The Hindu Business Line : TCS sees no slack in momentum

GROWING from a $ one billion company in 2003 to $2.28 billion in revenue in 2005 may be seen as good for some companies. But the markets didn't seem to think so and pummelled TCS' down (an 8.37 per cent loss to close at Rs 1209.75) on the day it announced results for the quarter and year ended March 2005. TCS has argued that investors and analysts should take into consideration that it recorded a one-time profit of Rs 109 crore for the quarter ended December 2004 and that it was a non-recurring windfall. Add to that a Rs 102 crore Economic Value Added (EVA) payout to employees that was advanced by a quarter.

Mr S Ramadorai, CEO, TCS, spoke to Business Line last week on whether there was cause for alarm or it would be business as usual. Excerpts from the conversation:

Given the negative reactions of the stock market to your results, is there cause for concern?

From a business momentum perspective, nothing has changed and if at all, it has changed for the better. What has changed is the segmentation of the opportunities. And some of the parameters of evaluation have changed. Orders see a lot more lead time than before. For example, when a financial services institution wants to outsource to India, they do multiple models of evaluation. It's not one - two persons but a team of 10-12 that visits us. And they would have not only the business leaders or IT chiefs but those from security and from other aspects of due diligence such as legal and finance.

They are thorough and are so paranoid about any data getting leaked and about any legal implications it might have on their business in case something happens. They also bring the infrastructure people as part of the team. In the server room they want to see, if I have 3 clients, what kinds of physical partitions we have amongst these 3 customers. Within these partitions, if the new client is going to expand work, can the vendor give more server capacity? Are we following international best practices, is another query they raise. It looks like even big MNC players have been taken by surprise by the slowing momentum. Some big names have consistently fallen shorter of their estimates for order bookings through four straight quarters.

The evaluation cycles and due diligence they are going through has got extended a lot. Let us look at large outsourcing contracts. Large outsourcing by, say, a large financial institution is going to look at a 3 or 5 years time horizon.

And if they are going to outsource, let us say, $100m, they are going to take their own time to decide. On top of it is the cultural issue. If they are going to transform jobs for the first time, they have to keep in mind at what speed this organisation can or cannot move. So they ask us about transitions - how do you transition from my place to yours, risk to business, etc. Since they are transforming jobs and if they (the new folk) leave in the middle, then it's a risk.

So they ask an enormous number of questions that we have to address repeatedly and convince them. And then in between, they will ask, "What is your China/LatAm/Eastern Europe story?" It is a risk putting everything into India, would be their feeling.

Here we are at an advantage with our software development presence in Latin America and China. Some of the jobs we have procured have seen an additional four clients in China. That's why we had the Chinese premier coming to our premises and saying that he had a lot of respect for us, that "We definitely want you to increase presence in China."

Then they also want to meet the teams. If all vendors say the same thing, they want to see the difference. The only difference is if it can relate to this organisation and team better. Sales and marketing guys are great but at the end of the day, who are the people doing the job for them? So, they see the team.

Are long lead times here to stay? Looking at growth in North American revenues for the industry, if there is a slowdown indicated, then long lead times only confirm it.

I wouldn't call it a slowdown. It can be cyclical. On a year-to-year basis, is the growth momentum there or not, is the question we have to ask. If the industry is growing 25-30 per cent and Nasscom has given 31 per cent growth - that is the measure we have to use, instead of comparing quarters, which is the typical analyst way of measuring.

No one is saying that growth is not important. But when a company doubles revenues from $1 b to $2.28 b from 2003 to 2005, and it has not compromised one percentage point on bottom line margins, if one says that the performance is lousy, it is very difficult to accept it.

This quarterly framework for evaluation has been there for some time.

It has been there but has been questioned even in the US. One of the cola giants does not give guidance and does not have analyst conference calls on a quarterly basis and the market accepts it. On the questions of SOX compliance, companies feel that it is difficult to meet all those compliance standards and run the business and so prefer not to list in the US. Foreign companies are saying that compliance standards are crazy. I am not referring to compliance from the process or IT perspective - those are important.

But if I spend millions of dollars on audits I either have to pass it on to customers or settle for a lower margin.

On the issue of the tyranny of quarterly evaluations by analysts, couldn't TCS have prepared the investor community... ?

I completely accept your viewpoint. We should have put forward a point of view but the only explanation I have for this is mere inexperience. We weren't listed on the exchanges for so long. It's sheer inexperience. That's the truth. So we could have prepared the market. An additional profit of Rs 109 crore from our hedge position in Q3 was a windfall income. That's not our normal business. We kept telling the investors this won't repeat in Q4. But people have short memories.

Would not brand equity built over years help shrink lead time for orders flowing in?

If for instance, you have done something for Merrill Lynch and Morgan Stanley wants to look at you, he does not care about past projects. Even if the (decision maker) has shifted from the former to the latter, he only wants to view you independently.

Lead times could shrink in smaller jobs. In smaller jobs, for instance, post-SAP implementation, a client has performance problems, TCS would tell him how to fix the problem, how he could enhance performance and the study would cost $1,00,000. He might decide in a week. He won't visit 10 companies shortlist three and so on.

(For larger projects), they now shortlist 16 companies sometimes before they narrow down to the last 2 or 3 in a span of 9 months.

Does it end with a final list of 2 or 3 vendors? Now, multi-vendor strategies are in favour with clients. Metagroup had a study in which 76 per cent of respondents actually preferred multiple vendors.

Nothing more than 2-3. They won't deal with 5 vendors. Those days are gone. Definition of multi-vendor means more than one.

Given this and given the flat nature of profits, is it a pause before the next leap or will it remain like this because of competitive pressures?

I think it will remain like this. But, the bulk of revenues for any company still comes from the US. Purely because of spend and potential to spend. The second thing happening in the US is that Silicon Valley is seeing a lot more activity now than last year. This is more by personal experience being there 6-10 times a year, I can see activity picking up. Technology companies are getting funding.

And if you look at the SunGuard acquisition, it was not an IT or product company taking over. It was a consortium of private equity players. They acquired it for $11.3 billion and took in the balance sheet which was very healthy … $8 billion came from debt. None of us can value that company at that level by any stretch of imagination. If you ask the guy how he is going to make money he says he will cut and paste, rip this, sell off something. So they will kill the company by selling in N number of ways.

We have to see the models that are changing where we as the industry and TCS have to play a different game and get into the bigger league.

You said that opportunities are there but that there are differences in terms of segments offering more promise. Could you list some of these segments where you see more growth?

Packaged enabled services as for Oracle, Siebel, PeopleSoft or SAP. That's coming back, because time to implementation becomes shorter. You don't want to do a custom development from scratch. So more of these opportunities are coming. We have centres of excellence for SAP and for Siebel. We have verticalised specialisation for an automotive and other industries. We would recruit large numbers of people for such specialisation. Not entry level people alone but also experienced folks. For the latter, it won't be from the IT industry alone. We pick them from those vertical industries. You train them on say, SAP modules and then engage them in projects.

Another opportunity that is emerging but will take time is purely transaction based BPO services. Claims or loan processing or any of those F&A or HR processes, in the pharmaceutical or bio sectors. Pure process outsourcing with the efficiency you bring with a technology platform is a play that is coming. That is a very big play. It will have multiple forms. They may outsource to TCS or may set up shop in India. Or they may have joint ventures.

As to what these capabilities mean to an Indian model, it may be a combination - it may be completely reengineering based, platform-based or package-based pure development. For example, look at the third-party administration software. CSC has a hold on the entire property and casualty industry. And they have licensed (products) to a majority of insurance companies.

What they do is, they put all kinds of restrictions in the past when they licenced it. When people want to get out of it (the arrangement), they fleeced them with licence fees. The open book positions that they maintained and once you have an insurance policy, till the person dies, you have to maintain that policy. Then the framework of the technology platform was supplied by one company, CSC, and now they (clients) want to get out of that.

The cost of running or maintaining a policy is about 45 GBP per year per policy. They want to reduce it. Those opportunities are there. But the concerns remain - in terms of security, business risk if policy is not administered correctly, do we have domain expertise to service them, and the like. Because it's not IT alone. You need to know about insurance, about claims and about third-party services. That's the level of sophistication that we have to build up.

You talked about the long lead times that stem from stringent evaluation of vendor capability. Is that here to stay? Looking at growth in North American revenues for TCS and other players, if there is a slowdown indicated, then long lead times only confirm it.

I wouldn't call it a slowdown. It can be cyclical. The point I am trying to make is, don't measure on a quarter, whether we have grown 7 or 8 per cent. On a year-to-year basis, is the growth momentum there or not, is the question we have to ask. If the industry is growing 25-30 per cent and Nasscom has given 31 per cent growth - that is the measure we have to use, instead of comparing quarters, which is the typical analyst way of measuring.

No one is saying that growth is not important. Without growth, there would be problems. But when a company doubles revenues from $1 b to $2.28 b from 2003 to 2005, and it has not compromised one percentage point on bottom line margins, if one says that the performance is lousy, it is very difficult to accept it.

This quarterly framework for evaluation has been there for some time.

It has been there but has been questioned even in the US. One of the cola giants does not give guidance and does not have analyst conference calls on a quarterly basis and the market accepts it. On the questions of SOX compliance, companies feel that it is difficult to meet all those compliance standards and run the business and so prefer not to list in the US. Foreign companies are saying that compliance standards are so crazy. Not compliance from the process or IT perspective - that is important.

But if I spend millions of dollars on audits I either have to pass it on to customers or settle for a lower margin.

On the issue of the tyranny of quarterly evaluations by analysts, couldn't TCS have prepared the investor community?

I completely accept your viewpoint. We should have put forward a point of view but the only explanation I have for this is mere inexperience. We weren't listed on the exchanges for so long. It's sheer inexperience. That's the truth. So we could have prepared the market. An additional profit of Rs 109 crore from our hedge position in Q3 was a windfall income. That's not our normal business. We kept telling the investor community that this won't repeat in Q4. But people have short memories…

But this is an exceptional item so you could have taken it as a capital receipt or as a one-off instead of bringing it into the operating profit situation. Unwittingly you might have created expectation.

It was a one-off item and indicated accordingly. Operating profit was shown separately.

Could you not have taken it as an item below the PAT?

PAT will include this. In accounting definition terms, PAT includes your one off items also. We mentioned this repeatedly. We also explained in detail what our hedging policy was and why we changed it. We were protecting receivables until Q2. Then we saw what happened to rupee-dollar rate. So we decided to protect revenues. So we took forward positions. We are constantly reviewing and monitoring our positions. In the last quarter, end of any reporting period, we had to mark it to market. At that point we had a loss of Rs 10.71 crore and we had another loss of approximately Rs 29 crore on account of receipts. When we book revenue, it is at a certain rate. When we actually get the money, there is a slight difference. That was the latter amount. Technically, about Rs 39 crore is a forex loss.

Looking ahead, would you say that all forex related gains and losses would have to be treated as part of the normal above the line adjustments to profit after tax.

In our reporting, we have clearly shown it as other income. At the net margin level, you take into account everything. So, for a figure of Rs 470 crore which is the quarter net profit, that has taken into account all entries. If we remove the one-off items, then the operating income has not taken that bad a hit.

Would you continue to make provisions to the economic value add once a year or would that change to providing for it across quarters? (TCS used to make once a year EVA provisions in the first quarter of every year for the previous year figures. This time, it had made that provision in the fourth quarter of the year itself.)

It would be across quarters. The thinking was there before. What we used to do in the past was: When I do the plan for this financial year - 05-06 - I take previous year's (04-05) EVA payout figures. Let us say Rs 425 crore was the EVA pay out. The accounting of this would always happen in the Q1 of the following year. As we went on our IPO roadshows and subsequently during our Q2 and Q3 results one of (feedback suggestions ) we got was to account for the EVA pay out in that year itself. We deliberated it at the board level and acted accordingly. Hence, the one-time provision of Rs 102 crore. So the 325 crore plus Rs 102 crore makes for the EVA pay out of Rs 427 crore of last year.

For this year, what ever is the total EVA payout planned on for the year based on revenue growth and profitability would be spread over the four quarters.

So, 04-05 would have five quarters? The Rs 325 crore would include the previous year's.

I wouldn't say that. The EVA generated in 03-04 was Rs 325 crore was paid out in 04-05. Actual generation of EVA in 04-05 was Rs 427 crore. We made a pay out in that year itself. The Rs 102 crore that has come in this quarter is additional. To that extent there is double accounting.

This roughly accounts for one-fourth of salary paid out. Would employees feel comfortable with a portion of their pay being in a black box paid at the end of the year?

It is transparent. It is paid out each month.

We have heard of cases of Indian IT companies re-negotiating billing rates and then suffering future volumes. Does this affect the industry's hopes for higher billing rates?

Billing rates are not going up for the same service. If at all, they would ask for a lower price. If for example, the SAP situation we explained to you, we can demand a higher rate because you are selling a higher competency. If anything you can increase offshore leverage that would impact your margin. It is the responsibility of program managers and account relationship guys to maximise revenue from accounts by cross selling services or using the offshore to leverage bottom line. In case of unique skills, they would automatically pay higher rates. But even for a new player requiring similar skills as you are already offering others, and if it is a volume play, it would always come down to a price issue.

Do they also ask for milestone discounts? That is if they cross a certain revenue size with you for a year, would they ask for lesser rates?

They will always negotiate. Per hour reductions or one per cent discount for a $30 million revenues per year. But we do not see this any more now than we have seen in the past.

How do you say that this business momentum is not going to change?

We used to see 100 per cent growth and then 60 per cent growth and now 30-35 per cent growth. Don't expect 60-70 per cent growth and then rate companies. Now, the growth is healthy for any industry. Margins are stable. It is not that we are saying that business is going to drop to 10 per cent growth and margins will drop by 5 per cent. Instead of giving forward guidance, I am actually giving a guidance.

But there is fear that momentum could be affected. For example in the UK's National Health Service (NHS) deal, IT MNCs have seen work slow down and have even taken bottomline hits.

In the case of the NHS, the real issues are as follows. NHA is a very complicated project. British Telecom is creating the infrastructure. They have to create along with an Accenture IT services company and along with a software product called IDX, a core healthcare engine licenced from the US. To create customisation of IDX and create platform is the responsibility of BT and IDX. Till then, whether it is an Accenture or TCS, we will have to wait. This is the framework under which customisation and implementation has to be done. This is the reason we haven't seen the ramp up we expected.

And in any large projects these are likely to happen. Can't be without slippages, especially slippages from someone else. IDX and BT have not yet delivered for us to go and implement it as London South.

These are pent up revenue opportunities and could be unleashed once it gets going.

Yes, because, these are all signed contracts and are not conditional.

Given these numerous aberrations in the short terms and the long lead times you talked about, to make up for these, would your SG&A be higher?

Europe is growing faster for the first time. SG&A has gone up in excess of 2 per cent. That's an investment we make for the future.

Any special capability build up needed to target Europe?

Some sales front end with locals because of the language etc. Second capability is to have people with language proficiencies (in the back end). Third competence is to ramp up in local delivery capabilities in addition to India deliveries. Fourth is travel related to be able to connect to European clients a lot more.

Across the industry and for ourselves, we travel a lot more to Europe than we ever have. I used to travel to Europe once a year and now it's 4-5 times a year. We are not managing European operations from the UK. We have separate operations.

Language teachers say that capability is hard to get in India, particularly German and French.

You won't get this capability in large numbers. You are right. So we have to recruit locals. We recruited 200 people in Hungary. They speak English, German and the local language. We need to go into the local space.

So parts of French Africa would interest you?

Exactly. We are looking at some other countries such as the ones you mentioned.

With your focus in Europe, growth of clients excluding top 5 or top 10 would be faster now than they have been before?

In Europe, yes. It is a different market. They have a lot more engineering mind set than the US.

In terms of skill sets, as a country what do we need to maintain this momentum?

Very clearly we have to go into the solutions game. This means that project and programme management skills are critical. Companies working purely on offshore model using labour arbitrage giving a Cobol, C or C++ skill will have difficulty unless they can keep on compromising on margins. For a packaged implementation service, it is noT SAP skill alone. The point is to take responsibility for an entire project, irrespective of the size of the project. Example is the Canadian depository project we did. We were the turnkey solutions provider.

That also reflects on the kinds of hires you have had. Nearly 50 per cent of your new additions have been lateral hires, who would be useful in turnkey solutions. But the market seems to see lack of enough freshers as a sign that not enough new projects are visible.

With freshers you can only have a healthy mix. For a moment, if I want to recruit 10,000 people, which we will do this year, the management of 10,000 more people requires a certain number of programme managers. Else it would be impossible run a company.

What would your staff strength be next year?

With a 10,000 addition and if our attrition remains at 8 per cent, we will reach a figure of 55,000.

Indian companies generally do not believe in outsourcing software development work. Any change in mindsets? What are you doing to accelerate that change?

It will change. We have to keep pounding at them. If the world is doing that, they need to do it. Early successes are needed to stimulate change.

What is the level of outsourcing within the Tata Group?

It is beginning to happen. We have taken up the outsourcing for Tata Teleservices. Tata Chemicals has outsourced its IT to us. We are doing quite a bit of Indian Hotels. Tata Steels and Tata Motors have been talking about it but we will have to make them move. It's a mindset issue. If you have been doing something in one fashion for 50 years, even if you want to change that, it will require some momentum.

In the case of the US and the Europe, the issue of manpower cost has driven outsourcing. But Indian companies can get the same manpower at similar costs in the country itself.

The issue is of attrition. No IT fellow would stay at Tata Motors or Tata Steel when he has the opportunity to go abroad through an IT company or has a competency that he can build upon through constant learning and he gets a salary which is way different from what he can get in a non-IT company. Indian companies are threatened by the fear of no one being available to support their systems.

Your share of domestic business is slipping?

In absolute terms, the contribution of Indian revenues to the total has grown. As a percentage it might have gone down. It only reflects maturity levels here. It is not adequate. If I don't make Rs 5,000 crore in this market every year, it is not exciting. We have to keep pushing till we can achieve that. Potential is there. But will people spend and by how much… it is our responsibility to build a market.

The problem in India is agreeing on the scope of the project. You contract for something and they never go by that. They keep changing and then say that they won't pay anything. The experience in the West is different. If a change happens, then we can demand an increase in manpower and rates. Pretty stringent there. They will haggle, but end of the day, a clause does protect you from these things.

Larger issue about software industry that bothers investors and analysts. There is no objective measure or quantity of output unlike in other services industry. In hospitality or transportation, there is some metric. In transportation, you would have passengers or kilometers travelled as measures of output. As an industry couldn't you create such measures making it easier for outsiders to measure?

We can. What we have to see is the percentage of manpower utilisation in terms of billable hours that translates into realisation per hour based on this. Internally we do it. For certain businesses, internally, we are looking at business impact that we have made. If I have saved the client $30 million or made him extra revenues that is a clear measure.

Can you say that for your entire operations?

Ultimately yes. The reason we can't say that for everybody is that some clients don't know their data at all. Even if I tell them that I saved them so much, they are worried that I would demand a portion of those savings.

This may not appropriate. In case of transportation, they don't see what it means to user. It should be an internal value of output. Say, for Indian Hotels, he has been trained to see at rooms sold one year compared to the previous year. For software companies, it could be a measure of the millions of lines of code as you did for the Y2K solutions.

It is a productivity norm only. Lines of code could be dangerous. Lesser lines of code achieving the same result as more lines means that efficiency has increased. The fastest programmer can do up those 10,000 lines of code done in 2 days but 1000 lines of creative code done over two weeks could be a lot more effective. I have just come back from a review meeting at IIT Chennai - for a PhD student doing a project in computational fluid dynamics. The whole algorithm and simulation for the last five years is done through 40,000 lines of code. How do you produce that and get a multiplier effect, is the question. One of the things could be that as you go into the solution or asset leveraging space, how much of money you have generated through your R&D or asset leveraging effort. In a people intensive business, utilisation is the only measure.

You don't provide comparative numbers for previous years.

Indian GAAP numbers of TCS is not comparable since TCS as a company did not exist last year. For the Indian GAAP, TCS was only a division of Tata Sons.

But since you provide US GAAP numbers, to a layman it is only an accounting norm that differentiates the two. Internally you would have some figures. How do internal numbers look?

For US GAAP, we report only consolidated. You can't have standalone numbers for US GAAP. Year-on-year we have grown. Sequentially, ignoring the special items, there is a small slump. That is the reflection of longer sales cycles we talked about earlier.

Same service that you provided five years ago, there is a change in revenues now.

If I start a project today, invariably, the project would have onsite and lesser offshore components. Five years later, offshore would be significant. Second, if I use a certain number of people in the first year or two, five years down, number of people for the same work would reduce thanks to efficiencies. Over five years, they would have newer engagements and would ask us to take care of it. To derisk, they might also give a small component to another vendor. Then, they would continue to give us work but would want a China component. That is the evolution we are seeing.

This type of work changes when they replace their systems. We have to be proactive in pushing those kinds of changes.

(With inputs from Krishnan Thiagarajan.

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