Why the Downturn May Not Leave Outsourcing Firms Down and Out

During the economic downturn early in the decade, Indian outsourcing companies were viewed as an avenue to savings by customers looking to rid themselves of mundane technology tasks and their accompanying expensive labor. Aided by regulatory changes, the companies’ revenues and profits grew sharply.

But this time around, the scenario is different: The same companies are more mature, so strong growth is naturally more elusive. Meanwhile, the current economic crisis is global and spread across multiple industries — including financial services, which represents anywhere from 23% to 44% of Indian outsourcing sales, according to a UBS report in October. The slowing economy, lack of client diversification and an unstable rupee have hurt the firms’ profit margins: Indian technology giants such as Infosys, Wipro, Tata Consultancy Services and Satyam Computer Services have all lowered their revenue forecasts.

“The global economic environment has deteriorated significantly over the past couple of months, and our outlook is cautious in the near term,” Azim Premji, chairman of Wipro, said in the company’s earnings statement in October.

But Wharton faculty see a glimmer of hope for outsourcing companies to stay afloat during the crisis — and perhaps even get ahead — by offering more “core” services and replacing transaction-oriented client relationships with strategic partnerships aimed at helping businesses transform themselves in the current economic environment.

In many respects, the fate of Indian outsourcing firms resembles that of any industry that has exited the rapid-growth, start-up phase. “During the last downturn, there wasn’t nearly the [current] penetration by Indian companies,” says Noah Gans, an operations and information management professor at Wharton. “They were naturally in a growth phase. I don’t know if there are [still] any big pockets of industries that are considering [offshore outsourcing].”

Indian outsourcing companies also run the risk of being squeezed by rival firms in other countries and larger competitors such as IBM and Accenture, says Wharton management professor Saikat Chaudhuri. But for services such as research and development, product development and legal outsourcing, Indian firms may find a receptive audience during the downturn. “Spending of this sort goes countercyclically, since companies are looking to lower their cost base,” he says. Additionally, a downturn will force Indian companies to diversify their customer base and perhaps target countries where outsourcing hasn’t been as prevalent. “For instance, companies in Germany and France haven’t made much use of outsourcing, but due to the slowdown they might. There’s more low-hanging fruit there compared to their U.S. counterparts.”

Ravi Aron, senior fellow at Wharton’s Mack Center for Technological Innovation, acknowledges that offshore firms are caught in a challenging cycle. As companies cut back on growth initiatives, they aren’t taking older information technology processes offshore to make room for new business. In addition, increasing layoffs in the United States minimize pressure on labor costs — one of the primary reasons for offshore outsourcing.

However, opportunity exists if offshore firms transition their businesses properly. Aron says that offshore firms should seize on acquisition opportunities in the United States and Europe since valuations are low, hire laid-off technology talent from the financial services sector, acquire niche outsourcing companies, and focus on integration work and standardizing processes. “There’s a huge opportunity in complexity arbitrage,” Aron says. “The biggest thing that’s going to happen is massive change and standardization as companies look for a great decrease in complexity. There will be huge changes in the front, middle and back office.”

Peter Cappelli, a management professor at Wharton, says the turmoil doesn’t suggest that the Indian companies will suddenly go into a tailspin. “Because [these companies] were growing so fast, the downturn may just mean no growth and modest consolidation, rather than cuts,” Cappelli says.

Why This Downturn Is Different

The last downturn ushered in a period of growth for Indian outsourcing firms. Indian technology companies were relatively young and in a hot niche, and they could deliver returns, especially for financial services firms that were growing amid a U.S. mortgage boom. Meanwhile, the outsourcing firms were benefiting from India’s effort to become more business-friendly through reduced regulation, says Philip M. Nichols, a Wharton legal studies and business ethics professor.

In the late 1990s, the Bharatiya Janata Party (BJP) came to power and emphasized economic issues including strong growth, privatization, foreign investment and tax reduction. The BJP run ended in 2004, but its economic policies remain in place.

“The economic downturn five or six years ago was interesting in that it pushed things into India’s corner,” Nichols says. “You also have to remember that India went through an incredible period of regulatory change in how it deals with business.” The move to make India more palatable to international business was as critical as the need to cut costs in driving the boom in technology services. “The current economic downturn won’t have the [same positive] effect because it’s not being augmented by change in regulation,” Nichols says. Many outsourcing firms benefited from being in the right place at the right time, he notes. “It was the perfect situation for India. If the same pressure existed and India didn’t have its regulation changes, we’d be talking about a different place right now.”

Harbir Singh, a management professor at Wharton, agrees. “The regulation changes made a huge contribution. People presumed that it was extraordinarily complicated to do business in India at the time, and they were right. The government has had a big impact on the success of the industry.”

The current economic slowdown is significantly different from the last one. Girish Paranjpe, co-CEO of Wipro, noted in the company’s earnings conference call that the last downturn was the result of too much investment in technology. The current credit crisis impacts all parts of the economy, including key sectors — banking and personal finance, manufacturing, telecommunications, retail and transportation — that utilize offshore outsourcing.

One of the biggest worries for Indian outsourcing companies is a lack of client diversification. Tata gets 44% of its revenue from banking and financial services firms — the sector that’s under the most economic strain — according to UBS. Infosys derives 36% of its revenue from the sector as well. And this diversification problem extends into geographies. The major Indian technology companies all get at least 50% of their revenue from the United States, according to UBS, with at least 20% to 30% coming from Europe. Both face strong economic headwinds. The Indian outsourcing companies “certainly are much more dependent on financial services clients and the U.S. overall,” Chaudhuri says.

These troubles are expected to sharply curb Indian outsourcing firms’ growth rates, according to UBS estimates. For instance, Infosys’ growth is estimated to slow to 10.8% in fiscal 2010, from 29.7% for the current fiscal year. Growth at Wipro, Tata and Satyam is similarly expected to decelerate.

Moving Upstream

Survival for these companies depends on a continuation of their existing strategies, experts at Wharton note. Indian outsourcing firms began by maintaining technology systems and code, then moved to back-office operations, and are increasingly offering research and development as well as consulting services.

“They have moved up the value chain, away from low-cost to higher-priced, more sophisticated services,” Cappelli says. “They’ve been doing very well at this, and many companies now see India as the source for IT R&D because it has the greatest depth of talent there.”

Premji made the same argument in his earnings statement, noting that the Indian technology sector will do well in the long run because it “is doing work which is significantly more embedded into customer requirements and customer strategy.” In other words, Indian firms need to be experts in transforming businesses, not just servicing them.

“What all of this means to our IT business is that we need to move from a business-as-usual approach to a more transformational approach that will help our customers realize better cost and service optimization in their times of need,” Premji explained.

Aron agrees. Although it may take a year or so until the financial market turbulence dies down, he expects that offshore outsourcing firms will move toward offering better business process outsourcing services. He notes that it doesn’t make sense for offshore firms to “diversify just for diversification’s sake,” but predicts that India’s technology giants can find new business from financial services customers, which are rapidly integrating mergers while shedding non-core businesses. With new offerings created for financial services firms, offshore outsourcing firms can target other struggling or inefficient industries, such as retail and health care.

“Financial services firms are very interested in reducing complexity and minimizing risk,” Aron says. “They want to standardize processes, and when finished they will look at automation. Offshore outsourcing firms have a great opportunity to offer platform-based business process outsourcing where they provide the technology and automate what a company does. The future for offshore outsourcing companies is to take 1,200 systems to 800 to 700 then 500 on down. There will be wrenching change in the back office.”

With that technology, Indian firms can expand into similar markets. However, offshore outsourcing firms will need expertise from a lot of project and product managers who have been laid off by the financial services sector. “Indian companies need to pick up domain experience in the United States,” Aron says. “Companies in India need to acquire people and niche companies. It is a terrific time to do it because assets are undervalued.” He adds that Indian companies have typically looked to U.S. labor for help selling products, but they should hire expertise to develop new services during the economic downturn.

If Aron’s vision plays out, Indian outsourcing firms could move up-market in a way that uniquely benefits them. Chaudhuri says Wipro and other companies have tried to move upstream before with consulting services, but that move just put them in competition with Accenture and IBM. “Initially, these companies were trying to reach high-end markets by the consultant route with limited impact. Instead they are trying to engage of high-end activities like product development, legal outsourcing and R&D,” Chaudhuri says. “These companies are redefining the rules and offer more analytical-development-type work.”

Gans and Nichols say the need to adapt is critical given the intense competition. Both note that emerging countries such as the United Arab Emirates, Malaysia and Mexico are trying to offer technology outsourcing services similar to what Indian companies provide. Gartner, a technology research firm, cited at its recent Symposium ITxpo conference in Orlando, Fla., countries including the Czech Republic, the Philippines, Singapore and China as rivals to India. “As these companies reach a more mature life cycle, they have to take offshoring beyond just a cost-based thing,” Gans says.

For David Hsu, a management professor at Wharton, the big question is whether Indian technology firms can become big brands. Wipro, Infosys and others have moved in that direction and offer a suite of services. But perceptions are hard to shake. “How can India convert expertise in IT to add value? If they become multinational, it can allow them to capture more of the mark-ups,” Hsu says. But with that move upstream, Indian tech firms will increasingly compete against U.S. giants such as IBM and Hewlett-Packard’s EDS unit that have set up shop in India.

What remains to be seen is whether the Indian outsourcing players can thread the needle between competition with much larger rivals and upstarts that can undercut them on price. “You don’t go to India for lower-end services any more,” Chaudhuri says. “If you want expertise, you go to India, which is not the cheapest and not the most expensive either. It is risky to move up the value chain where you compete with IBM, EDS and Accenture, but Indian companies have no choice because they will be squeezed in the middle otherwise. You have to start pushing higher.”

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