The Hindu Business Line : Four-sight!

Investor interest in software stocks, which were shunned at the bourses in the first half of the year, has grown by leaps and bounds over the past couple of months. . The CNX IT (Information Technology) Index, which was underperforming the S & P CNX Nifty since April, has managed to catch up with the latter. The re-rating of software stocks has followed a strong earnings performance in the quarter ended September by almost all frontline stocks and select medium-sized companies. Besides this, the expected resurgence in growth in IT spending, firm trend in offshore outsourcing gaining momentum and the fleeting signals of stable billing rates have offered an attractive trigger for growth.

In this backdrop, eWorld examines four key trends that are poised to dominate the software services (and IT-enabled services, to some extent) scene in the year 2004.

Vendor consolidation

As offshoring becomes strategic and mainstream for Indian frontline companies, the prospects of vendor consolidation are more likely than ever before. Going forward, it appears that the top five software companies, namely Tata Consultancy Services, Infosys, Wipro, Satyam and HCL Technologies, are slated to widen their revenue gap vis-a-vis medium-sized and smaller vendors in the industry. The ability of the larger vendors to participate and bag larger multi-million and multi-year deals will set the stage for consolidation. As deal sizes grow bigger, it is likely that Fortune 500/Global 1000 clients will also prefer dealing with a smaller set of vendors.

The small companies who have attempted to merely replicate the business model of the large vendors, without any differentiating niche, are likely to get acquired or marginalised over the coming year. The staying power of these smaller vendors may also be tested by medium-sized companies as the latter attempt to cannibalise maintenance and migration projects of the former to impart greater stability to revenues from their niche-oriented strategy.

Turf wars with MNC vendors

Slowly, but surely, multinational vendors such as IBM Global Services and Accenture (and to a lesser extent, Cap Gemini, EDS and Computer Sciences Corporation) have acquired the necessary scale and size to compete with Indian frontline companies. In terms of pure employee numbers at around 3,000-5,000 employees, they are still no match for the employee strength of around 15,000-25,000 of the top software companies. But over the next one year, global vendors are likely to fight a different strategic battle to protect their turf. Till recently, Accenture has categorically stated that in large Request For Proposals (RFPs) in excess of $100 million, it continues to compete with global vendors of the likes of IBM, CSC or EDS as opposed to the Indian frontline companies. Over the coming year, it is expected that Indian frontline companies will start bidding and participating actively for RFPs in excess of $100 million. And it is clear that IBM, Accenture or CSC (to some extent) will go to any length to protect deals of this size.

With the existing employee strength conferring them an India advantage, they will attempt to ensure that the scales are not tilted decisively in favour of the Indian companies.

Challenge of margin retention

The year 2004 will be crucial in determining the course of operating profit margins for the frontline companies in the Indian software industry. There are signs that the pricing pressure is beginning to ease and with volume growth remaining fairly strong, there is a likelihood of margins stabilising over the next couple of quarters in 2003-04. Having said that, these companies will have to contend with practically all the other challenges of an appreciating rupee, control over sales, general and administrative expenses, building a global brand and the cap imposed on billing rates by MNC vendors over the coming year.

The ability to scale up by bagging the right mix of maintenance-based annuity contracts and high-end application development projects will hold the key to the operating profit margins (OPMs) of these players. Any improvement in the OPMs of the four listed players — Infosys, Wipro, Satyam and HCL Technologies — over the next couple of quarters will dictate the sustained re-rating of the software sector.

Fear of outsourcing backlash

Considering that the US economy is entering an election year, the emotional impact associated with job losses in the US may outweigh the intrinsic merits of the quality and cost-effectiveness of offshoring to low-cost based locations such as India. Moreover, the US Congress has commissioned the General Accounting Office and the Information Technology Association of America to study the impact of job losses on account of offshoring. This report is expected to come out soon. Depending upon the contents of this report, the revival of the debate over the merits of outsourcing may haunt the Indian software industry.

Secondly, a Bill has been introduced in the US Congress to restrict the flexibility offered for intra-company transfer of employees through the L1 visa. With the annual H1B visa quota scaled down to 65,000, any steps taken by the US Government to impose either a ceiling on the number of L1 visas or restricting its usage for specific purposes may hurt the competitiveness of the Indian frontline companies. It is obvious that sustained diplomatic efforts by both Nasscom and the Indian Government alone can help maintain status quo on this front.

maverick@thehindu.co.in

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