The Hindu Business Line : `Sustainable growth has started and margins would grow next'

In this business you have to constantly innovate to remain the leader. If I have to maintain a relationship with a customer for a $100-million order, my focus would be to have 20 per cent EBITDA margins and then reinvest the rest for co-creating the business with the customer. — MR ARUN JAIN, FOUNDER, CHAIRMAN & MD, POLARIS SOFTWARE LABS

Journalists are used to asking questions. But Mr Arun Jain, has a question before you can quiz him. "I want to ask you, before you start off, what the story is about?" Mr Jain has not been keen on meeting the media for the last 18 months or so. He feels that since his last meeting with Business Line in October 2004, what he has to say may not have changed.

Clearly, he does have something to say now, just after a satisfactory June quarter for Polaris Software Labs, the company of which he is Founder, Chairman and Managing Director. Is it a turnaround by Polaris? Is the growth momentum sustainable? These are the questions we went prepared with, and here are his answers:

Excerpts from the interview:

Have you turned the corner this quarter? Other than the lumpy nature of the products business, is this kind of growth sustainable?

Yes. Why is this quarter better? Initially when you enter an account, you have to invest. You don't get revenue initially — the customer needs proof of concept, etc. He says he doesn't trust it. The idea looks good but it's not on the ground. Show me that it works, is his demand.

So, almost all of last year, we spent a lot of money building proofs of concept with these 14 customers. Initially we had four or five of them. When they start getting this concept, it takes 6-9 months to build it. That was the lag that you saw in the last two quarters.

Fourteen AAA customers you have said have the potential to give you more than $10 million a year each. Link this to last quarter, where you talked about 40 accounts that are you focusing on. What is the nature of those accounts and how are they linked to the 14?

The total (number of accounts) we are saying is 50 — last time it was 40. So now it is 14+12+24, the last of which is single A, while 14 are AAA. Our business from new accounts has grown 35 per cent quarter on quarter. Citibank revenue is constant... obviously as a $100-million-per-year business, it can grow only so much.

From 60 per cent revenue contribution, the Citi business has come to 51 per cent. During the next three quarters, we want to make it 40 per cent... Our target is that Citi business should become 30 per cent of our total revenue eventually.

A 35 per cent growth suddenly in a quarter is a result of the investments we made in these accounts in the last four quarters. Some of these are still small — only $100,000, $200,000 or $300,000 accounts. That's why we are confident of the coming quarters.

Even with opportunity, banking products is a crowded space, where differentiation and distinctiveness are difficult to build. Is it a case of not being able to convey to the investor that you can enter through the side door and still make a big difference?

As of now, investors want it proven in the results. In the last six months, I have been telling my corporate communications not to fix meetings. For, every time I have to say the same story.

But, I think the intrinsic value of the company is there. People have to trust in those deliverables. A lot of people have stayed in the company when there was external pressure.

The other important thing is that Arup (Gupta) has put an execution engine in place. I did not have a COO with me. I have been looking for one for the past one-and-a-half years. I didn't have execution managers able to manage scale since Polaris has grown from a small company. Arup wanted to take time to understand Polaris' culture. He was with TCS for 26 years. Very few have that kind of experience. He has taken two quarters to put the execution engine in place. I have to move back and let him do his work.

He has also upgraded the sales team — there is a sales team in the US and Europe since the last two quarters. We have 100 sales persons in those geographies. This is what he did as soon as he came on board.

You talked of three levers for higher margins from services — one, linked to intellect, two, through domain expertise and, three, in the form of application development and maintenance. When do you think margin levers come in... ?

We have seen a smaller impact — not significant this quarter. My business is different because my Asia business is 30 per cent. No one else has that. Singapore and Middle East have lower rates. The average rate is $25-30. My rate is $57 — if I take the US and Europe separately, it would be $65.

Looking at the operating profit margin, except for this quarter, for which it is 15 per cent against 12 per cent for the earlier quarter, the average has fallen to below 10 per cent. How do you push this up to the 25 per cent level, and over what time?

First of all we need to look at sustainable growth. Margin improvement may be another one percentage point quarter over quarter. Sustainable growth has started. Margins would grow next.

What sequential growth would you be looking at hereafter?

About 5-7 per cent (quarter-on-quarter) comfortably. We are being conservative. That's sustainable. Visibility is there. Margin growth is the next step. A 25 per cent EBITDA margin is possible but I don't want to commit. I don't want to have 25 per cent margins anyway.

You have already invested $30 million. Would you think the engine would now come out firing, rather than... ?

A 20 per cent EBITDA is a good margin, for global companies. In this business you have to constantly innovate to remain the leader. If I have to maintain a relationship with a customer for a $100-million order, my focus would be to have 20 per cent EBITDA margins and then reinvest the rest for co-creating the business with the customer. The next model for IT would happen when you are co-creating solutions — because each model would be different. Banks would be differentiating themselves in their space — but that would be five years hence, not right now. You need to really look at how to co-create a business model then.

The next three years' focus is clear. Let's grow the revenue and improve the margin — a percentage point quarter-on-quarter is a good way to look at margin growth.

For margin growth, would the services engine be a good strategy to play on? Aren't products the drivers for margins?

What Tier I banks want is a solution from us. Tier II banks may be okay for the strategy you talk about. When you are addressing the Tier I banks, I would say that the ideal model would be 30 per cent revenues from products and the rest from services. If you have to grow to half a billion dollars in revenues, you can't have only products. For them there is a Death Valley point. After $100 million, i-flex moved quickly into services... If they hadn't, they would have been in trouble now.

When your share price fell to Rs 65 and you bought in the markets, what was the trigger or the thinking behind the purchase? Would you think that associating in some way with a bigger player would be inevitable for you to move to the next phase?

Buying at that level was a no-brainer. It's a once-in-a-lifetime opportunity. As to associating with a bigger player, it comes to the DNA of the company. I am not resistant to doing things in a particular way for a global corporation. It's about building a unique DNA for the company. A strategic alignment or acquisition does not help us.

You have a watertight agreement with Citigroup on this. Does Citigroup share that commitment? Seeing where the business has been in last eight quarters and seeing what they have done with i-flex, I would say that their interest is waning... .

Their interest would be in getting returns on investment. So, in terms of investment, it's only a story to be discovered by the investor. If CPS of Rs 7 last year and if my EPS is Rs 8-10 this year, the share price would be Rs 300... . So they should be happy.

But that value isn't there today...

i-flex anyway was a 100 per cent controlled company. No one else had a say. There's a significant difference between i-flex and us. I have 30 per cent ownership. Even if Citigroup does not share my commitment, what will they do? They are an investor already. They have a commitment because they know the investment has been done. Investment return at this point in time is not valuable. They will lose anyway if they sell now. People should ask themselves common sense questions before they jump to conclusions. Some blogs pick it up. I can't stop that... but why will an investor come out at this stage? If he comes out even next year, he would get a better price than he would now. Second issue is that it is possible only when I want it to... .

How has your overall strategy changed since we last met in October 2004?

From October 2004 to now, nothing has changed. I told you that we wanted to focus on Tier I banks, on large budgets. Large budgets mean large business. So the challenge back then was how to penetrate big banks. How do you knock at their doors?

The Big 5 of the global IT industry have already closed those doors. So, where is the scope for us to enter Tier I banks, which is where money lies? Sustainable growth and money lies in Tier I banks, not Tier II or Tier III. That was the challenge

Now, we wanted to enter from a side door. We said that too, then. It takes that much time to execute on the ground. Nothing has changed. Now we have 14 AAA customers. Arup was surprised at the shorter time that Polaris took to enter such clients so quickly, when TCS took so much time. But our strategy is `side-door' entry.

We suggest to our clients that we manage liquidity better for them — cash management, that is. It's the Chanakya strategy. Don't attack the centre. Target the corners. The centre has enough defence. In these kinds of contracts, you have to sign a master services agreement. Then, you have a hole inside. Even if you have to take a small service here, the rules are that any vendor who comes in should have this agreement. Once you have that, you get into the whole set-up and then people can breakthrough.

But, first, you have to break the gatekeeper. You have to do it at the business management level. So we address the issue of how a corporate bank makes money. When we go deeper, it's not about cost arbitrage. A corporate bank makes money through efficient transactions, that is, by reducing the cost per transaction or managing risk or through cost arbitrage — these are the only three ways a bank can make money.

When we come with innovative models for the bank and it listens to us. Trying $1 million, $2 million, or $3 million kind of service like this, is small change for such banks. Once they do this, around this liquidity bit, they try backward integration. Then you expand the pipeline around that particular project.

In the June presentation, you talked about $36 million invested in the Intellect Suite. You have been in investment mode since 2003, leaving aside integration from 2004. You had said that you would turn around by 2006. What were the steps in the journey... what went wrong in between?

Nothing went wrong. It takes that much time. Before 1998, no one knew that the IT sector would boom. We could not look beyond Y2K. The media also talked about a bust after that. Similarly, awareness in the media on the company studies, within India is also low... If you are looking at a technology company as a global company and not as an Indian, Tier-II company, then it's different.

It's difficult for me to communicate that I am not a Tier II player. If you slot me as a Tier II company, then it's OK... it's your call.

From our viewpoint, we are playing in the global field. We are situated in India, that's OK. But we are leveraging the India advantage to level the playing field, with Misys or Temenos on their turf. We are playing that game. So you need to see if my business model would go beyond cost arbitrage.

In 2004, I could have taken a decision to show profit... If I hadn't made investments, my EPS would have been Rs 15 today. It's not a big issue. My share price would have been Rs 300-400 today. If you look at cash EPS, it was Rs 7 for us last year. It's not a small EPS, when you are in investment mode.

It's so much PAT driven for the investor that he does not go even two lines above the PAT in the P&L — to look at depreciation or amortisation. The analysis is so much focused on PAT... I understand that he might not trust the strategy of the company because he is risk-averse and wants to see if his returns are quick... But he can at least see two lines above PAT...

You had employed a consultant to sensitise the sales force about the need for a cohesive strategy. What are the contours of that and how did it make a difference to the overall sales effort?

We did a sales conference in December. Selling on cost arbitrage and consultative selling are two different models. We moved from the first to the second. The point of the workshop was to bring all the 100 sales people together to share with them how the new process works. The workshop was on how you build a presentation — using TIPS as a methodology for consultative selling — trends, implications, possibilities, solutions for this... The point is to present the solution, however good it might be, so that it fits the customer requirement.

You might think your consumer finance tool is the best. But why would anybody buy it? If you explain it in the context of TIPS, you could possibly sell it. Every one has some technology or the other in the banking industry. So ours is a replacement model. First time business could be in India or China but we are not focusing on China.

What was McKinsey's role as a consultant?

In September, we roped them in to validate our model. We were convinced about it. But when you are taking such a big bet, it is best to get it validated by someone like McKinsey. They have given the report that the side door entry is the best strategy — there is no continued involvement by them after that.

This progressive modernisation business is a big strategy. Two validations to that: Banks are going to spend more and more on technology. Second is going with a small point solution, which is the right way go, rather than saying that you would change the core.

Is that approach working better in Europe? The US' contribution has come down 5 percentage points in the last eight quarters or so. Europe's has increased...

Europe is certainly working better. Banks there are not working for cost arbitrage. We get better rates from them. They listen better to us. The US banks sometimes get into debates on rates... Whatever these rates, they do not make a difference to your bottomline. It becomes like buying vegetables. They lose the perspective of what they are buying.

What is the nature of requirements for your AAA customers?

Our confidence is increasing because we are able to get clients from all geographies. Very few companies in the world, including Temenos or Misys for Tier I bank accounts, can claim that. The lead indicator of the strategy will be, `Do I understand business in the local market place?' If the top banks in Australia, the US and the UK use my solution, then my strategy works.

What are the cross-selling possibilities when you enter through the side door?

Cross-sell opportunities are huge. We entered an account in January with one proposal. Now we have four proposals with the same account — in Hong Kong, the US, and spread across. Cross-selling was an important focus of sales for us. If I enter with a loan origination system, tomorrow I am selling a treasury system to him.

You enter an account because of a niche speciality that you possess. The client already has a relationship with an established vendor. Why would they allow you to cross sell?

We fulfill requirements in the business value chain. One is the cost arbitrage. Second, when a bank wants a solution, it has to buy a product from one company, get it implemented by another and possibly maintained by a third.

In the last few years, they have faced so much difficulty because of the segmented nature of the industry. This is the problem area of the Western world. Because, you can't invest in 500 people who are doing product engineering, unlike when you are a 6000-people company.

A product company cannot have more than 50 people in the US. Even with the best of ideas, you need to have muscle. They don't have that. A pure services company cannot nurture the idea. For, they come from the factory model. Our challenge was to integrate such thinking into one company. For a customer, he needs one accountable point.

That solution could be in a new technology - which is a unique selling proposition. If I am selling loan origination as well as treasury solutions based on a services oriented architecture... A Tier I bank wants customisation. It wants a vendor who has given good solutions to other clients in the past.

Then, don't your competitors currently offer integration or customisation? What names are you beating in the marketplace?

Most vendors don't offer ongoing customisation. Much of it is one time customisation. If I am a Calypso or some other like company, I will not modify my software if you need customisation.

Then, at some point, moving to packaged solution for clients means that eventually the likes of Temenos, SAP and Accenture would play in the same space that you are in, probably you are already seeing them here. This means that the services landscape that you built up somewhat disappears, it might not have the same punch as it does today.

If service gets hit, then all Tier I companies of India will be in trouble. That is a bigger risk for them than it is for us, by sheer size. The statement that you just made, I have been making from 2001, that we are the only industry in the world that is (exists) for the defects we created — and the customer is willing to pay us to fix our own defects. So the day the defects will not be there... I am of the opinion that this opportunity will soon vanish and Indian companies will have serious issues.

All I am saying I am protecting my business for five years. I am not saying I have protection beyond that. After five years, I will not be zero since I have products and IP. For many others in the service business you cannot say how the landscape will change beyond five years.

The US seems a geography that everyone finds difficult to penetrate...

In the US, Tier 1 banks exploitation (should continue) for next 18 to 24 months — our entry strategy is point solution strategy. Temenos has a core strategy but that has limited scope. But everyone requires an origination system that I offer.

So, for two-three years, we have a clear roadmap to go into these accounts. We have a small, initial traction in the US. We focused on the UK, when we had a new offering, instead of diluting the focus.

The year 2004 was of strategy, 2005 was focused on expanding footprint and 2006 is when our execution takes over.

If there is a compelling situation, if a buyer offers value irrespective of the market price, and the buyer helps opens doors in the US...

This is only a phenomenon. Infosys was asked the same question in 2001. Why shouldn't you buy out an international company? Same question you are asking me today... Why not create value by aligning with US companies. In the next five years, Indian companies will be driving global industry anyway... today Infosys or TCS is driving the value.

In services, you need to open doors. Oracle could do it for i-flex...

Same question for Infosys — Accenture could open doors more than Infosys could.

But for a product company...

Our cost structures are lower, we can anytime beat the pricing of the competitor, being an Indian company to win the deal. Infosys used pricing factor to beat Accenture which didn't realise when they were cornered. Our Western competitors then and now, think that they are impregnable. That is not so. Our hunger is much higher than theirs. We hire a lot of Americans — we do not find that kind of hunger.