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Krishnan Thiagarajan

THE Indian software services industry is at a crossroads. The sharp run-up in software stocks in India in October and November, in sync with technology stocks at Nasdaq in the US, seems a startling aberration from the deteriorating trends in the software industry worldwide.

This upsurge, close on the heels of revenue downgrades from frontline software companies such as HCL Technologies, Hughes Software and Satyam Computers and the post-September 11 terrorist attacks on the US, seems even more distressing. In early November, recognising the ground realities, Nasscom revised the revenue forecast downwards from 40 per cent to 30 per cent. With the industry averaging a compounded annual growth rate of close to 50 per cent for the past five years, this admission by Nasscom has confirmed the worst fears of the industry.

For some time now, the lack of visibility, pricing pressures, marked slowdown in IT spending and longer decision cycles have been retarding the growth prospects of the frontline and medium-sized software companies. And speaking to different software companies indicated that there was no material change in any of these variables in the recent past.

Fluctuating growth fortunes

Even a cursory examination of the revenue/earnings growth pattern of the software industry in the last five years and now reveals that the industry is gearing to face its biggest challenge. In the last five years, the industry was fortunate to experience two waves of opportunity in quick succession - Y2K followed by Internet/e-commerce. These opportunities were bolstered by a vibrant US economyandpresented the key frontline software companies with ''25-30 per cent'' of revenues dictated by ''premium pricing'' and significantly high margins for these activities in those years.

However, once the economy went into a downturn last year, the combination of lowered IT spending by brick and mortar companies in e-transformation and a freeze on investments in telecom, optical networking and wireless, served a body blow for the IT industry, with the software segment being one of the victims. In a single stroke, the significant contribution of 25-30 per cent of revenues of most of these frontline companies just evaporated into thin air. In our considered view, the inability of the frontline companies to immediately substitute this high margin 25-30 per cent revenue loss with newer sources of revenue destroyed the ''cushion of comfort'' enjoyed by the software industry in the past. To a large extent, we strongly believe that creating a new and enduring 25-30 per cent of ''high margin revenue stream'' holds the key to companies balancing revenues through volume growth, with high operating margins.

The strategic thrust

The current economic downturn has offered the much needed breathing space for frontline software companies to reposition themselves to address this ''volume and margin conundrum.'' In this context, three key and concurrent trends are emerging across frontline software companies.

*Creating a buffer: As the slowdown started taking a heavy toll earlier this year, one of the immediate priorities of companies was to create and harness revenues from two key lines of business - systems integration and business process outsourcing (BPO). Wipro has taken an early lead in the systems integration activity by bagging a systems integration contract of $70 million, one of the biggest orders bagged by any company in recent times from Lattice Group Plc, UK. Infosys has indicated that systems integration and BPO will be its growth drivers. In BPO (basically, taking over the backoffice functions of financial service or insurance or any other domain), Infosys plans to address existing clients through a suitable business model currently on the drawing board.

*In the midst of the slowdown: In the near term, the frontline companies are expected to work hard at enhancing their mindshare among the existing customers. This strategy is aimed at tiding over the current depressed phase. Over a slightly longer time-frame, assuming that the global economic downturn were to last more than a year, practically all these companies are positioning/pitching themselves as ''strategic'' outsourcers for Global 1000 companies. Going by the trends over the past six months, it appears that increasingly ''offshore outsourcing'' decisions among Fortune 500/Global 1000 companies are being viewed as ''strategic'' decisions involving Chief Information Officers (CIOs) and decisions are being taken by the Board of Directors in some cases. Considering the relatively higher ''scale and size'' of these decisions, the decision-making cycles have become slower and longer of late. However, once the mindset change occurs among global companies, software companies in India with greater brand visibility and a flexible global offshore delivery model stand to gain the most from large outsourcing deals.

*Coming out of the slowdown: To go up the software value chain and maintain the operating profit margins, companies such as Wipro and Infosys are aiming to enter the consulting services arena in a big way. Infosys recently articulated its strategy of enhancing ''consulting services'' which currently contribute 10 per cent of its revenues to 30 per cent. . The rationale for this move stems from the fact that the big 5 type of consultants (such as the Accentures or PwCs of the world) are examining and establishing offshore capabilities to enhance their value proposition. This growing convergence among service models between the Big 5 and Indian players gives Infosys the confidence to compete with them on a global basis in the medium term.

The key challenges

Going forward, if these strategies are to work, frontline companies must be willing to take calculated risks and brace for the following challenges:

*Acquisitions: Acquisitions hold the key to rapid inorganic growth. Most of these companies have raised funds through American Depository Share offerings with the principal intention of using them as a currency for global acquisitions. And with ambitious growth plans, this is probably the right time for them to take calculated risks. As the dust kicked up by the downturn shows signs of settling down, this is probably the right time to make these acquisition deals happen. Companies such as Infosys have outlined acquisition plans for growth into the consulting business. It has stated that it is looking for companies with a manageable size with revenues of around $100 million, strong vertical expertise and a good client base. Wipro has also outlined similar plans.

*Create brand equity: If strategic outsourcing relationships have to grow in future, creating a global brand equity is a prerequisite for success. And in turn, this will help the Indian companies being ranked higher in vendor evaluation among different customers vis-a-vis competition from medium-sized firms in India and players emerging in Vietnam, Israel, the Philippines and China. Companies such as Infosys are already investing in brand-building by associating with other brand leaders who are not their competitors. For instance, it appears to have recently had a co-branded event with the UK-based The Economist. 5x Onsite to offshore mindset: The global downturn also offers a good opportunity to change the mindset of global players on offshore outsourcing. It is imperative for Indian software majors to sell the ''Global Offshore Software Delivery Model'' or what Nasscom calls ''Smart Sourcing'' model as a cost-effective, high quality and reliable option to first time outsourcers and slowly expand it for mission-critical applications.

*Bear a riskier profile: With the huge cash hoard in their balance sheets, frontline companies are at the safest harbour at the moment. But if they have to keep improving the return on investment to shareholders, they must be willing to bear a relatively riskier profile - by balancing inorganic and organic growth. That can be achieved only if they can infuse confidence in software stocks as good investments for the long haul.

maverick@thehindu.co.in

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