For a while now the two words that have characterised the IT industry are “cost arbitrage”. Investors and analysts now want the industry to learn two new words: Pricing power.
Hit on the cost side because of an increase in employee costs and on the revenue side because of a rise in the value of the rupee against other currencies, the industry needs to figure out if its clients need it enough to allow them to raise prices.
“I think it is obvious that these companies do not have power to renegotiate prices to completely offset the adverse circumstances,” says the India head of a multi-strategy fund that currently managed about $2.5 billion. Most companies are negotiating a price increase of 1-2% on contracts coming up for renewal. This is unlikely to nullify the 5-6% decline in profit margins. No wonder then that most frontline IT stocks have underperformed the Sensex by more than 10% over the last six months.
One stark indicator of the state of the industry is the return on incremental capital employed, essentially the additional profits generated by deploying additional capital in the business. On this criterion, most top firms have shown a decline over the last two years. “These guys have a great business. Profits are growing at 25-30%, and revenue growth is strong. It is just that they may not be great stock market investments because the capital efficiency of the business may have declined,” says the fund manager.
For many industry experts IT companies may not be doing enough. “IT companies have done a reasonable job till now but if the rupee and the wages keep rising then they will need to do a lot more,” says Gartner regional research director Partha Iyengar. The IT industry has always relied on external triggers to show the way.
It was Y2K in 1999 and then the Internet mania in 2000 that shaped the business model of the industry. And that was setting up a process to move work offshore quickly and delivered in a “factory environment”. “Everybody then followed this business model that won the Y2K battle for India. I suspect we may be at a similar inflection point and we will see people now choosing differentiated strategies,” says the head of a private equity firm that has large investments in the IT sector.
For almost all the companies the core of the strategy will really mean figuring out how they deliver their bread-and-butter service: The application development and maintenance or ADM business. Since the ADM business is close to 50% of the revenues any strategic move has to deal with this chunk carefully.
So TCS is talking about using much more automation while Cognizant has set up a software factory at Coimbatore where they will use both scale as well as automation to be more efficient in delivering such services. There are other companies that are taking their ADM businesses away from Mumbai or Bangalore to smaller towns like Nashik, Bhubaneshwar or Pune.
All these are the cost-side measures. Things that can get better margins are as yet unaddressed. “The consulting businesses of these companies are yet to take off and these companies have not been able to identify any high-profit niches,” says the fund manager.
To be fair to the IT companies, they have developed deeper relationships with their clients but not in new areas. So, in normal ADM contracts Indian companies do it almost like a turnkey contract today while four to five years ago they would get all the requirements and only do the programming.
In enterprise solutions (SAP software related work) many India companies have moved ahead from doing just grunge work and writing small time programmes for SAP software. “Most of the global rollouts of enterprise software and its customisation in large companies is being handled right out of India and that is a huge step,” says Mr Iyengar.
But there is nothing spectacular in the pipeline that will transform these companies over a five-year horizon. “I think they need to become much more choosy in where they direct their resources. For example, HCL is not going to rebid for almost $16 million worth of contracts,” says Mr Iyengar.
Choices such as these are clearly difficult. Indian companies do not want to walk away from contracts and give smaller companies an opportunity to enter their accounts. Something they had benefited from when large companies like IBM and Accenture and Cap Gemini chose to focus on higher-end business 7 years ago. But clearly something has to give for the industry to get the buzz back. And no, we are not talking about small-fry acquisitions or sponsored ADS programmes.
Hit on the cost side because of an increase in employee costs and on the revenue side because of a rise in the value of the rupee against other currencies, the industry needs to figure out if its clients need it enough to allow them to raise prices.
“I think it is obvious that these companies do not have power to renegotiate prices to completely offset the adverse circumstances,” says the India head of a multi-strategy fund that currently managed about $2.5 billion. Most companies are negotiating a price increase of 1-2% on contracts coming up for renewal. This is unlikely to nullify the 5-6% decline in profit margins. No wonder then that most frontline IT stocks have underperformed the Sensex by more than 10% over the last six months.
One stark indicator of the state of the industry is the return on incremental capital employed, essentially the additional profits generated by deploying additional capital in the business. On this criterion, most top firms have shown a decline over the last two years. “These guys have a great business. Profits are growing at 25-30%, and revenue growth is strong. It is just that they may not be great stock market investments because the capital efficiency of the business may have declined,” says the fund manager.
For many industry experts IT companies may not be doing enough. “IT companies have done a reasonable job till now but if the rupee and the wages keep rising then they will need to do a lot more,” says Gartner regional research director Partha Iyengar. The IT industry has always relied on external triggers to show the way.
It was Y2K in 1999 and then the Internet mania in 2000 that shaped the business model of the industry. And that was setting up a process to move work offshore quickly and delivered in a “factory environment”. “Everybody then followed this business model that won the Y2K battle for India. I suspect we may be at a similar inflection point and we will see people now choosing differentiated strategies,” says the head of a private equity firm that has large investments in the IT sector.
For almost all the companies the core of the strategy will really mean figuring out how they deliver their bread-and-butter service: The application development and maintenance or ADM business. Since the ADM business is close to 50% of the revenues any strategic move has to deal with this chunk carefully.
So TCS is talking about using much more automation while Cognizant has set up a software factory at Coimbatore where they will use both scale as well as automation to be more efficient in delivering such services. There are other companies that are taking their ADM businesses away from Mumbai or Bangalore to smaller towns like Nashik, Bhubaneshwar or Pune.
All these are the cost-side measures. Things that can get better margins are as yet unaddressed. “The consulting businesses of these companies are yet to take off and these companies have not been able to identify any high-profit niches,” says the fund manager.
To be fair to the IT companies, they have developed deeper relationships with their clients but not in new areas. So, in normal ADM contracts Indian companies do it almost like a turnkey contract today while four to five years ago they would get all the requirements and only do the programming.
In enterprise solutions (SAP software related work) many India companies have moved ahead from doing just grunge work and writing small time programmes for SAP software. “Most of the global rollouts of enterprise software and its customisation in large companies is being handled right out of India and that is a huge step,” says Mr Iyengar.
But there is nothing spectacular in the pipeline that will transform these companies over a five-year horizon. “I think they need to become much more choosy in where they direct their resources. For example, HCL is not going to rebid for almost $16 million worth of contracts,” says Mr Iyengar.
Choices such as these are clearly difficult. Indian companies do not want to walk away from contracts and give smaller companies an opportunity to enter their accounts. Something they had benefited from when large companies like IBM and Accenture and Cap Gemini chose to focus on higher-end business 7 years ago. But clearly something has to give for the industry to get the buzz back. And no, we are not talking about small-fry acquisitions or sponsored ADS programmes.
