Upscaling no easy program

Suresh Krishnamurthy

IN TERMS of opportunities available to and threats facing small IT companies, some parallels can be drawn to what the pioneers in this sector faced in 1999 when the industry was at crossroads.

The future of even the majors depended on managing to go beyond the Y2K projects. They had to do this and also deal with other such routine business challenges as retaining their employees, moving up the value-chain and acquiring domain expertise. They did all this, and quite well too.

The small IT companies appear to be facing a similar predicament, if not worse, given that 2001 promises to major changes. From that year on, these companies will have to deal with a change in the profile of the services demanded worldwide -- the growth in demand for client-server projects, web-enabling systems, and web-based packages or services in place of application maintenance. This is what the Nasscom-Mckinsey study says and this is not all. Further, from October 2001, the US Government is to reduce the number of visas to 65,000 from 1.15 lakh.

While indications are that this may not happen as the US law-makers may yield to the demands of the local corporates, this is certainly a contingency most Indian companies, especially the small ones, need to plan for. Also, they have to meet the other challenges involved in growing -- attracting talent; moving up the value-chain; and those that have made acquisitions managing the integration of the acquired entities.

Managing change

As the quota of visas for IT professionals by the US Government declines, the emphasis is likely to shift to offshore work. And, as operating margins in this business are higher, more offshore work would for many a small company be a welcome development. There are a few buts... One, the profile of the service demanded may have changed; it is very likely to be related to web-based services rather than any typical application maintenance service that software engineers may have provided in the US.

Two, the size of each job may, typically, be much larger even if it is outsourced by other software vendors or consultants. Of course, there would still be companies offering application maintenance and other low-end work in their offshore development centres. Only, the rate at which such business volumes would be growing would be much lower than in the past. In contrast, the growth in demand for web-based services is likely to increase at a relatively rapid pace.

The mechanics of executing these projects demand different skills from the small companies. The lead time involved in the implementation of such services is also likely to be much lower. Managing such projects is likely to throw up some challenges that would test the ability and the quality and delivery processes of these small companies. This aspect cannot be downplayed. In effect, the off-shore business model in all likelihood would be more demanding for the small companies.

The number of technical professionals required and the type of skills expected from them is also likely to be pose challenges of recruitment. It has been noticed of late that if a company continues to offer services in leading technologies, recruitment of talent is less of a problem even for the offshore development centres.

Nevertheless, there is a felt need for an upgradation in the human resource practices of these companies and for the creation of a brand that can attract prospective employees. As of now, the scale of operations of these companies does not allow for a greater focus on such practices. There is, therefore, the possibility of some of the small companies facing problems in rapidly scaling operations.

As for investment in infrastructure, most small companies have either invested in creating infrastructure or have adequate cash-on-hand to meet such demands. The cash reserves of these companies may also come in handy in recruiting employees in anticipation of large projects. Over a period, funding is unlikely to be a major issue for companies that manage this transition successfully. Such companies would find willing investors while the unsuccessful ones would not need the cash.

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Client concentration, a necessary evil

Yet, if a substantial number of the existing employees are going to be engaged in a single project, the client concentration level would go up. The revenues contributed by a single customer is likely to increase -- which once again enhances the operational risks for the company.

But such concentration provides some benefits also. The business of moving up the value-chain would get addressed automatically as much of the work would be offshore projects. Also, with a larger number of employees working on a single project, there is the possibility of their acquiring domain expertise. Overall, the implication is that the company cannot afford to shy away from such businesses. Even at the risk of increasing exposure to one customer, these companies would be forced to take on such projects.

Acquisition risks

Companies that have made acquisitions face the added problem of integrating the businesses. Most acquisitions have been done to enhance the client base. However, as the profitability of overseas operations is generally lower, they may have to transfer necessarily some of the work done abroad to their offshore development centres to improve profitability.

This is easier said than done. If existing work is transferred offshore, the employees of the acquired entity cannot be retained. However, this is necessary to preserve skills. This implies that the business of the acquired entities also need to grow if the percentage of work transferred offshore is to increase. But overseas IT service businesses are typically growing at around 10 per cent, again posing problems. The implication is that the profitability and the return on capital of such companies, which are unsuccessful in transferring offshore work, may be hit.

In short, integration of the acquired entities is unlikely to be trouble-free. For example, one of the early acquisitions by an Indian company -- of DataView Solutions (now named Infotech Enterprises -- Europe) by Infotech Enterprises, while not exactly running into rough weather, has had to tackle such issues. The company now hopes that work transferred offshore would increase only over a period.

This, however, is not likely to deter companies from making further acquisitions. For example, Infotech Enterprises is itself on the look out for other acquisitions. This may be essential to access a client base that can exploited for more offshore business opportunities. Nevertheless, each acquisition enhances the risks faced by these companies. Growth through acquisitions needs to be financed through the capital market route while organic growth can be funded by internal accruals. The latter is less riskier compared.

Need for rapid upscaling

Much of the threats the small companies face can be countered by rapidly scaling up the operations. Companies that are successful in this are likely to be better placed than others. These companies would have at their disposal a larger number of employees as also cashflows. Rapid scaling up of operations would produce the necessary cashflows which can help in meeting the investment needs.

A larger employee base would provide them the comfort of working on large projects, which are typically taken offshore. Without a large scale of operations, it may be practically impossible to work on projects of Fortune 500 or even Fortune 1000 companies. And working on companies outside this universe has several adverse implications. One, the enhanced risk of getting hit by a downturn in the US economy. Two, such large projects usually involve the use of cutting-edge technologies. They also have implications for acquiring domain expertise.

The rapid scaling up of operations is also not likely to pose risks from the standpoint of moving up the value-chain. A large chunk of the demand for services is only in hi-tech segments and as such scaling up of operation is only likely to improve the contribution of revenues from relatively high-value added services. Also, if the projects are typically application maintenance oriented, the cash flows may help in retaining employees and investing in infrastructure. In short, even such projects are better compared to no projects.

Overall, small companies that are successful in growing their revenue base appear to have a much better chance of dealing with the challenges the likely in the next couple of years. However, upscaling -- either through the organic route or by acquisition -- is not likely to be easy.