Has the ‘Dream Run’ for Indian IT Ended?

After years of sitting on piles of cash, Indian information technology (IT) services firms are suddenly dispensing some of it to their shareholders by way of buybacks. In mid-February, Tata Consultancy Services (TCS), India’s largest IT services firm, which has a cash pile of around Rs.40,000 crore ($6 billion), announced that it would buy back equity shares worth up to Rs.16,000 crore ($2.4 billion). This is TCS’ first buyback scheme since it went public 13 years ago and also the biggest share repurchase program in the country. (A few weeks before TCS’ announcement, Nasdaq-listed Cognizant Technology Solutions, which has the bulk of its workforce in India, declared a dividend payout and a share buyback of $3.4 billion.) In March, HCL Technologies said it would buy back Rs.3,500 crore ($340 million) of shares. Others like Wipro and Tech Mahindra are expected to follow suit. On April 13, announcing its results for the fourth quarter of fiscal 2017, Infosys said that up to Rs. 13,000 crore ($2 billion) is expected to be paid out to shareholders during 2018 in dividends, share buybacks or both. In addition, the company expects to pay out up to 70% of free cash flow next year in the same combination. Currently, Infosys pays out up to 50% of post-tax profits in dividends.

The buybacks are a move to boost share price and soothe investor sentiments. They are also designed to make them less attractive to predators. After years of giving high returns, the industry has been delivering below expectations; most Indian IT services firms have been performing below the Sensex, the benchmark stock index. Recent developments like U.S. President Donald Trump’s election and the ensuing controversy surrounding outsourcing and H1-B visas, and technology disruptions caused by digital transformation and automation are in fact threatening the very fundamentals of the $108 billion IT-BPO exports industry. That industry put India on the world map because of its high-quality, low-cost tech talent and a successfully executed offshore-global delivery model. (Indian IT firms use the H-1B temporary work visas in large numbers to fly their engineers to client sites in the U.S., which is their largest market accounting for over 60% of exports.) There are also pressures from other quarters, such as Brexit and the consequent delays in decision making; slowdowns in the banking and financial services sector, and reduced discretionary IT spending.

The projections of industry body Nasscom (National Association of Software and Services Companies) mirrors the growing uncertainly. In sharp contrast to the heady growth of over 30% of previous years and in line with dipping growth in recent times, at the beginning of fiscal year (FY) April 2016-March 2017, Nasscom had forecast a growth of 10% to 12% (in constant currency terms). In November last year, it lowered the outlook to 8% to 10%. In February, for the first time in 25 years, Nasscom deferred giving the annual revenue outlook for fiscal 2018 by a quarter.

Other projections, too, are bleak. A few weeks ago, Goldman Sachs said that the revenues of the top five Indian IT services firms are likely to grow at a compound annual growth rate (CAGR) of 8% as compared to 11% during the FY 2011 to FY 2016 period. The U.S.–based Deep Dive/Everest Group IT services forecaster expects a 6.3% growth for the top five IT companies for calendar year 2017. For the industry as a whole (excluding multinational captive centers), the growth in 2017 is projected to be a mere 5.3%.

“For several years now, experts have been predicting that the dream run of the Indian IT services industry will soon be over. By all indications, that time has actually dawned now,” says Rishikesha T. Krishnan, director of the Indian Institute of Management Indore.

But this is not the first time that the industry is looking down a long dark tunnel. The Asian Crisis of 1997, the dot-com bubble burst of 2001 and the economic crisis of 2008 were all trying times. Each time, the industry managed to bounce back. So what is different this time around?

Lacking Strategic Relevance

Ravi Aron, professor of information systems at the Johns Hopkins Carey Business School, says Indian companies are struggling with a problem of strategic relevance. “The current protectionist regime in the U.S. and the anti-trade mood will result in legislations that may cause some temporary but not very large setbacks. The real problem for India IT services companies is that they occupy positions of very low strategic relevance with their clients.”

“For several years now, experts have been predicting that the dream run of the Indian IT services industry will soon be over. By all indications, that time has actually dawned now.” –Rishikesha Krishnan

Aron points out that several emerging technologies are changing how companies compete, the way they engage with customers and even the nature of work inside the firm. Big Data and analytics, artificial intelligence and robotics are all top of the mind not just for CTOs in corporations but also for all CXOs. “When we [business school faculty] talk to senior executives, they do not ask us to explain the difference between supervised and unsupervised learning in machine learning. Instead, they ask specific questions about how will machine learning have an impact on predicting customer response to products in retail financial services? Or, how can data mining be used to identify opportunities in new product development by analyzing and classifying patterns from transaction data?”

But Indian IT companies are operating on a different model altogether. They expect the clients to tell them what they want from these emergent paradigms and offer to find out a cost effective way of doing it. “They are not ready to deal with the ‘what aspects of business can I transform with technology’ question, which is of high strategic relevance,” says Aron.

Saikat Chaudhuri, executive director of Wharton’s Mack Institute for Innovation Management, adds: “Essentially, Indian IT firms have been stuck in the middle; they are not low-end providers anymore with low costs, neither have they been able to propel themselves to become high-end providers performing core work and high-margin services. At the same time, on the technology side, automation threatens to render obsolete much of the labor arbitrage work on the lower end; while political changes such as protectionism compound the problem.”

Keeping pace with technology and the changing requirements of clients is the most difficult challenge that the Indian IT industry is facing today, says D.D. Mishra, research director at IT research and advisory firm Gartner. Pointing out that the current situation is “very unique and we are possibly going through the most interesting phase of evolution in terms of IT services,” Mishra lists his key concerns: “We see that creative destruction has become a norm for many businesses. Re-skilling people is a big challenge, especially when you have a large workforce. The short supply of skilled labor will be one big inhibitor. Endpoints of the Internet of Things will grow at a CAGR of 32.9% from 2015 through 2020, reaching an installed base of 20.4 billion units. This will drive a lot changes in the business models and business opportunities which need to be tapped. And though tactical innovation is the strength of Indians, in my view, the cultural aspect around innovation is the most difficult change organizations will struggle with.”

Sudin Apte, CEO and research director at Offshore Insights, an IT advisory and research firm, says that Indian IT firms could survive the many challenges earlier — whether it was shortage of skills, fluctuating currency, macro-economic factors, growing competition from multinationals and pressure from clients to build skills such as domain expertise, program management and consulting capabilities — because “they had the benefit of the TINA (‘there is no alternative’) factor.”

But that is no longer true. Now, there are several point solutions available which are part of the enterprise resource planning ecosystem. Many business process providers offer specific business processes as well as cross industry processes on demand. Cloud and software-as–a-service (SaaS) companies are changing delivery and payment parameters. “The industry is facing structural changes. All aspects of a solution — what clients are buying, in what format they are buying, how they want to pay, what value they expect, competition — are undergoing change simultaneously. The gaps between what clients are looking for and what the Indian IT firms have to offer is widening. The industry has not faced such issues before,” says Apte.

He points to another disturbing trend: Even as global IT spending is growing, it’s not coming to India. Instead, most of it is going to other companies. “Look at the growth of firms like Salesforce.com, Amazon Web Services (AWS) and Workday. Even cloud divisions of Oracle and Microsoft Dynamics have been doing well and so are numerous firms like Tableau, Marketo, etc. There are around 200 or 250 companies which came from nowhere and are today in the range of $200 million to $1 billion,” says Apte.

“The real problem for Indian IT services companies is that they occupy positions of very low strategic relevance with their clients.” –Ravi Aron

New Skills Are Required

Krishnan believes that Indian IT firms were successful in riding multiple waves like the shift from mainframe to client-server, Y2K, internet and e-commerce, social media and the mobile because “the core skills needed to succeed didn’t change dramatically — essentially good programming skills plus the ability to manage large teams across geographies.” He notes that while the programming languages and platforms did change, the ability of Indian companies to train large numbers of software professionals in new programming languages in short timeframes allowed them to stay ahead.

However, the latest wave embracing big data, machine learning and artificial intelligence requires fundamentally different skills. It’s more research-intensive. “Many existing employees can’t be re-trained for these requirements. And India’s engineering education will be unable to meet these needs, at least not immediately,” says Krishnan. According to a recent McKinsey & Company report, more than half of the 3.9 million people employed in the Indian IT sector will become “irrelevant” in the next three to four years.

Ganesh Natarajan, industry veteran, chairman of Nasscom Foundation and founder and chairman of 5F World, a platform for skills, startups and social ventures in India, describes the current scenario as “a perfect storm” created by three forces. The first is digital transformation of clients with applications and infrastructure moving to the cloud and clients asking for new services like mobility, analytics and cyber security which cannot be delivered using the traditional dual shore model. The second is automation of knowledge work, which is seeing traditional manpower intensive offshore services like applications management, infrastructure support and testing becoming automated and reducing or, in some cases, eliminating the need for manpower. Third are the forces of protectionism that is leading to tightening of visas and making cross-border movement of people extremely arduous.

“Each of three forces can have severe ramifications for the Indian IT services industry. Digital transformation can take away as much as 20% of existing services volumes, automation can eliminate 30% of manpower and protectionism can reduce revenue opportunities and profitability by at least 10%,” says Natarajan.

Transform or Perish

Clearly, the rules have changed for Indian IT firms. The big question is: Can they in fact get back into the game?

Only if they differentiate themselves, says Kartik Hosanagar, Wharton professor of operations, information and decisions. He suggests two strategies. One, become a partner that can guide CEOs with strategic initiatives like digital transformation. This will require them to be part of the “what to do” and “why do it” conversations and not just “how to do it.” Two, specialize and build deep expertise in certain areas. For example, CMOs are increasingly spending on IT including custom IT implementations. Another such area is Big Data and analytics. “Organizing into divisions or perhaps into sub-brands, each with deep expertise, is the way to go,” he says.

According to a recent McKinsey & Company report, more than half of the 3.9 million people employed in the Indian IT sector will become “irrelevant” in the next three to four years.

Chaudhuri suggests that while Indian IT firms have been making investments over the past five years in emerging technologies, they now need to scale up those efforts and do so quickly. “They need to increase the investments in those areas drastically, and hire top talent from established Western firms and startups alike. At the same time, they also need to leverage acquisitions of small firms and/or build alliances to rapidly increase access to those capabilities and be part of an ecosystem.”

Indian firms need to be innovative, agile and flexible, says Gartner’s Mishra. “Thinking out of the box will differentiate the winners. They must be able to predict the changes faster and adapt themselves to leverage it much ahead of others.”

For Natarajan, the most important imperative is to re-skill employees for the new digital challenges at a rapid place. “The winners will be those who use technology to enable just-in-time and on-the-job learning and are able to equip their workforce with skills needed to pivot their own careers as well as the organization.”

Apte offers an additional prescription. Since Indian IT companies have grown mainly in the era of client-pushed business growth, their corporate functions such as strategy, planning, market research and strategic marketing are not very strong. “They need to ramp-up on all these fronts. They need to invest much more on sales and marketing, grow their selling sophistication and competitive positioning. They also need to embrace a truly global delivery model where 40% of resources are placed in on-shore, near shore and other alternate geographies,” says Apte.

Looking Beyond H1-B

While the possible tightening of the H-1B visas in the U.S. is giving most Indian IT firms the jitters, Aron suggests that they can in fact turn this temporary adversity to long-term advantage if they can acquire some additional capabilities. He explains: “First they need to invest in the ability to translate business needs into software features – these are professionals that can talk to users (business managers) and translate their needs into a set of software features and then create a system of codification that can transfer this to the offshore production location.” In a study based on multiple years of data on offshore information services, which Aron conducted with former Wharton doctoral student Ying Liu, they showed that such codification capability improved both the output and quality of work and lessened the need for onshore managers.

The blended rate that Indian IT firms offer their clients usually combines a mix of offshore and onshore wages at 70:30 or 80:20 ratios. By developing this capability, Aron says, the onshore presence can be reduced to 2% to 3% of total project capacity. “By deepening this capability, Indian IT majors can actually make this a long-term competitive advantage and wean themselves away from the need for large numbers of H-1Bs.”

Indian IT firms could survive the many challenges earlier … “because they had the benefit of the TINA (‘there is no alternative’) factor.” –Sudin Apte

Another way to reduce dependence on H-1B visas is to focus more seriously for business from ASEAN, Middle East and Africa and other emerging markets. Currently, the bulk of their overseas client revenues come from the U.S. and Europe. “In ASEAN, the Middle East and Africa, a wave of automation is beginning to take place. IT spending in many of these countries is set to increase by 8% to 22% according to some industry reports. Many of these countries do not have local firms with the ability to strategize and provide consulting services and sell them on top of an ‘IT stack’ – a set of technology solutions that will make the strategies work. The time is right for Indian IT majors to take on these markets,” says Aron.

Of course, the challenge for Indian IT firms is that they need to make all these above suggested changes even while continuing to deliver the services that bring them the revenues at present. Some of them have already started making their moves. TCS, for instance, has been on a massive re-skilling exercise and has trained more than half of its 380,000 employees on digital platforms. Tech Mahindra is looking at its DAVID (digital, automation, verticalization, innovation and disruption) offering to keep pace with the evolving needs of its clients. It is also looking to collaborate and crowd-source instead of trying to build everything in-house and is working with more than 15 startups.

At Infosys, CEO Vishal Sikka is passionate about his ‘zero-distance’ strategy. In a recent interview with Knowledge@Wharton, Sikka said: “The idea is that we don’t just do what we are told, but in every single project, no matter what it is, no matter how mundane, no matter what area it is in, you do something innovative. You find some problem and you solve that problem, you go beyond the charter of the project and do something innovative to delight the client, and do something that they did not expect. Something bigger than what you were thinking about.”

The direction is right. Now it remains to be seen if Indian IT reaches the destination.