DQ Top 20: Exports - Tough Times, Tougher Men

Chop Shop: An American slang for an illegal business primarily dealing in
stolen goods

Senator Charles Schumers description of Infosys as a chop shop has
justifiably raised the hackles amongst business communities in both the
countries. After all, American outsourcers as well as Indian IT service
providers both understand the compulsion of offshore outsourcing to India, more
so in the aftermath of the recession. Today, its much beyond the benefits of
cost arbitragerather, its an issue of not just better quality, but improving
productivity and ironically adopting global best practices that determine most
of these relationships.

The context of Schumers uncalled for diatribe against Infosys and its ilk
came during the passage of a bill in the US Congress to raise revenues for
broader border security by taxing mostly Indian companies that were investing
heavily in the US. The bill is scheduled to be financed through a visa fee hike
of $2,000 to $2,500 for firms having a higher proportion of non-American
workers. Even as associations like Nasscom and USIBC strongly criticize the
draconian measures that tar-brushes Indian IT majors as chop shops and link
India to border security with Mexico, there is a strong feeling of deja vu
behind the whole episide.

Starting from 2004 when John Kerry ran the presidential campaign against
George Bush Jr, it has been the favorite pastime of American politicians to
virulently criticize Indian IT services exports companies. The motive is simple
and straightforward: to pander to the sentiments of a local constituency that
has come under severe job pressure. Schumers case is no different as elections
to the US Houses are pending in the near future. In isolated cases, some of the
states have followed up with legislations seeking to curb offshoring to India,
but mostly these measures will fizzle out under the pressures of market
economics and once the elections are over.

So, even though India might feel (and rightly so) indignant about the unfair
border security bill and worse being labeled as a chop shop, the Indian IT
services exports industry should not lose sleep over the Schumer aftermath.
Considering what this industry had to bear and survive in the last five years,
the latest controversy would appear like a teddy bears picnic. Right from a
series of similar populist anti-India offshoring calls to Obamas definite
anti-outsourcing posture to the worst economic recession in nearly a century;
from the terrible credibility crisis following the Satyam scam to the
topsy-turvy world of currency fluctuations, the Indian IT services exports
industry has seen it all in the second half of this centurys first decade. What
an industry often learns over a generation, this industry has assimilated and
inculcated in these five years only.

Recession Followed Currency Googly

Nothing illustrates better the impact of the wild currency fluctuations in
the last few years than the growth patterns shown by the Indian IT services
exports industry (in both rupees and dollar terms). The last normal year was
FY07 when the relatively stable currencies meant at par rupee and dollar growths
at 40% and 37% respectively. The two subsequent years saw first the rupee
appreciating strongly against the dollar and then in a 180 degree turnaround, it
was the dollars turn to appreciate strongly against the rupee. Result: while
the sector recorded 26% growth in rupee terms both in FY08 and FY09, the dollar
growth swung from 40% to 10% over twelve months. Intense currency hedging by
most players in the industry took its tollHCL Technologies who hedged over a
billion dollar was still writing off its losses in FY10.

Nevertheless, the resilience of the sector shone through as it survived the
currency swing and was eagerly waiting for normalcy to resume in FY10 on the
currency front. That did ultimately happen as after a strong round of
appreciation, the dollar did stabilize against the rupee. Unfortunately, it
coincided with the worst economic recession in living memory in the US, still a
predominant market for Indian IT services exports, and its global repercussions;
so though the rupee (5%) and dollar (3%) growths were again at par (after FY07),
measly rates took away much of the sheen. Translated into actual numbers, the IT
services exports market grew from Rs 1,67,533 crore in FY09 to Rs 1,76,321 crore
in FY10; or for a more global audience from $36.05 bn to $37.05 bn.

Even individually, it was not the best year for the top three exporters. TCS,
Infosys and Wipro grew by only 2%, 5% and 3% respectively; in fact, the pride of
the Top 5 (or the WITCH club) was somehow restored by the good showing from
Cognizant (22%) and HCL Technologies (25%). These were, however, aberrations as
the Top 20 exporters grew by only 6% in FY10 as against 19% in FY09 or 24% in
FY08. These numbers reiterate that the recession did impact even the elite of
the IT services exporters; from the big three to even the leading tier-2
players, no one escaped the brunt of the slowdown. In fact, barring the two
aberrations, it was only MphasiS which registered a double digit growth in the
Top 20 exporters club (and that too was influenced more by its HP lineage);
while six of them witnessed decline in revenues, the remaining were either flat
or recorded marginal growth.

But, numbers can only tell this much of the story. It can never capture the
resilience shown by these Indian IT service providers, notwithstanding the
recessionary challenges. Indian IT services exports in FY10 was ultimately not
for statisticians (whose only solace is in analyzing numbers), but for
tacticians (who adopt measures that ensure margins in a slow economy even when
toplines suffer). Increasing both the offshore component as well as the
fixed-price fixed-time contracts were two obvious measures adopted by most
companies. It was not only TCS growing offshore from 44% to 51% or Wipro from
47% to 50%, but even tier-2 players like L&T Infotech who increased it by ten
points to 85%. Not surprisingly, this ultimately led to the situation that
invited the wrath of Schumer and his ilk, especially when unemployment was at an
all-time high in the US throughout the year. Increasing fixed price contracts
also to a large extent insulated IT service providers from any short-to-midterm
impact of business reversal for outsourcers. TCS revenues from fixed price deals
was at 48% (up from 45%), Wipro raised it to 41.5% from 34%, while Infosys
increased it to 41% from 38%. The utilization rates too were up by six points.

While these measures minimized the damages to the operating margins, it would
be naive to assume that Indian exporters survived only by squeezing the maximum
out of whatever resources were available. Numbers which otherwise have remained
constant for years assume different connotations in FY10. Even amidst
recessionary challenges, Indian players proved their growing mettle as the
contribution of routine ADM work came down by a point, while testing and other
auxilliary service offerings gained. Some like Cognizant gained by acquiring the
French IT testing firmGalileo Performance, while the likes of Persistent
expanded organically by expanding offerings on other platforms.

Finally in FY10, Indian IT service offerings have evolved from ADM to emerge
as full service players providing testing services, infrastructure services,
consulting and system integration. Within that, IT outsourcing exhibited a
strong growth, in line with the global trend, driven by an increased spend in
remote infrastructure management, application management, testing and SOA
segments. Further, cloud computing took center stage this year as it offered
clients access to best-in-class process management at reduced capital
expenditure levels.

True, the proportion of consulting work or infrastructure management and
managed services went down as enterprises drastically reduced their
discretionary spending (though deals like CSC-Zurich Financial Services or HCLT-Equitable
Life even bucked that trend), but what more than made up for that was the
product development contribution going up by two points. And, this was not just
Infosys launching its Flypp mobile platform; for companies like Polaris and 3i
Infotech, products contributed 23% and 32% of their revenues respectively.

But what comes up in contrast to popular perception was that revenue
contribution from North America (the US) and BFSI showed no declinein fact, the
US contribution gained by a point. While that reiterated that America needed
Indian IT services players to help them negotiate the downturn, it in turn is a
backhand compliment that makes Schumer and his friends appear ridiculous.
Geographical status quo in FY10 was another endorsement of the standing Indian
IT service providers have built up in the developed world. Though TCS revenues
dipped from 19% to 16% from the UK, the overall European contribution for at
least the biggies remained stable. The only criticism that could be extended is
that expansion in emerging geographies never took place, though the slowdown
would have definitely impacted that.

Worse, though BFSI still accounted for 35% of their revenues, the IT services
biggies looked at alternate sectors to keep themselves in the black. Deals like
Cognizant-Sanofi Pasteur or HCLTReaders Digest ensured that both healthcare &
life sciences and media grew by more than three points. The worst victim of the
recession remained manufacturing (down by five points), despite a number of
players looking to expand their offerings there. Accentures deals with
Electrolux, BMW, Wartsila and VELUX illustrate this better.

The Software Captives

While the Indian IT services players enjoyed the lions share of the exports
pie, there were over 900 MNC captives in India accounting for over $10 bn. But
excluding BPO players, the top 20 of these accounted for only $1.89 bn. This
showed how scattered this market is; not surprising, since basically this
involves R&D centers of most of the global technology companies. The list
includes giants like HP, Oracle, Intel, Google to the likes of Tyco, Juniper and
Red Hat. The fact that for many of them like Microsoft, SAP, EMC their India
centers becoming either the first or second largest outside the US is an
endorsement of the quality of workforce involved. And, while even these R&D
centers were impacted during the slowdown, many continued recruiting even in
FY10; and subsequently in FY10, the top 20 captives grew faster than the overall
top 20 exporters.

Keeping with their low spend strategy in FY10, most technology vendors
reduced the spend on their mature products and instead focused on new products
for both the US and emerging markets. Most software companies looked at
maximizing RoI from their software products, while extending the output from
their R&D teams on new products. Unfortunately, still over 80% of the total
software R&D spend in FY10 went towards activities to support products that were
in a maintenance mode. Yet margins on new products were significantly higher
than on maintenance contracts. This presented two major challenges to software
product companiesfreeing up resources to work on new products and maintaining
margins for legacy products. To meet these challenges, many of these software
companies outsourced low-end R&D work like QA/testing related to mature products
to the centers in India.

A recent Zinnov study shows that the cost of running R&D centers in India has
continued to decline over the last two years and currently stands at $38,199 per
person per year. That translates into a 4% decline in dollar terms in FY10 only.
The decline was primarily driven by strict budgetary constraints by MNC R&D
centers in the form of minimal or no salary increments, focus on variable pay,
freeze on hiring and cost optimization across infrastructure, travel and
communication. R&D centers in India have generated significant cost savings for
the headquarters because of lower operating costs over the years. In a
conservative estimate highlighted in the study, R&D centers in India have helped
parent organizations save a cumulative of $40 bn for the last three years. The
study also forecasts an expected inflation in costs in FY11 with companies
planning around 10% salary hike, hiring laterals, escalation in rents and
opening up of travel. However, the report also reads that in the long term
scenario, costs are expected to go up only by 6.7% CAGR through FY20. These
conclusions prove that Indian software exports is not just the story of Infosys
and Wipro, but also includes the likes of Intel and EMC R&D centers.

Hunt for the Elusive Tier-2

Even within the Indian IT services players, the limelight mostly stays on
the Big Five; sometimes like in FY10, a few like Tech Mahindra or Patni too had
their own share of media attention, but that was more due to the formers
acquisition of Satyam or the intercenine feud between promoters of the latter.
Unlike, Infy, Wipro or even HCL who were often referred to by analysts to
explain the FY10 situation, there was little focus on the other players during
FY10. The problem has been that though the IT services sector has matured, a
viable potentially strong tier-2 has never emerged. Though till now companies
created news in isolation, the recessionary challenges of FY10 threw up hints
about some possible strong tier-2 contenders.

While the likes of Tech Mahindra or MphasiS (though now part of HP) have
always been close to the Big Five, what has been disappointing has been a set of
companies who started quite early with the Infys and Wipros have not been able
to keep up the pace. They have not even fulfilled their promise to emerge as
strong contenders for the tier-2 category. And ironically, when the recession
hit with all its fury in FY10, these were the companies which seemed to have
taken the maximum brunt. The likes of Hexaware (14% decline), Mastek (22%), NIIT
Technologies (7%), Mascon Global (1%) and Patni (1%) came within this category.

Dataquest, on the other hand, would bet on a few genuine tier-2 contenders
emerging during FY10. The likes of MindTree, L&T Infotech, Syntel and 3i
Infotech would come under this category. None of them were insular from the
impact of recession on their toplines (it went down 8% for 3i Infotech, while it
grew in single digits for the other three), but these companies managed to
maintain a healthy bottomline. More importantly, they were at par with the WITCH
club on various operational metrices like increasing fixed price contracts,
reducing SG&A expenses and increasing the offshore component.

Rajneesh De

rajneeshd@cybermedia.co.in