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India's upstart IT-services firms face their own challenges from their giant rivals in the West.
Justin Wood, CFO Magazine
June 1, 2004
Eleven floors above the heat and noise of Mumbai's busy streets, Seturaman Mahalingam sits in the air-conditioned offices of Tata Consultancy Services (TCS) sipping tea. He looks relaxed, sanguine even, as he discusses his role as CFO of the biggest IT-services firm in India. Before long, he says, TCS will be among the biggest in the world.
Six hundred miles to the southeast, in an office campus outside Bangalore, Mohandas Pai, CFO of TCS's rival Infosys, is equally confident. He talks excitedly of growth, profitability, and overseas expansion.
So does Suresh Senapaty, finance director of nearby Wipro, which wildly exceeded analyst expectations in April by announcing a 43 percent increase in fourth-quarter net profits, and a 23 percent increase for the full fiscal year.
Who can blame them for their optimism? The accomplishments of India's rising IT stars are well known. "In 1994, we were a $10 million company. In 2004, we'll have revenues of more than $1 billion," says Pai. "We've grown 100 times larger in 10 years."
The records of most of India's other large IT-services firms, such as Satyam Computer Services and HCL Technologies, are equally impressive. Figures from India's National Association of Software and Services Companies (NASSCOM) show that the country's IT industry grew from $5 billion in 1997 to $16 billion in 2002.
That rosy picture plays nicely into Western fears of domination by India's IT firms. But scratch the surface of the industry, and one finds these companies facing challenges familiar to their U.S. counterparts; among them, currency fluctuations, wage inflation, and public grumbling over jobs moving offshore.
The biggest threat to Indian IT firms, though, is the threat of competition from such long-established IT and outsourcing consultancies as Accenture, IBM Global Services, and EDS. During the past 18 months, these behemoths have grown acutely aware of the threat posed by their Indian competitors, and are squaring off for a showdown. But any effort to pick a winner in the coming fight quickly reveals that the IT-outsourcing industry is far more complex — and global — than often suggested by the current U.S. political debate.
It wasn't until 1991 — when India began to liberalize its protected economy — that the IT industry really started to gather steam. Foreign businesses saw the potential of India's highly educated, English-speaking workforce and sent coding assignments there, where they could be handled for a fraction of their cost in the West.
At first, the work centered just on writing the proprietary software that companies used to automate internal processes. But as the Indian firms grew larger and honed their project-management skills, the assignments grew more complex.
Plummeting telecom costs during the 1990s made offshoring even cheaper, and soon Western businesses were relying on India not only for writing programs but also for installing such software packages as SAP, providing IT consulting, and even conducting research and development for new products.
Most recently, the Indian companies have added business process outsourcing (BPO) services to their menu of capabilities, and now handle all manner of back-office functions, from staffing customer call centers to analyzing tax returns. As Wipro's Senapaty explains: "We want to capture as much of the budget of our clients as possible."
The problem is that Wipro and its peers have done rather too well, according to Pramod Gupta, an analyst at ABN Amro Securities. While India's IT players have enjoyed compound annual growth rates of between 50 percent and 60 percent in the past decade, the IT-services industry itself has grown at a more sedate 5 percent to 6 percent. "The whole Indian IT-services story has been about taking market share," says Gupta.
At first, the big Western multinational IT-services providers didn't mind too much. After all, their Indian competitors were concentrating on relatively low-end, low-value work. During the past three or four years, however, India has moved upmarket into the core businesses of its Western rivals — areas such as designing the architecture of IT systems, and acting as IT and business consultants.
A Quiet Revolution
"It happened in a stealthy fashion," observes Jayant Sinha, a partner in the Delhi office of strategic-consulting firm McKinsey & Co. For a long time, he says, the likes of IBM, Accenture, and EDS ignored the Indian IT-services companies as "simply capturing the labor arbitrage between India and the West."
Then came the dot-com bust, and the Western firms suddenly could not afford to be so cavalier. "They took their eye off the ball, and when they looked up, the Indian companies were suddenly right behind them," says Sinha.
Today, he adds, "these [Indian] companies are really starting to inflict some hurt on the global multinationals." That may be an overstatement, given the disparity in revenues between Indian firms and their rivals (see chart, right), but it is true that in addition to snatching some customers, the Indian firms are inflicting huge pricing pressure on companies based in the United States and Europe. "What we do is very disruptive for the global majors," says Infosys's Pai, with a grin. "It's a disruptive business model."
Other commentators agree, for the Indian firms have done much more than simply harness cheap labor. In particular, they have developed a new generation of project-management skills that lets work be carried out from lots of locations in many different countries simultaneously. Core to this so-called global delivery model that links on-site engineers in the West with cheap labor in India is a heavy emphasis on quality standards.
Take TCS. The company currently has 26,000 engineers — more than any other company in the world — assessed at the highest level of Carnegie Mellon University's SEI-CMM scale, the industry benchmark for software quality. Other Indian companies are equally dedicated to SEI-CMM, as well as to such other quality standards as ISO and Six Sigma. The result is often not just a cheaper service in India, but a better and timelier one, too.
East vs. West
No longer wasting time in responding to the threat, Western businesses are now building or expanding their own cheap back-end operations in India and other low-cost locations.
Just look at EDS, the Plano, Texas-based IT-services firm with $22 billion in annual revenues. Speaking at a Lehman Brothers investor conference in March, CFO Bob Swan acknowledged the pricing pressures that EDS faces. "We need to take 20 percent out of our cost structure over the next three years...not in order to expand the operating margin but to improve our win rate for new business," he explained.
And how does EDS plan to cut costs? By ramping up its Best Shore strategy, whereby it locates workers in low-cost countries. Currently, EDS has 8,700 staffers in offshore centers — a quarter of them in India — but it plans to increase that number to 20,000 during the next 18 months.
Accenture, a $13.4 billiona-year rival to EDS, has a similar story. In December, it announced that it would be increasing its head count in India from 4,300 to 10,000 by the end of 2004.
Also in December, IBM announced that it would move 5,000 software development jobs from the United States to India this year. And in February, Bearing Point — formerly KPMG Consulting — revealed plans to hire 2,000 staff in India in the next two years.
The Sincerest Flattery
It's all very flattering for the Indian firms, but it's equally worrying. At Mphasis, CFO Ravi Ramu acknowledges the issue. "The fact that the global multinationals are coming to India certainly means that some, if not all, of our cost advantage will be whittled away," he concedes.
Nonetheless, Ramu remains confident that the global delivery model Indian firms have perfected gives them an advantage. "Offshore isn't just about hiring a bunch of guys, putting them in a room, and getting them to write code or answer phones," says Ramu. "It's a completely different way of working, of selling a service." That model, he reckons, will take the Western multinationals three or four years to master — a valuable window in which the Indian firms can grow and gain critical mass.
At Wipro, Senapaty is equally confident. "Because we developed our project-management skills and our commitment to quality while we were small, we've grown up with it," he says. "It's in our DNA."
But good DNA won't help with the appreciating rupee, an emerging headache. "A rising rupee would have a serious impact on profitability," admits Neeraj Bhargava, CEO of Mumbai-based WNS Global Services. "And there are certain scenarios that suggest the currency could rise a lot further."
Then there's the question of rising wages. The rapid growth of India's IT industry creates huge demands for new staff. Wipro hired 10,651 new employees in the six months leading up to December 2003, increasing its workforce by 65 percent.
Inevitably, such large-scale recruitment has led to rampant wage inflation for certain jobs, especially experienced project managers. NASSCOM reports that the average salary for an IT project manager rose 50 percent in 2003 from a year earlier.
Put it all together, says ABN Amro's Gupta, and "the cost advantage for Indian firms won't last long." He's calculated that the labor arbitrage between the United States and India has already fallen by 18 percent in the past two years.
To make matters worse, Indian firms have started putting pricing pressure on one another. At the low-value end of the market, a raft of second-tier companies has piled in, sending prices tumbling. Venu Reddy, research manager in the Asia Pacific for IDC, an IT market-research group, observes: "The traditional offering of Indian vendors — application development and maintenance — has become a commodity, and prices are falling."
The Grass Is Greener
It is in response to all these challenges that India's leading firms are desperately trying to move into the higher-value-added areas of IT services. For example, Infosys, Wipro, and TCS are starting to mix broad industry-consulting skills with IT in order to deliver "business outcomes" rather than just IT services.
The irony, of course, is that while Western firms rush to create a cheap offshore delivery capability, the Indian companies are racing to build a sophisticated front-end consultancy in the West.
Many industry watchers foresee tough times ahead for the Indian firms. The global majors have a worldwide presence capable of serving multinational clients, and plenty of resources. Revenues at IBM Global Services alone, for example, are $43 billion — almost three times the size of India's entire IT sector.
Just as important is the question of "domain expertise." In order to provide high-end consulting services, companies need a deep understanding of what makes particular industry sectors tick. Indian firms do not have this expertise — at least not yet. But gradually that's changing. Thanks to a policy of hiring away "rainmaker" consultants from Western rivals, the Indian companies are starting to develop the knowledge and contacts they need.
Many Indian firms also are hotly pursuing acquisition opportunities. In March 2003, TCS bought Aviation Software Development Consultancy from Singapore Airlines to further its penetration in the transport sector. In June 2002, Wipro bought U.S.-based NerveWire, a consultancy serving banks and insurance companies.
Partnerships are another way of gaining much-needed knowledge, such as Infotech Enterprises's five-year relationship with U.S. jet-engine maker Pratt & Whitney, which is helping the company develop skills for the aerospace sector.
Indian firms are also expanding geographically. In December, for example, Infosys bought Expert Information Systems, one of Australia's leading IT-services providers. It also announced plans to set up a 200-seat software-development center in Shanghai.
Clearly, the Indian vendors are moving in the right direction, but Gupta suggests the pace may be too slow. "The progress on anticipated growth drivers — that is, domain expertise, services breadth, and geographical diversification — remains less than satisfactory for most," he says.
Pooja Narayanan, an analyst at BK Securities in Mumbai, highlights another problem. "These companies will need to fight the perception that India and Indian firms are only good for low-end, low-value, low-risk jobs," she warns. "Brand-building will be central to that effort."
Chief Fighting Officer
Inevitably, the CFOs of the Indian firms will play a crucial role as their companies face increasing competition from Western multinationals. Of central importance will be the need to pay close attention to operating margins. Traditionally, many firms have enjoyed margins of as high as 35 percent, not to mention enviable return-on-capital figures — Infosys's was more than 50 percent last year — but that looks set to change.
That's partially because prices at the low-value end of the IT-services market are being squeezed tight, thanks to stiffening competition within India. But as such companies as Infosys, Wipro, and TCS move into higher-value services, they also will need to invest heavily in building new capabilities — a fact that will add further margin pressure.
At TCS, Mahalingam acknowledges that growing margin pressure. "A big part of the game will be about efficiency," he says. "It's vital to work out the optimum utilization rate for the people in your organization so that you have the maximum number working as a billable resource without ignoring the need to train staff and build for the future." He says his target is to have 78 percent of all staff working on billable assignments at any one time.
Just as important, adds Mahalingam, is the need to drive out cost and continually improve TCS's project skills and internal processes. To that end, of the 22 percent of staff who are not working for clients, a good number are employed building software tools that TCS uses internally to operate faster and more effectively.
Equally, Mahalingam oversees a program of activity-based costing that examines every project TCS undertakes to see where money is spent and where it could be saved.
Ultimately, increasing margin pressure creates something of a paradox for the CFOs at these Indian firms, argues McKinsey's Sinha. "There is a weight of expectation around existing margins from investors," he says. "And yet it will be difficult for the Indian vendors to make the necessary investments to survive without diluting those margins." As such, with CFOs typically managing not only the investment-appraisal process but also merger-and-acquisition work and investor relations, the next few years will be tougher than any yet experienced.
Justin Wood is managing editor of CFO Asia, based in Singapore.
How West and East stack up in terms of revenue.
|Western Firms (in US$ millions)|
|IBM Global Services||$42,600|
|Cap Gemini Ernst & Young||7,100|
|Indian Firms (in US$ millions)|
|Tata Consultancy Services||$1,350*|
|Satyam Computer Services||566|
|Patni Computer Services||251|
|WNS Global Services||$85|
|All figures are for the latest full financial year. Figures for IBM, Hewlett-Packard, Infosys, and Wipro include only the IT-services divisions of those companies. *CFO estimate|
Sources: Company reports
|Passages to India|
|Company||Total Manpower||India Manpower||Plans for India Office|
|Accenture||83,000||4,500||10,000 workers by 12/04|
|Bearing Point||15,300||NA||2,000 employees in 2 years|
|Cap Gemini||52,000||1,300||2,000 employees by 12/04|
|Cognizant||9,500||6,000||Growing in line with Indian companies|
|Covansys||4,500||2,000||Expanding Indian center|
|CSC||92,000||1,500||Aggressively expanding Indian center|
|EDS||138,000||1,000||2,500 workers in 8 months|
|HP (incl. Digital)||142,000||10,000||Aggressively expanding Indian center|
|IBM Global Services||150,000||5,000||10,000 employees in the next 2 years|
|Keane||7,600||1,000||Expanding India center|
|LogicaCMG||21,000||700||1,200 workers by 6/04|
|Oracle||40,000||3,000||Expanding Indian center|
|Perot Systems||14,000||3,500||7,000 employees in 1 year|
|SAP||25,000||1,200||Plans to grow Indian center|
|Sun Microsystems||35,000||800||Plans to grow India center|
|Syntel||3,500||2,000||Growing in line with Indian companies|
|Xansa||7,700||1,400||4,500 employees by 3/05|
|Source: ABN Amro|