The Hindu Business Line : Software sector hits the purple patch

As frontline companies are set to comfortably clock growth rates of over 35 per cent for the year, the revenue and profitability gap between frontline and Tier-II companies is set to widen.

WOOING FRESHERS and retaining middle-management talent still remains a supply side challenge. — R. Shivaji Rao

When the Nasdaq-listed Cognizant Technology Solutions recently raised its revenue guidance to 55 per cent for calendar 2006, from 42 per cent at the start of the year, it reinforced the belief that the software sector had hit a purple patch. Coming on the heels of a sharp upward revision in guidance by Infosys Technologies, it epitomised the buoyant demand for offshoring from bluechip clients in the US and Europe.

With onsite project starts rising sharply and discretionary IT spends for development in key verticals set to expand further, the future course of the Indian software industry is likely to be steered by a few crucial trends:

Widening gap

As frontline companies are set to comfortably clock growth rates of over 35 per cent for the year, the revenue and profitability gap between frontline and Tier-II companies is set to widen. Moreover, on a significantly larger base, the frontline companies have registered double-digit sequential growth in revenues that have been matched only by a few Tier-II corporates.

Tier-II companies are already feeling the impact of this trend on several fronts. And this will get more pronounced if there is a slowdown in the US economy. Frontline companies have been using their scale and deep pockets to enhance the range of their service offerings to include infrastructure management, testing, business intelligence and BPO. They have also marched ahead by broad-basing their vertical focus to include retail, transportation and energy and utilities. By making concerted investments over a fairly long time frame, frontline companies have also managed to pump up revenues from Europe.

Consolidation trigger

Will this widening disparity between frontline and Tier-II companies trigger consolidation on a major scale? Not in the near term. The overall buoyancy in the services space is likely to help the Tier-II players also and perk up their valuations. However, if the US economy starts to slow, then the valuations of Tier-II companies may throw up some compelling buyouts. In any case, the players will be keenly watching how the EDS-MphasiS BFL integration pans out. Since integration is always a tricky exercise in services, buyouts of Indian companies will be pushed more by European or American vendors, such as Cap Gemini, Atos Origin, or Keane, on strategic compulsions. A merger between two domestic mid-cap companies still appears unlikely in the near term.

Large deals

Since the ABN Amro-GM deal put through last year, talk about such large transactions has been relatively subdued. The robust growth in volumes from the top ten clients of the top five frontline vendors in the past six months clearly shows that their ability to cross-sell and deepen their relationships with clients is unquestionable. With the Infosys top management claiming that it will be hesitant to commit large resources in a buoyant environment at low prices, this issue may be receding to the background.

But sooner or later, the focus will be back on large deals, as the frontline companies may not be able to maintain the scorching pace of growth without a healthy contribution from such compacts. Moreover, if the billing rates of existing clients do not move up over the next couple of quarters, companies will be forced to consider growth from large deals.

The attrition challenge

The dynamics of the services sector is shifting away from the demand side towards a host of supply side challenges. As companies in this sector have offered average wage hikes of 15 per cent for the third successive year, this issue is likely to be at the top of the mind for some time.

Though frontline companies have managed to negotiate this wage inflation with productivity gains and other initiatives, it is expected to pose a significant challenge for the Tier-II companies. Clearly, the Tier-II companies are being forced to shell out wage hikes that are substantially higher than the frontline companies.

Secondly, the relatively weaker Tier-II companies are becoming a good hunting ground for middle management talent for frontline companies. Finally, the frontline companies are really turning on the heat by substantially revising the entry-level salaries. Cognizant has announced that it is increasing the entry level for the 2007 batch by 20 per cent. This is in response to Infosys stepping up the freshers' pay from Rs 2.4 lakh to Rs 2.7 lakh.

Despite all these measures, the sector is still facing high attrition levels of over 15 per cent on the services side alone. No wonder, in a recent management succession exercise, Mr Lakshmi Narayanan of Cognizant is transitioning from his managerial role to assume a more critical role of addressing a range of supply side issues at the industry level.

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