Combine new business friendly government policies with increasing domestic demand from consumers and businesses alike and 2013 is shaping up to be a good year for the $100 billion IT Services industry in India.

It couldn’t come at a better time. India’s economy experienced its worst performance in a decade in 2012, which took its toll on all business and industries in the country. For IT Services in particular, uncertainty in the global economy – leading to flat IT budgets and a lessening of demand – increased competition from countries with lower wage and other cost structures, such as China and the Philippines, the declining value of the rupee and increases in borrowing costs piled on added pressure.

However, India’s economy is expected to rebound 2013, although it will take some time for GDP growth to regain its former pace. And an extremely important new development is a recent shift in government policy that has led to economic reforms. Late last year, the government announced a new policy on foreign direct investment that opened up some previously off-limits sectors to foreign investors. As a result, it is now possible for foreign investors to participate in retail, aviation, broadcasting and power exchanges.

These measures should reduce the fiscal deficit, boost capital inflows, strengthen the rupee and boost overall economic efficiency through increased competition and productivity. More such policy moves, rumoured to be in the works, will only strengthen and accelerate this resurgence.

A rising middle class

In 2012, the government also reaffirmed its commitment to improving infrastructure and communication services across the country. A key beneficiary of such improvements will be India’s rising middle class, which IT research firm Gartner expects will increase from 71 million households in 2011 to 89 million in 2016. This is a large, growing and largely untapped market today that spells huge new opportunity for IT Services providers.

Consider, for example, mobile payment systems. According to Gartner, today nearly 65 per cent of consumer transactions in the Indian retail market are cash-based and 40 per cent of the population lacks access to banks. As the IT industry shifts from PCs to mobile devices such as smartphones and tablets, Indian consumers will no doubt embrace mobile device-based transactions. IT companies with service offerings in social media, cloud, analytics and mobility that can help businesses optimise and ensure efficiency in their consumer services offerings could be big winners as this market unfolds.

In fact, by 2015, Gartner projects mobile payments will become the second biggest revenue generator for IT Services companies after voice revenue in India. We also see continued high demand for highly differentiated, high value services for businesses in industries such as banking, healthcare, and insurance.

Indian IT firms must go global

In addition to the promise of a more robust domestic market for Indian IT Services providers, we also see a continuation of Indian IT firms to go global. By expanding their global presence, Indian IT providers can drive synergies and innovation while recruiting talent that is closer to their clients to fulfil their growing high-touch needs.

Going global will require cross-border acquisitions. Flat IT budgets and an uncertain macroeconomic environment affected M&A activity in India in 2012, but we expect to see a large jump in activity in 2013 as Indian companies look beyond labour arbitrage to non-linear value creation. In particular, we believe that acquisition of providers in specialised, domain-specific segments such as the cloud and mobile services will increase significantly. Making acquisitions in these hot and emerging areas have the potential to bring IT Services firms back to the same growth path they enjoyed a few years ago.

One example of a smart cross-border transaction of this type is the MphasiS acquisition of U.S.-based Digital Risk for $202 million on December 2, 2012. MphasiS is a mid-sized Indian IT and BPO services company and Digital Risk is one of the largest independent providers of risk, compliance, and transaction management solutions to the U.S. mortgage market. With this acquisition, MphasiS significantly enhanced its onshore presence in the US, which should enable the company to deliver on its strategy of offering specialised services in chosen segments.

Another example is Wipro’s acquisition of Promax Applications Group for $37 million on June 30, 2012. The acquisition of this Australian data analytics company shows that Indian IT firms are making a stronger onshore presence and beginning to embrace new technologies such as social media and data analytics.

As Indian IT firms continue to push higher up the value chain and into new value-added services, another promising target for acquisition is management consulting firms. An example of a cross-border transaction in this space is Infosys’ purchase of Zurich-based Lodestone Management Consultants AG for $350 million on October 22, 2012. Lodestone will bring in over 200 clients from several industry segments, including manufacturing, automotive and life sciences, to Infosys’ existing pool of over 700 clients. From this acquisition, Infosys expects to bring in revenues of more $1 billion and position itself better against IT consulting giants Accenture and IBM.

Large cash positions will drive M&A

Another driver of acquisitions by Indian IT firms is the large cash balances on many IT providers’ balance sheets. At the end of 2012, Tier 1 Indian IT providers such as Wipro, Infosys and TCS were sitting on billions of dollars each. With that much cash and an improving macroeconomic environment, these firms will spend some of their reserves to buy companies that drive growth as a way of delivering more value to shareholders.

What is clear from these trends is that many of India’s IT companies must change or adapt what they do – or they will continue to work harder for less.

(Gaurav Sharma is Senior Vice President and Managing Director of India Practice, Martin Wolf, M&A Advisors)

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