In India, we love blaming the Government for all our problems and crediting all our successes to the dynamism of our corporates. “Indian corporates succeed despite the Government” is an oft repeated refrain on the conference circuit. In that context, it is worth looking at a very current story of decline where the private sector rather than the Government occupies centre stage. That this decline relates to what many would see as the crowning achievement of our country over the past 20 years is all the more worrisome. Yes, I am talking about India’s IT sector.
At the turn of the century, the frontline IT companies in India – Infosys, TCS and Wipro – seemingly effortlessly made the transition from being “backroom boys” who, most famously, debugged Y2K code, to becoming Application Development & Maintenance (ADM) specialists. As a result, most of the code for complex bespoke projects in the West is now written in India. By combining this Western clientele with the low cost labour force that India offers, these IT companies have generated not only rapid earnings growth but world leading EBITDA margins of around 30% (as compared to 10% for market leaders in the West). This confidence inducing story of technological innovation fuelling sustained earnings growth is now being challenged on multiple fronts.
If you look at how revenue growth of the frontline IT companies have been eroded relentlessly over the past eight quarters (from well over 30-40% YOY growth to sub-20% growth now), you are left with little doubt that something has structurally changed in the Indian IT sector. So what has changed? My colleague, Ankur Rudra, who specialises in the sector, points to the following:
Whilst our IT companies specialise in ADM, most Western companies can no longer justify the expense of a bespoke ADM build. Instead what they are looking to buy is “off the shelf” packages, like SAP or Oracle or Microsoft, which can be customised. Implementing such packages, called Enterprise Application Software (EAS), is the new source of growth in the sector. Publicly available data suggests that the EAS market (software plus implementation) is worth around $70 billon per annum globally and is growing at 11% p.a. (source: AMR Research). In contrast, ADM globally is worth around $120 billion in revenues p.a. (source: Gartner) but is growing at only 0-1% p.a.
Unfortunately, for the frontline Indian IT plays, whilst they do have ERP practices, these are only a half to a third the size of their ADM practices. Hence as the buying pattern of Western customers change, the top Indian IT firms will have to reposition their offerings and retrain their staff rapidly.
The global giants, Accenture and IBM, have over the past 20 years set the benchmarks for excellence in working with the top management of large Western companies. These firms have extensive consultancy expertise and pre-packaged software skills that the Indians can’t yet match. The top management in these firms is also on first name terms with their counterparts in the Boardrooms of large Western companies. On top of these formidable competitive advantages, these firms have now added labour forces in India larger than those of the frontline Indian IT companies. As a result they have been able to create their own low-cost offerings (Concadia for Accenture and Daksh for IBM) which is taking away market share from the Indians on their home turf.
Finally, what is being held against the leading Indian IT firms is their inability to wake up and smell the coffee. If you have cash on your Balance Sheet and you know that there is a gap in your skillset (eg. consultancy skills, boardoom contacts in the West), you consider acquiring specialist firms in the West especially in a year like FY09 when valuation were depressed. And yet we did not see any such acquisitions from TCS, Infosys or Wipro despite Gartner, the IT focused research house, saying that “it will still take a number of years for Indian companies to challenge the top service providers – unless they make a major acquisition.”
In any sector, as consumers’ tastes evolve, product providers have to adapt. Indian IT did this admirably through the nineties and the noughties. Having got so far, it would be a shame to lose the plot and hand over the prize to the global behemoths who are currently doing to the Indians what the Japanese car industry did to the American is the 70s & 80s i.e. provide a world class offering at emerging market prices.
Saurabh Mukherjea is the Head of Indian Equities for Execution Noble.
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