Shrinking deal size: Over the past couple of years, there has been a structural change in the global services landscape. First, mega billion dollar deals have become less of an industry norm.

Take, for instance, the deals signed by the multinational vendor, IBM Global Services in the April-June quarter of 2004. Of the five long-term deals totalling $1.2 billion, contract sizes ranged from $100 million to $350 million, each averaging 5-7 years.

Second, sole-sourcing deals where, say, the entire data centre operation was handled by a single vendor have become almost a rarity.

The phenomenon of shrinking deal sizes is turning into a huge competitive advantage for Indian offshore players. Given that the top three companies are already servicing $40-50 million clients, this translates into onsite revenues of over $100 million.

This effectively means that Indian companies, especially those in the top-tier, will participate in every deal in the $100-500 million bracket that matters. Given the offshore delivery model, which helps them offer a pricing advantage and strong execution capabilities, the rate at which new clients are won may keep rising in the coming quarters.

Post-US elections momentum: For the first time since the downturn in 2001, there are indications that IT (information technology) spending may perk up, at least in select verticals. This is bound to increase the quantum of discretionary spend for application development-related work (with higher margins) among Fortune 500 companies with billion-dollar IT budgets.

Second, billing rates that are beginning to show signs of stability may start inching up sooner rather than later. The top Indian companies are suggesting that new clients are coming in at higher bill rates and large existing clients are keeping the rates stable. As long as the US economy does not slow down sharply, there may not be much pressure among existing clients to renegotiate lower rates, though it cannot be ruled out altogether.

Finally, with Mr George W. Bush back in the White House for a second term, the prospects of an outsourcing backlash may also recede to a large extent.

What will be keenly watched?

Going by these trends, it seems a near-picture-perfect setting for the Indian software industry, especially the frontline companies, to rake in revenues and notch up earnings at a robust pace. Based on sustainable revenue and earnings growth, TCS, Infosys and Wipro are trading 25-30 times the projected 2004-05 per share earnings.

Since 2004-05 has already been factored into the valuation, the projected growth rates of 2005-06 and performance in the first two quarters, will hold the key to the absolute and relative valuation of these stocks. In our view, the critical factors to watch out for over the next year or so are:

Differentiation in business model: Most research outfits have claimed that the top three companies, especially TCS and Infosys (see Table) look alike in terms of service offerings, skill-sets, employee base, pricing and client service. With India becoming a truly attractive offshore destination, for the first time, each of these three companies will have to possibly create differentiation in the marketplace and play to their strength. This will be crucial to assessing their pace of revenue growth in future.

For instance, TCS may be banking on its ability to mine its deep client relationships and bag mega deals (such as the National Health Service, UK, contract) as a crucial differentiator. It will be hoping to use its long-standing relationships with such clients as P&O Nedlloyd, AIG, HP, Prudential, Standard Chartered or Target to build its revenue share and increase the offshore component.

Infosys, on its part, may bank on its consulting foray to offer a `differentiated' space for expanding its relationship with existing clients. Or consider Wipro. As a player with a presence in both technology services and enterprise applications, it has the widest repertoire of service offerings in the market. If the demand environment stays bright, Wipro can play along both the technology and enterprise flanks and make a big difference to its revenue growth.

Competitive positioning of MNC vendors: Both IBM Global and Accenture, the two key MNC vendors, have turned in a weak performance in the latest quarter, largely because of their weak outsourcing services business. Clearly, this is in stark contrast to the performance of the top three Indian companies.

The pressure on these companies to enhance their offshore presence and make it a part of their delivery model is stronger than ever before. Over the next year, they are likely to get their act together. The strong demand environment may provide them the leeway to experiment and refine this model from servicing clients worldwide.

At the same time, there will also be a tussle between the Indian and MNC vendors to create a successful `Integrated IT Services and BPO model' that will offer a bargaining leverage with the customers. Similarly, at the lower end of the software value chain, cost pressures may force automation in areas such as maintenance or remote infrastructure monitoring through reusable components.

Operate from multiple geographies: Since MNC vendors already operate out of multiple geographies, sooner or later, this could become a differentiator in the IT services and BPO marketplace. Post 9/11, a pure India-centric operation has emerged as a cause for concern.

As Indian vendors come to take more out of the wallet while implementing high-end and critical work for global clients, this will become increasingly important. While an India-centric presence will hold sway for at least five years, establishing centres in other low-cost geographies will be a crucial risk mitigation element in the coming years.

Among the top three companies, TCS probably has the best near-shore capability. Operating global development centres out of Uruguay, Brazil, Hungary and China, it serves nearly 35 customers in these geographies. At this point, it is still a small component of its overall revenues. Both Wipro and Infosys are still making inroads into some of these areas.

Inorganic growth: As Indian software companies try to move up the software value chain, selective strategic acquisitions can play a complementary role.

Over the past three years, companies such as Wipro (through their three key acquisitions — Spectramind, AMS and Nerve Wire) and Cognizant Technology, a Nasdaq-listed company (through the acquisition of Aces International, Infopulse and Ygyan) have used them quite effectively.

With the exception of Spectramind, all of these were small strategic acquisitions that, if integrated successfully with the parent company, have the potential to generate accelerated returns. This may be a trend that TCS and Infosys will replicate to grow quickly in the BPO space, where both have but a relatively marginal presence.

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