most Indian companies enter the game when the CTO (chief technology officer) office floats an RFI (request for information) or RFP (request for proposal). Well before that, there are a bunch of events that take place for which Indian companies do not have the visibility," he says. Global firms, such as IBM and Accenture, typically come in at the earlier stages -- translating the business needs into technology needs -- and thereby provide higher-value IT consulting services.
Aron points out that while the top four Indian companies -- TCS, Infosys, Wipro and Cognizant -- are trying to capture such consulting contracts, they still have a long way to go. "In some sense, they may have gone slightly ahead of the RFI/RFP stage by going into the back office and recommending ways to standardize and automate disparate processes, but it is still not a market-facing solution at which they are interfacing," he says.
New Business and Pricing Models
Even so, the big Indian IT majors have been winning business transformation contracts. Infosys last year helped a multinational retailer in Europe define its global e-commerce road map; a grocery retailer in the U.K. to shape its workforce management system to achieve better scheduling and planning; a North American paper and building products company with an enterprise-wide mobility strategy; and a global consumer electronics company with an engineering support model for its cloud-based services.
R. Chandrasekaran, Cognizant's president and managing director of global delivery, says his company recently developed a mobile application for a global consumer products company that allows delivery personnel to collect competitive intelligence about product placement in retail stores. The application captures information about where the competitors' products are placed in each store, the amount of space they are allocated and a qualitative opinion of how their own placement stacks up. "This information was previously not captured," he says. "Today, however, it has started providing valuable input to promotional decisions."
Why are these new business models important? In recent years, Indian IT firms have sought to break away from their conventional linear growth model (where increase in revenues is linked directly to increase in headcount), to one where they can claim rewards proportionate to the gains they bring to customers. This is called "outcome-based pricing" or "hybrid pricing," where the latter is a mix of time-and-materials billing, fixed transaction fees and payments linked to business outcomes. Wharton's Aron is currently putting together a study where he compares pricing parameters across nearly 200 recent Indian IT services deals. Outcome-based pricing or hybrid pricing deals clearly score over conventional time-and-materials transactions, with higher margins, he says.
To successfully deliver on such contracts, it is imperative for IT vendors to have a deep understanding of the client's business. They must be able to anticipate and identify a client's business problems and proactively offer solutions through their knowledge of technology, domain expertise and consulting capabilities.
Nasscom notes that the industry's employee strength grew 10% last year while revenues grew nearly 19%. Nasscom's Mittal believes that the industry is beginning to show real traction in moving beyond time-and-materials pricing. About 40% of the industry's total transaction value now comes from fixed-price deals (irrespective of the number of man hours spent), and outcome-based pricing deals account for about a tenth of the total, by his tally.
iGate was among the first to clinch outcome-based pricing contracts five years ago.According to Murthy, besides knowledge of a client's businesses, IT services firms also have to factor in some obstacles at the client's level before they can pull off such deals. While in some cases the functions covered in a deal may fall under different departments, in other cases, procurement or sourcing departments at companies don't understand outcome-based models. They hesitate to sign such contracts because they are unable to compare them with bids from others that offer plain vanilla time-and-materials billing. "In any large company, when two senior executives meet and agree on some things, it is like an act of God," says Murthy.
Moving to the Cloud
Along with new business and pricing models, Indian IT firms are also looking at new technologies. The current big buzz in the IT space is about cloud computing. With cloud services, users can download software from the Internet and also access IT infrastructure, such as servers and storage devices, by simply paying a fee each time they do so, instead of actually buying them. Software and hardware manufacturers benefit because the lower price for each use expands their market to include users who otherwise couldn't afford the capital expense. IT service providers benefit because they can aggregate and offer software from multiple manufacturers in a cloud, and also offer businesses private cloud services with customized software.
TCS in February launched iON, a subscription-based cloud computing service targeted at small and medium businesses. "Cloud services eliminate any upfront commitment by users, thereby allowing companies to start small and increase hardware resources only when there is an increase in their needs. Thus, companies can deploy a service and scale on demand without taking the risk to build or provision a data centre for an unknown future," TCS says in a white paper. TCS aims to sign up 1,000 customers in the first year in the domestic market and later expand internationally. It hopes its cloud business will grow to earn revenues of US$1 billion annually in five years.
Gartner's 2011 CIO survey reveals that almost half of all CIOs expect to operate their applications and infrastructures via cloud technologies within the next five years. "This change will necessitate that CIOs reimagine IT and lead their organizations through a process of creative destruction," Gartner says in its report. It adds: "At the moment, adoption of cloud services is still anything but predictable -- though apparently inevitable."
Chandrasekaran of Cognizant points out that his clients find it useful that they can adopt cloud-enabled services "where it makes good business sense." He adds, however: "It's critical to keep in mind that cloud services will not simply replace traditional delivery modes at the enterprise level overnight." He talks of "a new normal" for the industry, built on three pillars: "A new generation of highly distributed and virtualized business models; a new generation of cloud and mobile technologies; and a new generation of born-digital workers and consumers, the so-called Millennials."
Indian IT companies may be heavily dependent on foreign business, but the domestic market, too, is growing rapidly. The domestic BPO industry grew 17% in 2010 to US$787 million, while its employee base grew 6% to 560,000, according to Nasscom. Over and above the increasing use of IT by Indian businesses, new initiatives by the government offer huge opportunities for the industry. These include programs to issue unique identification (UID) numbers to Indian residents, linking 250,000 villages with Internet connectivity, and so on.
Rekha Menon, executive director overseeing corporate functions at Accenture India, blogged at the end of the recent three-day Nasscom meet that "IT and BPO firms will need to build strong domain expertise and will have to embrace disruptive innovation to remain globally competitive and facilitate inclusive growth." If that message sounds similar to last year's takeaway, the difference this year is in the context. Last year, she says, the industry was preoccupied with "endurance and consolidation." Now, it needs to focus on action to build domain expertise and "engage with disruptive innovation" against the backdrop of the improving macroeconomic scenario.
iGate's Murthy is optimistic of the way ahead. Indian IT services firms "are addressing a US$1.5 trillion-US$2 trillion marketplace for IT and BPO services. We are only 5% of the way there," he says. "There is a good, long-term secular growth opportunity."