IT Services Exports : From SWITCH to TWITCH

Lets have a quick quiz, more of the cerebral kind like BBC Mastermind,
rather than the popular KBC. What was common to Barack Obama, Richard S Fuld Jr,
Ramalinga Raju, Pope Benedict XVI and P Chidambaram, particularly in 2008-09?
The answer is they were all movers and shakers of the Indian IT services (and
BPO) exports sector which significantly altered its destiny in FY 09. Most of
them perpetrated a chain of events that had much longer lasting and deeper
implications for the Indian software services industry in the global
perspective.

Obama gave an official sanction to anti-outsourcing with his stringent stance
(I would want more jobs in Buffalo than Bengaluru); Fuld Jr was the Lehman
Brothers CEO when they declared bankruptcy in October 08 (more than anything,
Lehman going down signified that the US slowdown would seriously impact Indian
IT services firms considering their US BFSI exposure); Ramalinga Raju and his
misdemeanors at Satyam are too well-documented (with most agreeing that the full
extent of the scam is yet to be revealed); Pope Benedict XVI in his encyclical
generally supported globalization but criticized western companies that
outsourced business to developing countries; and Chidambaram was the finance
minister for most of the period (till 26/11) and he presided over most of the
rupee depreciation against the dollar (probably the most significant impact on
the sector).

CyberMedia Research    DQ Estimates

The currency fluctuations have led to average growth for the sector over the last two years; but then which other sector can boast of 26% growth in a year of global recession? Exports still remained the mainstay in Indian ITs contribution to the countrys GDP. More heartening to see was the increasing secularization of the sector, as the contribution of the Top20 dipped by four points

In rupee terms (thats what DQ Top20 is all about), the IT services exports
market grew 26.1% in FY 09; not bad in a global recessionary economy. And
particularly considering its dependence on the US, where economists have
certified this as a worse financial crisis than the Great Depression of the 30s.
It looks even better compared to FY 08, when even in the face of strong
appreciation of the rupee against the dollar, the market had grown only by
25.7%. So, even in status quo, in growth terms, the Indian IT services exports
market was not in such a desperate state as predicted by many doomsayers. But,
yes, the nearly 40% growth in FY 07, which has been hovering in the mid-20s for
the past two consecutive years, would officially result in the labeling of this
sector as having been impacted by the slowdown.

The S-word assumes more menacing proportions when viewed in dollar termshere
the situation has been absolutely reversed from FY 08. While dollar
depreciation meant a 40.2% growth in dollar terms, it has come down to only 9.6%
in FY 09. The fickle dollar rupee relation (worse than between two sparring
partners) had played havoc with numbers and analyses of the Indian IT services
exports for two years running. Its true that most IT vendors take a middle path
between these wild fluctuations, as part of their currency adjusted revenue
schemes, but even then the verdict does not differ. Indian IT Services has been
affected by the slowdownits not just a general statement, but well
substantiated by numbers.

CyberMedia Research    DQ Estimates

The turns and twists in the graph show the wildly fluctuating currency exchange in the last two years; it obviously swung the fortunes of Indian IT services exporters too quite drastically from FY 08 to FY 09. The dollar growth dropped from 39.6% in FY 08 to 9.6% in FY09it was the year for most Indian IT services exporters to consolidate their bootomlines

After recording a stupendous growth in the first half of 2008-09, the second
half performance for the IT services exports sector was impacted by the global
economic downturn. Additional headwinds included cross-currency fluctuations,
terror attacks, issues on corporate governance (in the aftermath of the Satyam
incident), the US elections, and then Obamas policies. However, most of the
adverse impact was in dollar termsthe moment one looks into the picture with
rupee-tinted glasses, the picture looks rosy. That after all was the ultimate
paradox of the Indian IT services exports sector in FY 09.

The Dollar Paradox

In FY 08, in a bullish global economy, the Indian IT services export
players grew much slower (25.7%) than previous yearsthe strong appreciation of
the rupee against the dollar was identified as the reason. Now in FY 09, even
against the backdrop of a global recession with the US slowdown assuming serious
proportions, the IT services managed to hold on to the same growth rate (26.1%)
in rupee terms. That in itself is a moral victory. But in business, the value of
a moral victory is as good as nothing. Its the strongly appreciating dollar
against the rupee that explains this apparent paradox. Its the cross-currency
fluctuationdollars appreciation against the pound and eurothat has shaved-off
nearly 2.2% growth from the export growth figures, in dollar terms.

For the biggies like Wipro and Infosys to the tier-2 players like MphasiS,
Prithvi and Aricent, the dollar appreciation against the rupee came as a
godsend. While in FY 08, the strong showing of the rupee had led to a
significant slowdown in their growth figures, the tables have been reversed this
time (albeit taking into consideration rupee figures). Dollar growth has been
relatively subdued, but the moment one considers rupee growth, the figures look
much healthier. Lets take Infy as an example: the bellwether of Indian IT
servicesin dollar terms it grew 11%, while in rupee terms that translated to
31%.

Yes, we did have some exceptions: TCS at 22% could have done better, but it
suffered primarily due to forward hedging. Tech Mahindra at 15% (the price of
focusing in one vertical, primarily in one geography) or tier-2 players like
Hexaware (high exposure to BFSI) and SISL (selling off to parent and becoming a
captive) had rupee growths that were ordinary, to say the least. On the other
hand, its not just Wipro and Infosys or MphasiS whose rupee growths looked
quite spectacular in a challenging year, but a host of relatively unfancied
tier-2 players like Birlasoft (62%) or Mindtree (67%) too tasted significant
success.

Much Ado About Something

Even as the rupee depreciation against the dollar brought smiles on the
faces of Indian software exporters despite the slowdown, the threat came from a
highly unlikely quarterthe expected-to-be liberal regime of Barack Obama. As
Obama completed his first few months of presidency, some of his policy
announcements started creating ripples for the Indian software export
sectorphrases like protecting American jobs, Buy American, tax
multinationals who move jobs offshore and level global playing field started
giving jitters. For the Indian players, the phrases were no music, but sounded
more like impending doom.

However, the general impression that Obamas policies would sound the death
knell for offshoring, particularly to India, looks to be mere media hype,
besides a bit of obvious public posturing by the US president to boost local
morale during the recession. True, the Tax Haven Abuse Act, 2009 initially
threatened to regulate US outsourcing, but most analysts felt that its impact on
the long run would be negligible. Also, the different International Trade
Policies ensured that offshoring discrimination was very unlikely to happen.

CyberMedia Research    DQ Estimates

One would wonder what all the fuss is about the slowdown impacting offshoring to India. Contribution from the US (North America) rather rose by one point, contrary to popular perception that recession, high-profile bankruptcies and Obamas anti-outsourcing tirade would create a roadblock for the US offshoring to India. Japan still remains a missed opportunity for Indian IT service providers (though Japan was in the doldrums this year); newer territories like Latin America, the Middle East and APAC need to be tapped better for having a more de-risked model

The core elements of WTO, NAFTA, and other free trade agreements were still
standing. The buy American policy was applicable only to steel and
construction material, at least as of now. None of the policies, even those
which may have sounded protectionist, contravened any of the WTO regulations,
hence not impacting IT services. More serious could have been the impact of
Regulation of the US Workplace.

The current framework allowed easier unionization and equal access to
employees for the unionization process. The union contracts stipulated the
extent of outsourcing permitted and to that extent, in some industries, there
was an apprehension that this would have a bearing on how much work gets
outsourced. Institutions that received a portion of the bailout money were also
prohibited from hiring H1B workers. This also could have had an impact on staff
augmentation companies in the IT sector and that in turn impacted Indian IT
services companies. There could also have been stipulations on employment of
foreign nationals by US companies. However, there were no new labor protections
under NAFTA and till now most of these apprehensions have turned out to be
unfounded or at best premature. And with the first signs of the US economy
recovery emerging, the whole issue might lose relevance soon.

Indias Still the Right Choice

Despite some of these real and perceived backlashes, India continued to be
the most preferred destination for companies looking to offshore their IT and
back office functions, according to AT Kearney. And despite growing salaries in
India and concerns about manpower, India also retained its low-cost advantage
and was among the most financially attractive locations when viewed in
combination with the business environment it offers and the availability of
skilled people.

India retained its numero uno position even as some other well-established
outsourcing hubs dropped in their attractiveness to be replaced by new emerging
destinations in the survey, which implies lesser competition for India in the
short run. While India, China and Malaysia remained the top three destinations,
previously popular East European destinations like Poland, Czech Republic and
Hungary lost out, getting replaced by the likes of Vietnam, Jordan, Tunisia and
Morocco. The growing recessionary trends ensured that smaller tier-2 US cities
like San Antonio (in Texas) also emerged as important outsourcing destinations.

Understanding the Outsourcing Paradigm

CyberMedia Research    DQ Estimates

The evolving maturity of Indian IT service providers is best exemplified by the five point drop in ADM revenues and the subsequent three point rise in contribution from infrastructure outsourcing and managed services. While growing contribution from newer areas like engineering services, testing services were welcome news, its sad to see that product development is still not in the priority list of Indian IT service providers

Six Indian cities were also among the top eight outsourcing centers
worldwide, according to the Global Services study. Titled Top 8 Global
Outsourcing Cities, the study concluded that Bengaluru, Chennai, Delhi and NCR,
Hyderabad, Mumbai and Pune, besides Dublin in Ireland and Makati City in the
Philippines formed the top eight global outsourcing cities. India also had
Kolkata, Chandigarh, Coimbatore and Jaipur among the Top 50 Emerging Global
Outsourcing cities. No wonder, large IT services players like Wipro, Cognizant
or TCS kept adding manpower in their Kolkata centers during FY 09.

The maturing of some key trends in FY 09 reinforced Indias status as the
premier offshoring destination. Outcome based pricing models gained mainstream
acceptance following some of the large deals signed during FY 09TCS-Boeing,
Wipro-Origin Energy and HCL Tech-Nokiawere some of the examples. Under this,
the complete processes, technology and the supporting infrastructure were being
priced under a single scheme with unified SLAs. Bundling of processes along with
the appropriate applications and with a single provider being asked to provide
integrated solutions has led to many companies proposing platform-based
solutions, SaaS models, etc, for delivery. More innovative was Patni launching
CaaS (claims as a service) as another service line.

Geographical Status Quo

The geographical contribution for Indias Top 8 IT services players (that
would be fairly representative of the whole industry) hardly changed in FY 09.
This was again contrary to popular perceptionthe continuing recession in the
US, high-profile bankruptcies like Lehman Brothers, Chrysler (few of the large
outsourcers to India) and World Bank denouncing few of the Indian players post-Satyam
had given the impression that US contribution to Indias IT services exports pie
would come down. On the contrary, in FY 09, this proportion from the US went up
by one point (from 61% to 62%). Correspondingly, Europe went down by one point
(31% to 30%).

CyberMedia Research                                                                                                       DQ Estimates

Mindteck, Rolta, ACS India, Bartronics and Core Projects & Technologies recorded three-digit growth; signs of increasing secularization of Indian IT services exports. It were mostly the India captives who showed a decline, proving that the US companies were worse hit than their Indian counterparts

This proved two points: one, the quantum of outsourcing from the US to India
has reached such a magnitude that slowdown or not, there is little chance of it
getting impacted; two, even if some organizations stop or reduce their offshore
outsourcing work to Indian firms, there are several more waiting in the wings to
more than offset the losses. In fact, the slight loss in Europe had more to do
with the worsening economic situation in the UKIndian IT services firms have
not been able to tackle mainland Europe to the extent expected. And the double
currency fluctuations (dollar-euro-rupee) has acted as a double whammy for many,
especially for those like Capgemini India.

It was true that emerging geographies like the Asia Pacific, Middle
East/Africa and Latin America started contributingTCS had 5% revenues from
Latin America, Infosys and Wipro had 9% and 8% revenues from Middle East/Africa
respectively. But for Indian IT services players it was still a US showin fact
vendors like Tech Mahindra, who was primarily focused on Europe, increased its
US contribution by six points (from 19% to 25%) during FY 09. Historically,
Indian IT service providers had always missed out on JapanFY 09 was no
exception, though the economic doldrums in Japan were also responsible for this.
Vendors like HCL Tech (15% to 13%), Wipro (3% to 2%) and Patni (1% to 0.10%) had
shrinking fortunes from Japan.

Identifying Key Outsourcing Areas

One positive fallout of the challenges of FY 09 has been the maturing of
Indian IT service players. Nothing illustrates this better than the fact that
ADM contribution to the overall pie was 46% in FY 09this used to be in the
mid-60s just a couple of years back. And for the top four players, this
contribution was even lesserTCS at 38%, Infosys at 42.4%, Wipro at 41% and HCL
Tech at 33% proved that Indian IT services exporters were truly evolving. And in
a tough environment, they had to look at more innovative ways beyond the obvious
to sustain themselves.

While ADM was still the meat and drink for most tier-2 players (like MphasiS
at 56% or Patni at 64%), there was increasing traction in areas like RIM,
software products, testing services and engineering services. Continued growth
across software product development and engineering services, reflected Indias
increasing role in global technology IP creation. Export revenues from these
relatively high value added services such as engineering and R&D, offshore
product development and made-in-India software products grew at 15%.

Infrastructure outsourcing and managed services was one key growth areafor
vendors like Wipro, HCL Tech and even Mphasis, it contributed a healthy 20%, 16%
and 18.6% to their toplines. Infosys, on the other hand, scored high at 24.9% on
IT consulting and packaged implementationunfortunately packaged software
product development was still accorded lower priority. Infosys at 3.9% and TCS
at 2% are ample proof of this sentiment. Adding capabilities through a major
acquisition could often change the equation this was best illustrated by HCL
Tech whose Axon acquisition made them one of the largest SAP deployers in the
world, and subsequently enterprise application services accounted for 15% of its
topline in FY 09.

The delayed decision making across all industries, coupled with the tight
capital market and credit squeeze that forced companies to either cancel or
delay their discretionary spending, led to delays in IT outsourcing decisions,
especially in Q3 and Q4 09. However, a particularly spectacular H1 (Infosys had
its best Q2 in history) ensured that the overall annual figures did not record a
sharp decline. Especially BFSI in North America, where the Indian software
exporters, at least initially, faced some heat in Q3 09.

BFSI, at 33%, in fact still remained the top vertical for Indian firmsfor
the likes of TCS (44%), Infosys (33.9%), Cognizant (45%), Patni (38%) and
Mphasis (50%), it remained the lifeline. Manufacturing (17%) was definitely hit,
ceding ground to telecom (22%) that remained fairly insulated from the slowdown
impact. One could argue though that telecoms share is unnaturally pulled up by
Tech Mahindra (97%); on the other hand, vendors like HCL Tech (30%) and Patni
(25%) still profited from manufacturing, thanks to their evolved engineering
services and product engineering offerings.

A New Avatar

India was proud that the global offshoring lexicon prominently used the term
SWITCH to denote the top six Indian IT service exportersSatyam, Wipro, Infosys,
TCS, Cognizant and HCL Tech. In one stroke, Byrraju Ramalinga Raju and his
cohorts turned SWITCH to WITCH (the demise of Satyam to be re-born in another
avatar), and ensured that the world embark on a witch-hunting spree against the
Indian IT services companies. It was, obviously, more than just the misdemeanors
of a single personinitial reactions across the world snowballed into a general
lack of client confidence in Indian IT services providers. Particularly with the
news of World Bank banning Wipro and Megasoft emanating at the same time, the
confidence was fast ebbing.

That also coincided with perhaps the most difficult time of the slowdown.
There was a strong possibility that investor confidence in Indian companies
would take a beating. At least in the immediate term, every provider was
scrutinized a lot more closely. Partly as a result of this closer scrutiny,
general industry image and credibility was maintained, although international
competition initially felt encouraged. Even as more skeletons came tumbling out
of the Raju cupboard, analysts worldwide were busy penning the epitaph of the
Indian IT services export sector.

That things did not take such a turn for the worse was largely the handiwork
of the much maligned Indian government. The haste with which the Ministry of
Company Affairs formed a governing board for Satyam (with men of impeccable
reputation like Kiran Karnik, Deepak Parekh and Achuta Menon at the helm) was
laudable. They did everything conceivable to clean up the Augean stables at
Satyam (which given the magnitude of the fraud was indeed a Herculean task), and
more importantly, ensured that confidence in the Indian IT services industry was
restored globally.

They also made sure that Satyam did not just go into oblivion; rather after a
very transparent bidding process it got a new parentTech Mahindra. The company
which had proved its mettle till now only in the telecom sector, was catapulted
into the top league of Indian IT services echelonsSWITCH would now become
TWITCH (Tech Mahindra Satyam); hopefully, this will ensure that Indian software
exporters keep twitching on for a much longer time.

CyberMedia Research                                                                                                       DQ Estimates

As expected in a slowdown year, the number of acquisitions came down; however, HCLTs acquisition of Axon was the biggest in the history of Indian IT services till date. Though many rued missing out a cut-throat corporate bidding war between HCLT and Infosys over Axon. Inorganic growth proved beneficial for smaller companies like Mascon Global, MindTree, ITC Infotech, and Infotech Enterprises. Though smaller than the HCL-Axon deal in size, the most high profile would obviously be Tech Mahindras takeover of the beleagured Satyam

True, there are considerable challenges that Tech Mahindra faced in the form
of taking over a potentially lower-margin business and taking in a headcount (Satyam)
that may not be proportionate to revenues, in the immediate future. The
synergies that are apparent are an access to a diverse set of verticals, a set
of top-notch existing clients (helping reduce reliance on BT, which currently at
57% dependence has remained Tech Mahindras achillees heel for years now),
greater access to US-based clients, and a strong workforce. Only time will tell
the full impact of the Satyam crisis on Tech Mahindra and the overall IT
services industrybut as of now in FY 09, the immediate crisis is definitely
averted.

The M&A Report Card

There are two schools of thought about M&A in an economically challenged
yearone would believe that most players would desist from too much of such
activities due to the financial pressures of the market; the second school of
thought felt that this was an opportunity when most potential acquisitions would
come cheap. The Indian IT services market sort of adopted a middle path in FY
09; the highlight of the year would have to be Tech Mahindras $576 mn
acquisition of the beleaguered Satyam. However, nothing created much more
excitement than the prospect of a bidding war (that never happened) between HCL
Tech and Infosys over Axon. It turned out to be a battle that was not.

Those who expected a similar bidding war between CSN and Tata Steel for Corus,
were severely disappointed. Infosys who had initially offered to buy out
UK-based SAP consultant Axon for 407 mn, decided against raising the offer
value, even after the UK firm accepted a competing bid from HCL Tech which
offered a 8.3% premium, valuing the company at 441 mn or $658 mn. This was the
biggest takeover in the history of Indian IT, overtaking Wipros Infocrossing
acquisition ($548 mn) in FY 08. The acquisition of Axon shifted the balance of
power in the world of SAP consulting, giving HCLT access to 60% more SAP
consultants than its nearest Indian rival, Satyam (before its troubles began).
The impact was already visible when OND became the biggest ever quarter in
HCLTs history (deals crossing $1 bn) in terms of booking.

Its still early to analyze the effects of Tech Mahindras acquisition of the
tainted Satyam. There was no overlap between the two in terms of domain spread
and customers; while Tech M is strong in the OSS/BSS space, Satyams strength in
the ERP and BI space was well known. As of now, Satyam has been given the new
trust-worthy name of Mahindra Satyam, and it would function as a group
company. It might however be integrated into Tech Mahindra at a later date,
though that would be a different story.

Rajneesh De

rajneeshd@cybermedia.co.in