SOFTWARE EXPORTS: The Juggernaut Slows Down

Now is the winter of our discontent"

William Shakespeare, in King Richard III

For software exporters, financial year 2001-2002 was a long winter. A year of
Murphy’s law–if one might mix metaphors a little–in which everything that
could go wrong, did. When recovery and hope always seemed just around the
corner, but somehow weren’t. It was a year that began badly and then proceeded
to deteriorate steadily. In April, the affects of the slowdown were already in
full bloom. By September, the industry believed it had beaten that with tighter
belts and mass layoffs. But then came–of all things–the plane rammings into
the World Trade Center towers and the US ‘War of Terror at India’s doorstep.

When the industry began to pick up those pieces came the attack on the Indian
Parliament. As exporters were shrugging that off, came the standoff between
India and Pakistan, with some nuclear brinkmanship thrown in. If this were a
movie script, the producer would have thrown it out of the window for
over-dramatization. But it wasn’t, and the figures show it. For the first time
in history, four of the Top 20 software exporters showed negative growth rates.
Compared to 13 the year before, only one company grew over 50% (Digital
GlobalSoft). None grew over 100%, compared to five in FY 2000-01. Despite this,
the Top 20 exporters contributed to 62.7% of overall exports–an increasing
share of total growth, up from 63.4% in the previous year to 68.9% in FY
2001-02. Implicit in that data–barring a few exceptions, Tier 2 and Tier 3
exporters were getting squeezed even more.

Software exports grew by only $1 billion in fiscal 2001-02, compared to $2 billion the previous year No company grew 100%, compared to five the previous year. Only one, Digital GlobalSoft, saw over 50% growth The big got bigger: The Top 20 made up 63% of overall exports in fiscal 2001-02. In 2000-2001, they made up 62%. And in the year before that, the number was 60%

If outsourcing was the big word of FY 2001, then last year, it was offshoring.
But the changing nature of deals and a growing presence of global IT services
companies in India ensured that contrary to what the industry had hoped for,
offshore revenues of a number of the top exporters either remained the same or
went down. Combine this with pressure on billing rates and margins were looking
increasingly thin. The only piece of good news was despite everything, the
software exports segment remained the star performer, with total revenues up by
20%. This may be a third of the growth rate of the year before, but is still not
a number to be scoffed at–especially not in view of the reviews you’ve read
in the rest of the segments.

Here, we take a look at the trends of the year gone by, and of the year to
come. At lessons learnt and unlearnt. And most of all, at some new strengths and
weaknesses. This was a year that changed the industry for ever and its
reverberations will be felt for some time to come.

The new customer

The industry changed primarily because its customers did. Hit hard, if not
harder by the slowdown, numerous sectors in the US–still the primary market
for Indian exporters–came to a skidding halt. This, in turn, affected their IT
purchasing in numerous ways. First, of course, IT budgets got slashed. The days
of running to upgrade with every new hardware tweak came to a halt. And with
that, so did porting and migration, the part of the software service line that
rides on hardware upgrades. A good example of that was the poor offtake of Intel’s
much-touted 64-bit Itanium processor. In a cycle that is as vicious as it is
old, Itanium didn’t take off to the levels expected because there just weren’t
enough applications available on it. And there weren’t enough applications
available on it because not many customers were willing to incur the cost of an
upgrade in such slow times.

OFFSHORE IS THE BUZZWORD: The disparity in billing rates for offshore and on-site software development as well as the overall tendency to cut costs across the board, saw a 4% increase in offshore development projects

Similarly, new software projects got hit. According to a McKinsey survey late
last year, the first part of IT budgets to go was investments in new
technologies. The last–maintenance of existing systems or budgets committed to
ongoing projects. This had a few immediate consequences–support went up
significantly during the year as compared to products or new technology
deliveries; and in a slightly worrisome counter-trend despite the stress on
offshoring, onsite revenues of Indian exporters didn’t go down as much
expected. The simple reason–maintenance and support are comparatively larger
onsite payers than customized software development.

For instance, onsite revenues of Tata Consultancy Services went up from 62%
to 71%; of Cognizant Technology Solutions Inc from 60% to 68%; and of Satyam
Computer Services from 67.8% to 70%. Even Digital Globalsoft, which gets a bulk
of its revenues from Compaq, saw onsite revenues rise from 64% to 68%. Wipro
Technologies remained at more or less the same level, while Infosys saw a
marginal drop in onsite revenues. But far more fundamental was the attitudinal
change in enterprises toward technology investments–customers now demanded and
expected a compelling case for return on investments. Also, they were no longer
satisfied with technology solutions–they wanted business solutions and a very
high level of domain expertise in IT services companies.

US-BOUND ONCE MORE: Despite the software industry’s attempts to wean away from the US market, the dependence on this erstwhile key driver increased. The slump in the UK and its slow pace of outsourcing did not help matters either

Exporters reacted to the latter by hastening the process of aligning
themselves organizationally along their main verticals and putting domain
experts in charge of them. But there was little they could do on RoI, except
squeeze their margins further. According to a US productivity analysis by the
McKinsey Global Institute, a vast majority of IT investments between 1995 and
2000 have been "unproductive". Six sectors that accounted for 40% of
IT capital investment growth contributed to almost all labor productivity
improvements in the US economy…while 50 other sectors accounting for 62 % of
IT investment growth accounted for less than 1% of total labor productivity
growth.

TAILOR-MADE SOLUTIONS: As was the trend last year, the share of consulting dropped. Software products too were down, as clients demanded customized solutions and support–and this doubled growth

This IT overspend came from three main areas–Y2K, platforms and IT
standards upgrade, including telecom and network infrastructure, and concomitant
software expense, and the e-commerce boom. A price had to be paid for that kind
of profligacy–enterprises had paid for it, and it was now time for the IT
industry to feel the pinch. Infosys COO S Gopalakrishnan echoes every other
company in the industry when he says, "Every time we went to the customer
with our best price, they asked for a little more (cut)." It was almost
like every customer had suddenly turned into GE–notoriously the hardest
bargainer in the business. Which is why Satyam’s Ramalinga Raju told his
shareholders–"Last year, for the first time in the history of the Indian
IT services industry, billing rates saw a decline, putting pressure on operating
margins."

There was, however, an upside to the new customer behavior. As CIOs
centralized purchasing and consolidated vendors, there was a tendency to give
out a single large deal to a single vendor for better cost-efficiencies.
Ironically, in one of its worst years, this led to some of the largest deals
signed in the history of the services exports segment. Late last year, Wipro
signed a $70-million systems integration deal with the Lattice Group–a record
that was broken a few months later by a $100-million deal signed by TCS.

The new competition

Not only did customer behavior change last year, the nature of the
competition also did. Numerous factors contributed to it. If quality
certifications were the headlines of fiscal 2000-01, they were stale news in
2001-02. India has the largest number of SEI CMM Level 4 and Level 5 certified
companies. This is no longer seen by customers as a distinctive attribute–in
fact, it is deemed a necessary one. Add to that the undifferentiated offerings
by most Indian IT services players–what you get, then, is a sea of similar IT
companies, offering similar services at similar cost and quality levels.

When the pie was big–this wasn’t a big issue. As the pie shrunk, the
customer had to make a choice–he chose size. And thus began what McKinsey
& Co subsequently called the ‘Flight to Scale’. Small was suddenly no
longer quite so beautiful–which is what accounted for the Top 20 players
contributing to a whopping 67% of overall software export growth. Not that the
large players had it easy. For the last few years, the biggest competition to
Indian companies have been other Indian companies. This was never more so than
last year, when multiple rounds of negotiations and severe cost-wars led to some
large orders being won at billing rates as low as $18-20 dollars an hour.

The only companies relatively untouched by the phenomenon were niché players
like iFlex, which grew by a healthy 35%. Other telecom software players like
Sasken were also unaffected, though they faced other issues–that of falling
investments in new projects and the woes of the telecom equipment provider
industry. The year also saw China emerging as a threat to software exporters in
the medium term. With strong government backing, a well-entrenched hardware
industry and comparable if not cheaper software development costs, China
suddenly emerged as a competitor to reckon with, and prepare for. Even more so,
because it is a prime near-shore development center for the large, lucrative and
yet under-penetrated Japanese market.

Indian software exporters, however, have responded to this swiftly. Many of
the Top 20 companies have already set up (or are in the process of setting up)
development centers in China–among them Tata Consultancy Services, Satyam
Computer and Infosys Technologies. Others like Wipro and Mascot Systems already
have a significant presence in Japan. Mascot Systems gets a good 10% of revenues
from Japan, while Wipro Technologies has been getting 6% of its numbers from the
region for the last two years.

The new players

There were other more fundamental changes taking place, changes that will
have a more important and longer-term consequences for Indian exporters–the
setting up of offshore development centers (ODCs) by independent software
vendors and global IT services companies. Over the last few years, the presence
of MNCs on Indian shores has grown quietly but steadily. Dataquest has estimated
that the Top 20 MNC exporters in India today employ nearly 25,000 people and
generate Rs 4,500 crore in revenue measured on a cost-plus basis–at the rate
of Rs 15 lakh per employee per year (see box). This is by all means an
underestimation. They would spend over Rs 25 lakh per employee if they were
outsourcing.

FOCUS ON THE ENTERPRISE: The thrust is clearly on enterprise-side applications, which showed 2% growth. Packaged software implementation was up, as was Web-based e-commerce.Y2K projects, of course, dipped

At first glance, this may seem insignificant compared to the 80,000-odd
people employed and Rs 17,000-odd crore earned by the Top 20 Indian software
exporters alone. What the numbers do not tell, however, is the speed at which
the MNC sector in India has grown. Sure, come companies like Texas Instruments
have been around for long. Most, however, are comparatively recent entrants.
Today, 12 of the Top 20 ISVs have an offshore presence in India, including
Microsoft, Oracle, Novell, Rational, SAP, Cadence, i2, Symantec, Adobe, Veritas
and PTC. And all of them plan to expand their footprint in coming months, as the
stress on offshoring increases. While this is good for the India Inc brand,
Indian companies themselves are not at the moment geared to take part in their
growth, largely due to a lack of product orientation. India still remains a
largely services player and its product skill-sets are at best limited.

Apart from ISVs, global IT services companies have set up an offshore
presence in India in a big way (see box). For instance, IBM Global Services
India has more than 3,000 people spread all over the country, EDS has 850, while
both Accenture and Cap Gemini Ernst & Young are looking to enhance their
presence. These usually tend to be cost centers, with budgets to cover salaries
and overheads. However, since they avail import duty sops, they have export
obligations, to cover which they bill some revenues (declared to the local
software technology park). The declared revenues may be nominal, covering just
the export obligation, or may be substantial, going up to the kind of
revenue-per-employee of the Top 20 Indian software exporters. For instance,
exports revenue per developer is Rs 22 lakh for TCS and Rs 22 lakh for Infosys.
A few MNCs report revenues at that level–Rs 24 lakh per developer for IGSI and
Texas Instruments–but most have much lower reported exports revenues per
developer. For instance, Rs 9 lakh for CTS and Intel IDC, Rs 5-6 lakh for Oracle
and PwC, and so on.

The differences come because the development centers may or may not bill
fully. Often, such MNC development units do a mix of work–

1. In-house development for their parent companies, such as HP-ISO developing
   HP-UX compilers;

2. Work for customers of their parent companies, such as IBM’s IGSI
   implementing projects for IBM Europe’s business customers; and

3. Work for their own customers in the US or Europe, or elsewhere–businesses
   that may or may not be customers of the parent organization.

In the case of (a), there may not be internal billing at all, while (b) and
(c) usually will reflect in billings.

Dataquest estimates the minimum value (of salaries plus overheads,
infrastructure and development expenses) for MNC operations in India at about Rs
15 lakh per employee for software development, though it may be higher for
cutting-edge IP and engineering work, and lower for IteS (around Rs 10 lakh per
employee for most BPO operations, to Rs 6-8 lakh per person for call center
employees). ITeS (IT-enabled services) operations are, of course, not included
in these rankings.

The implications of this for Indian software exporters are manifold. The
upside–this imparts greater legitimacy to offshoring and enhances the India
Inc brand as never before. The downside–most, barring the top Indian
exporters, are not ready to take on this new competition. IGSI, EDS, Accenture–these
are all large systems integrators with an end-to-end solutions offering that
customers are increasingly favoring. Combine that with the cost advantage of
working off Indian shores, and they have an unbeatable proposition to offer.

During the year, a large chunk of IT outsourcing contracts, for instance,
went to IGSI, including a long-term ABB deal in which few Indian exporters were
even significant bidders. In the coming year, Tier 2 and 3 companies will find
themselves increasingly pushed to the wall on the larger SI and IT outsourcing
deals, even as the Top 5 will face stiff competition. Some of this, of course,
will be offset through partnerships, but by and large, global IT services
companies in India have changed the name of the game. So long as Indian
exporters went out to compete in the global market, they could pick and chose
their fights. Now, global competition has come right home.

The new landscape

All of the factors mentioned above combined to make for a year of tumultuous
changes and a few counter-trends. The slowdown hit European shores last year,
and given the continent’s slow pace of outsourcing, the industry’s efforts
to wean itself away from too great a dependence on the North American market
came to naught. In 2000-2001, exporters had succeeded in bringing down exports
to the US from 67% to 63%. This went up again last year–to 66%.

Exports to Asia Pacific–a difficult market to being with–were also down,
though there was a marginal growth in exports to Japan, largely due to efforts
of a few companies making inroads into large Japanese multinationals, which are
the first movers in that geography. Indian exporters’ presence in the Japanese
market today includes a dedicated ODC run by Wipro for Bussan Systems, an ODC
run by HCL Technologies for Toshiba, and one by Patni Computer for Hitachi
Japan. Canon runs a development center of its own in India, developing embedded
software. Japan is the world’s second-largest IT services market and an
increasingly good bet for exporters in the R&D services space, provided the
local language and culture issues are dealt with.

THE GIANTS GET HUNGRIER: The shakeout that the downturn resulted in sent several smaller players scurrying for cover. Though the biggies too battled a tough year, the share of the Top 20 grew once again to 63%

Finally, barring a few bright spots, the industry’s efforts to move up the
value chain also came to a halt. Both Wipro chairman Azim Premji and Infosys CEO
Nandan Nilekani warned that last year was and the coming year will continue to
be a "volumes game"–essentially low-margin, low-value maintenance
and support. This shows up in the numbers–consulting went down from 18% in
fiscal 2000-01 to 12% last year. As did product sales, from 11.5% to 9%. What
did go up was support, almost doubling from 8.5% to 16%. Just about the only
things that remained constant were the key verticals–telecom, manufacturing
and financial services.

There is light at the end of the tunnel, though, and it is not necessarily an
incoming train. Two years of a grueling downturn notwithstanding, India has a
talent pool whose quality cannot be denied. The mushrooming offshore development
centers of global services companies, ISVs and even design centers for companies
like Honeywell and Delphi are more than enough testament to that.

The low-cost volumes business may be the only opportunity today, but it will
not always be so. Though many like Mascot Systems CEO Gerhard Watzinger believe
that India will never lose its low-cost branding, that doesn’t prevent it from
replicating its success in customized software, in other service lines and other
verticals. A change in legislation in the telecom service provider, healthcare
and utilities segments in the US is opening up a new opportunity for Indian
exporters. At the same time, systems integration–billed to be among the big
growth areas in coming years–is already a service line in which larger Indian
exporters are building up competencies. As is R&D services–already,
companies like Wipro Technologies and HCL get nearly half their revenues from
this service line.

"There comes a tide in the affairs of men," said Shakespeare,
"which taken at the flood leads on to fortune." Last year was one
such, as will be the ongoing one. If software exporters can just ride this tide,
there is still a promise of great things to come.

TEAM DQ

The MNC IDCs: Figuring out those Revenues

For India development centers or India-based software development
subsidiaries of MNC companies, Dataquest is now using (for rankings and industry
size estimates) either reported revenue, or a DQ-estimated "development
cost" based on developer numbers–whichever is greater.