The Hindu Business Line : As much as the eye can see...

After a turbulent phase in the markets, everyone is asking: Are our software stalwarts slowing down? eWorld sounds out the industry on what's happening, and what the next year holds.

ONCE in a while, after a turbulent phase in the markets, you have to wait for the clouds to clear to get a better sense of the reality. This happens to be one of those periods, where perceptions about the future of the frontline software companies (or Tier-One vendors) have turned jittery and run way ahead of reality.

The trigger? Lower-than expected earnings guidance from Infosys Technologies for 2004-05 and a disappointing latest quarter from Tata Consultancy Services. (Wipro and Satyam have, however, bucked the trend with a reasonably good performance).

And the outcome: A slew of questions have surfaced on the future growth rates of frontline companies, if there is a slowdown in information technology (IT) spending in the US.

May 2003 and now: Any parallels?

In May 2003, the last time the sector was rattled by the Infosys guidance, cover stories in leading business magazines had painted a doomsday scenario of steep margin erosion and loss of competitive advantage for frontline software companies to multinational (MNC) vendors.

Are there are any parallels between the pressures witnessed then and now?

Hardly any, if the guidance provided by Infosys, which has traditionally set the tone for the rest of the industry, is anything to go by.

In 2003-04, the per share earnings growth projected by Infosys at 12 per cent was way out of sync with revenue growth of 23 per cent, indicating expectations of steep margin erosion.

In contrast, however, in 2005-06, the per share earnings growth of 24 per cent is comfortably in line with revenue growth of 26 per cent for 2005-06, suggesting no material change in margins.

Secondly, in April 2003, the performance of some frontline companies was affected on account of pricing pressures and volume-based discounts from existing large clients, whose comfort level had improved significantly with offshoring.

But this time around, billing rates have not been an issue so far, as the frontline companies have shown at least four quarters of stable billing rates, slowly inducing a positive bias for the future.

Playing a different game

Since 2003, the frontline companies have not only posted two successful years of strong growth in earnings, but also managed to keep the forces of billing rate pressure and margin erosion at bay. But all of a sudden, why is the industry going through yet another jittery phase?

It is even more intriguing as the offshoring momentum has not slackened, new client visits have continued to be robust, and shrinking deal sizes, with engagement lower than $100 million, are expected to play to Indian offshore vendors' advantage.

Is this just a case of the maturity of the sector and the law of large numbers catching up with these companies, with TCS ending the year with revenues of $2 billion and Infosys and Wipro likely to join this club this year? Or are there other uncertain variables at play?

To address these questions, eWorld spoke to a cross-section of analysts from Indian and foreign investment houses and at offshore advisory services, select industry CEOs and listened to conference calls of practically every MNC and Indian company to piece together five key trends that are likely to dominate the fortunes of the frontline companies in 2005-06.

IT spending and Offshoring

Despite the pace of global IT spending remaining sluggish over the past two years, the offshoring momentum has never slackened.

The past two years have, in fact, seen the frontline companies grow by over 30-40 per cent and that has helped offshore gain mainstream status in the developed world.

Confirming this trend, in the latest conference call in April, the senior management of Sapient Corporation, a US-based consulting and technology services firm, categorically stated that they did not see "any slowdown in overall IT spending" nor any deflection in demand on the offshoring front.

Sapient has been using the India-based delivery model quite effectively and had recorded a strong 16 per cent sequential growth in the latest quarter, after two sluggish quarters.

Even some of the outsourcing consultants/advisories such as Gartner or IDC have indicated recently that global IT spending may have only some slack of, say, about 1-2 per cent, built into it.

As long as the overall IT Budgets shrink by 1 or 2 per cent, it will not make much of a difference to the Indian frontline companies, says a software analyst with a leading investment brokerage house. At the moment, any sharp swings that may affect the course of IT spending in the US economy are not visible, he adds.

Since Indian frontline companies are servicing only a small fraction of the annual IT budgets of Fortune 500/Global 1000 corporations (with average budgets in excess of $100-250 million), the potential for volume growth from offshoring remains fairly strong over the next year or so.

Multi-vendor sourcing

As the comfort level with offshoring is increasing, existing clients (mainly Fortune 500 clients) are beginning to actively look at their cost equation and seeking to diversify their vendor base.

As a recent Datamonitor report pointed out, the average size of IT service contracts is coming down on account of a rising trend of multi-sourcing. Though this is not a clear trend yet, multiple vendor sourcing can typically happen in two or three different ways.

One is, of course, the pricing issue. Some of the existing clients who have been working with the top two or three frontline companies may be able to stall price increases by moving their application management or repetitive work to mid-sized vendors. This may not necessarily be bad for frontline companies, unless they are taken by surprise, as they can shed some less profitable work and acquire others through client churn.

Two, an attempt to spread work and derisk across frontline players or niche mid-sized vendors with vertical expertise. Typically, in some BFSI (banking, financial services and insurance) accounts, when an existing vendor reaches a certain limit, say, $50-75 million, or in specialised work such as business intelligence or HR processes, working with multiple vendors becomes the norm.

Finally, in new deals, clients can straightaway structure the deal with multiple vendors, straddling the frontline and specialised mid-sized vendors in different verticals.

Confirming this nascent trend, Ravindra Datar, Principal Analyst, Gartner India, says unless Indian frontline companies can build non-cost differentiators, multiple vendor sourcing will become more common in the future. Even today, he claims that outsourcing advisories for clients are doing aggressive peer-cost comparison, which ensures that certain types of routine maintenance work no longer command a premium in the market.

Acquisition-led churn

The pace of acquisitions by Indian/MNC vendors has the potential to trigger some unwarranted churn within the clients serviced by frontline companies.

Take, for instance, Patni's acquisition of Cymbal in November or Nasdaq-listed Cognizant Technology Solutions' of Fathom Solutions recently in the telecom vertical. For Cymbal, SBC Communications happens to be the top client and for Fathom too, it is one of the key clients.

Since SBC also happens to be one of the clients of the top three frontline companies, the possibility of a client churn or ramp-down in business or slower flow of new business gets stronger.

Also, take the Nasdaq-listed Kanbay Inc, which announced the acquisition of Accurum in early March. It counts Lehman Bros, JP Morgan, Merrill Lynch and Bear Sterns as its clients in the financial services space.

Similarly, in end-April, Satyam announced the acquisition of Citisoft, which counts several global securities firms such as UBS, JP Morgan, Merrill Lynch and Bear Sterns as its clients. These tuck-in acquisitions, made to expand either service offerings or add new financial service customers by frontline or mid-sized companies, can start exerting some changes in the client composition.

Add to this the impact of restructuring or internal re-organisation in the Fortune 500 space by clients of frontline companies such as American Express, HP, General Motors and AIG or financial service firms such as Bank of America, Goldman Sachs, Fidelity and others dabbling with their captive operations in India, and the uncertainty only gets bigger.Software analysts, however, remain divided on the implications of this trend. Most feel that frontline companies have faced such situations before and unless two or three of these trends hit them at the same time, the revenue implication may not be significant. Clearly, frontline companies with their strong client pipeline across different revenue brackets, ranging from $5 million, $10 million and $20 million, are cushioned from this impact in a big way.

Datar adds that companies' setting up captive operations may lead to some short-term pain, but this is bound to increase third-party outsourcing in future.

New service lines/geographies

Since the momentum gathered by new service lines, be it package implementation, infrastructure management, testing, BPO and consulting (business, technology and quality) has remained quite strong, this year will be prove to be the litmus test on this front. Since these account for over 20-30 per cent of revenues for the top five frontline companies, the ability to sustain and build on this will be watched closely.

Not only are service lines growing, but frontline companies are also shifting their focus towards Europe and Asia in the past year, slowly reducing their dependence on the US.

In a conference call in late April, Cognizant Technology Solutions has highlighted that since the last quarter of 2004, it has noted increasing interest in offshoring from companies in the UK and continental Europe. Infosys has also indicated that they have been proactively investing in sales and marketing in Europe, while Wipro and TCS have also made adequate progress in this geography. These are data points that analysts and industry observers will closely watch over the next year.

Upside in billing rates

Though the sector has been witnessing stable billing rates for the past few quarters, frontline companies have shown a marked reluctance to consider an upside in pricing for their earnings projections. The fundamental reason is that despite the demand environment appearing favourable, supply side factors may be exerting their influence on billing rates. There appear to be two or three key variables at play. First of all, in existing client accounts (any client which accounts for more than 3-5 per cent of revenues), the pricing power still resides with the client to a large extent on account of availability of other vendors. Secondly, there is always a lurking fear that any price increase by top Indian vendors can be resisted by MNC or other niche vendors, whenever they choose to. This year may prove the efficacy of these moves. Three, even though new clients are coming in at higher price points, since they account for less than 10 per cent of revenues of top vendors, their overall impact on the bottom line has been quite insignificant so far.

Responding to the prospects of a billing rate upside, an analyst with a securities firm is quick to point out that billing rates are a complex function of at least three variables - services mix, vertical and geography mix.

As long as frontline companies are able to mix and match this well, they will be able to effect price hikes selectively.

Rusi Brij, Vice-Chairman and CEO of Hexaware Technologies, also confirmed that though there has not been a secular improvement in billing rates, rate improvements were possible on certain projects on a selective basis.

maverick@thehindu.co.in

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