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Krishnan Thiagarajan

THE software industry bore the brunt of the 2001 downturn, exacerbated by the September 11 attacks. But business fundamentals in the sector have improved, buoyed by positive GDP growth numbers for the US in the fourth quarter of calendar 2001. The fears of a mild recession, the probability of a return to business-as-usual, and expectation of a resurgence in capital investment spending in the near term, have turned the sentiment positive across the board in the US, and the impact is being felt in India too.

With this development, the fears on the lengthening sales cycles (the time taken to progress from the request-for-proposal (RFP) stage to the closing of the contract), depressed fundamentals and lowered technology spending have been set to rest, at least for now. Players in the software industry realise they are, by no stretch of imagination, out of the woods yet. But they think that with the strong linkage of the software industry to the state of the US economy, it is only a matter of time before the mood swings from gloom to relative cheer.

Challenges galore

For the first time in less than a decade, the Indian software industry is being called upon to prove its mettle, emerging from a highly turbulent and traumatic phase in its history. In 2001, the industry had not talked about near-term prospects, but schooled itself to focus on improving long-term competitiveness. Over the year, the players also reconciled themselves to growth rates of 30-35 per cent (or less); they realised that the days of astronomical growth rates of 100 per cent were past.

The industry had, in the past, constantly talked of "moving up the software value chain". After the downturn, the players have, for the first time, made conscious effort to move away from being pure "offshore outsourcing vendors", using salary/cost arbitrage to move up the value chain, to declaring that IT consulting, systems integration and business process outsourcing (BPO) are the growth opportunity areas. And, for the first time, the strength of the "business models" of the frontline companies will be put to test vis-a-vis that of the medium-sized firms.

Even as the frontline companies are working towards reorienting their business models to operate in the changed business environment, it is obvious that near-term pressures (both in terms of generating business volumes and lower billing rates) will continue. Instead of concentrating on the near-term factors (see accompanying piece), Business Line examined the contours of the industry beyond 2001-02 and tried to gauge its long-term competitiveness.

Long-term goals

Achieving the required size: The realisation seems to have finally dawned on software players that `offshore' outsourcing (jobs done in India) is becoming strategic. Instead of being mere cost arbitrage `plays', as in the past, client demands for offshore outsourcing are now driven by a clearly defined value proposition that covers return on investment (RoI ) parameters, productivity milestones and an array of end-to-end service offerings.

From the 30-odd outsourcing RFPs (request for proposals) pending now, it is obvious that the evaluation process has become far more stringent. There are indications that outsourcing relationships with vendors (such as Infosys, Wipro, Satyam or HCL Technologies) will extend to long-term relationships (of at least three years). With such long-term commitments contemplated by, say, automobile, banking/financial services or technology clients, the trial run (or experimental stage) may be long. No wonder that, even if the frontline companies bag some of these trial run projects, the time-frame of the ramp-up could remain uncertain, though early indications are that it may be over nine months.

At least half a dozen large strategic contracts (of, say, $20-50 million) signed over the next six to nine months will probably be the precursors to a sustainable turnaround in the fortunes of frontline companies. Even in these contracts, a distinction has to be made between clients outsourcing maintenance/support functions and strategic outsourcing on a long-term basis. It is the latter that will be a sustainable model for business growth. Second, it will be important to keep tabs on the rates at which these contracts are signed. If the billing rates are squeezed further, the operating margins of frontline players may erode further from present levels.

Board-level connection: As outsourcing becomes more strategic, the decision-making on these deals is shifting from the ambit of the CIO/CTOs (Chief Information/Technology Officer) to CEO/CFOs (Chief Executive/Financial Officers) and, thereafter, to the boards.

The need to network and strengthen relationships with the CEOs could become the key for the top management of frontline software companies. Companies such as Infosys or Wipro are working towards global branding and visibility in the US markets. Their success will hinge on their ability to leverage existing relationships or forge new relationships with Fortune 500/Global 1000 companies.

Move up the value chain: With no event-driven initiatives such as Y2K or e-commerce to prop up software revenues, frontline companies are for the first time confronted with the onerous task of moving up the value chain. And almost all the companies are gearing up for the task. For instance, Wipro has spelt out plans to focus on systems integration. It has taken the strategic investment route (by investing $10 million to take a 25 per cent equity stake in Spectramind) to foray into the business process outsourcing (BPO) market.

Similarly, Infosys is sharply focussed on the IT consulting market, where it plans to ramp up its revenues from 5-6 per cent now to 25-30 per cent over the next couple of years. It plans to invest in the BPO initiative through a subsidiary.

Cross-selling strategy: The software sector had so far not worked adequately on cross-selling as a growth strategy within its existing client base. This was for two reasons. One, it had not developed adequate domain expertise (across verticals) to be able to make cross-selling feasible. Two, most frontline companies had only limited offerings and managed to widen and deepen their array of service offerings only over the past year or so.

If the frontline companies have to compete with the Big Five, or outsourcing majors such as IBM Global, CSC or EDS, cross-selling has to be one of their key strategies. An examination of the strategies of the Big Five or outsourcing majors reveals that these players completely bypass the RFP route in winning contracts, effectively shutting out a good part of the market for Indian players. If the Indian players remain confined to the RFP route, it is likely that volume growth will suffer in the long run.

Inorganic growth: If the software industry is to maintain its 30-35 per cent growth rate, or peg it higher, it will be dictated by the inorganic route to growth — say, through acquisitions, strategic investments or alliances. To a large extent, the valuations of these companies will depend upon acquisitions to be made by them to move up the software value chain into, say, consulting or BPO.

Sooner or later, with the huge cash reserves of frontline companies and the ADR currency available with Infosys, Wipro or Satyam, activity on this front is bound to trigger a run-up in valuation. At the same time, the downside risks of smooth integration and operational synergies will persist.

For instance, HCL Technologies has used a combination of strategic acquisitions (Deutsche Software or BT-Apollo Care Centre)/ alliances as a good platform for growth. And these deals were so structured as to be mutually rewarding to both partners. This may be the route for the other software players to follow.

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