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Indian IT's perfect storm

An appreciating rupee, rising wage costs, and potential withdrawal of tax breaks (not to mention a slowdown in the US) are coming together to create the worst ever conditions for Indian IT. What is the industry to do?

By Rishi Joshi        Print Edition: October 21, 2007

For an industry that was until recently the bellwether on Dalal Street, the recent slight from investors must seem humiliating. Even as the Bombay Stock Exchange index, Sensex, surged from 16,000 to 17,000 in a matter of just six trading sessions (the fastest 1,000-point gain, since the index hit 10,000 in February 2006), leading the rally were Reliance Industries, Bharti Airtel, L&T and ICICI Bank. Earlier, when the Sensex topped 16K on September 19, it was once again Reliance Industries, HDFC, and ICICI Bank (which together account for about a quarter of Sensex by weight) that led the surge.

Sure, the IT stocks—particularly, TCS, Infosys and Wipro—gained too, but less than 2 per cent compared to 6 and 8 per cent gains of Reliance and HDFC, respectively, on the day the Sensex topped 16K to close at 16,322.75. The second time around when the Sensex sped from 16k to 17K, the IT index rallied a bit, but only because the Reserve Bank of India generously eased restrictions on overseas investment, thus attempting to slow the rupee’s upward march. Step back and look at the leading IT stocks’ performance over the last one year and you’ll find that they have languished. The BSE IT index has remained unchanged in the period (September 25, 2006 to September 25, 2007) compared to a Sensex gain of almost 40 per cent.

There’s something about the IT stocks that is bothering D-Street and it’s not hard to put one’s finger on it. In a multiple whammy of sorts—or what looks like an ideal condition for a storm—an appreciating rupee, high wage inflation, the possibility of the withdrawal of the tax holiday in 2009 and growing competition from multinationals have all emerged as serious threats to the growth prospects of the IT services industry. “There are huge challenges before the industry today that can jeopardise its long-term growth story,” admits Kiran Karnik, chief of the industry lobby, Nasscom.

The Chief Culprit

The prime, and more immediate, concern for most Indian IT companies is the hardening rupee. It has appreciated almost 10 per cent against the dollar so far this year and has hurt profit margins in an industry that is primarily export driven. Most of the big players get more than 60 per cent of their revenues from the US alone. The socalled Tier-I companies—including TCS, Infosys, and Wipro, among a few others—did hedge against a stronger rupee, but just the same their operating margins were hit by 2-4 per cent. Says Suresh Senapathy, CFO, Wipro: “Hedging can at best smoothen the movement. It can not offset or beat the secular trend exhibited by the currency”.

Already the big boys are being forced to lower their guidance estimates for the full year. Infosys, for instance, lost Rs 287 crore in the first quarter of this fiscal due to the sharp rupee appreciation. “Our first quarter reflected the changed business environment for Infosys and indeed the entire Indian IT industry,” V. Balakrishnan, Infosys CFO, told BT recently.

“Hedging can at best smoothen the movement. It can not beat the secular trend exhibited by the currency”
Suresh Senapathy, CFO, Wipro

However, with the rupee dropping below 40 to the dollar, Infosys and its peers may be expected to once again revisit their estimates as the second quarter numbers come out. According to some analyst reports, the IT triumvirate (TCS, Infosys and Wipro) could see their top line and bottom line growth get hit by 5 to 10 per cent. Says Hari T, Head of Global Marketing and Communication, Satyam Computer Services: “Our analysis reveals that a 1 per cent rupee appreciation will negatively impact the margins by around 30 basis points and most of the companies in the sector are impacted likewise. We are trying to combat the rupee impact through enhanced operational efficiency and hedging.”

Most of the companies, including the big three, are trying to fight the rupee appreciation by negotiating higher billing rates with clients. But it’s not been smooth sailing. Says Sudin Apte, Senior Analyst, Forrester Research: “The IT companies have been pushing for steep increases of 10-15 per cent but have in most cases only managed hikes of 4 to 5 per cent”. The irony is, as a Gartner report points out, higher billing rates could turn out to be a handicap. “This erodes the competitive advantage (by way of price differential) enjoyed by these companies… and could make them less competitive compared with external services providers in other parts of the world,” cautions the report. The bigger Indian vendors are also exploring a pricing model, where they maintain a base level convertibility and assured returns in dollars.

Blue chips like TCS and Infosys are moving on other fronts for margin expansion. They are busy boosting front-end sophistication. This includes upgrading skills related to sales, relationship management, account management, negotiations, and standardisation of sales processes, among others.

Analysts also feel the IT players have to become more innovative. Says Forrester’s Apte: “Indian IT companies have to look beyond just pushing up utilisation. They have to take other initiatives such as enhance efforts for non-linearity (headcount and revenue linkage). For instance, Wipro’s Lean Principles methodology or IP Assetbased ‘Solution Accelerators’ used by Cognizant , HCL and Infosys.” “Solution Accelerators” are predeveloped software that is used by the IT services firms to automate a particular business process or aspect of product development.

The Other Bugbear

An acute shortage of talent at home is yet another concern for the IT industry. The big problem is the expected shortfall of around 500,000 people by 2009, according to a Nasscom-McKinsey study and the constant 10-15 per cent increase in salaries doled out across the board. That’s clearly eroding the cost advantage once enjoyed by the industry. According to Wipro’s Senapathy, the company is battling the problem by increasing the number of freshers it hires, expanding its reach into campuses (from 160 to 260 locations) and also looking beyond engineers to science graduates for some of its work. Then, Nasscom is collaborating with engineering colleges and technical institutes with its “finishing schools” concept to hone the skills of graduates and prepare them for the industry. Says Karnik: “The challenge is not availability but suitability of the manpower available.”

“We have two decades of experience in running process and cost efficient offshore centres and MNCs can’t buy into this”
V. Balakrishnan, CFO, Infosys

The industry is also being forced to adopt new tactics. Companies like TCS and Infosys are setting up base in Tier-II cities like Bhubaneshwar, Cuttack , Mohali, Coimbatore and Cochin. Approximately 70 per cent of their fresh recruits are from the smaller cities. Says T. Madan Mohan, Director, Consulting, Information Communication and Technolgy Practice, Frost & Sullivan: “Their gameplan is to hire in the smaller cities to rein in costs and attrition. Our studies indicate there is a 12 -17 per cent cost advantage by moving to Tier-II cities”.

They are moving on other fronts as well to control wage costs. In an interesting strategy, Indian IT firms, which flourished on the outsourcing boom in the West, are now themselves moving offshore to destinations from Malaysia to Mexico, besides the US and Europe. Tier-I players aim to have around a tenth of their workforce from outside India in the next couple of years. “We are diversifying our talent pool across the world,” Infosys’ Director-HR, T.V. Mohandas Pai, told BT recently. “We have opened centres in Manila and Mexico and we have people from 65 distinct nationalities aboard.” Wipro, too, is aggressively expanding its non-India delivery centres, buying a string of companies abroad. Broadening its geographical spread has also helped Wipro expand its reach into contracts that were previously off limits to India only vendors. Says S. Mahalingam, CFO, TCS: “We are focussing on the Euro zone and have doubled our quarterly revenues from here to $100 million in just two years.”

A Taxing Issue

Another contentious issue is the scheduled withdrawal of the tax holiday for the IT industry in 2009 once the Software Technology Park India (STPI) scheme expires. This could mean that subsequently all IT companies will have to pay corporate tax in excess of 30 per cent. If the tax holiday is withdrawn from the industry, it is estimated that the government will net $3-5 billion in direct taxes alone (without accounting for customs duty, excise duty and sales tax exemption). Says Apte: “The bigger companies like Infosys, TCS and Wipro should not get tax holidays. They should manage on their own.”

Meanwhile, the big boys (Infosys, Wipro, TCS, Satyam and Cognizant) are already gearing up for the eventual withdrawal of the STPI scheme. They are all setting up Special Economic Zones. In fact, there are an estimated 100 plus IT SEZs in the pipeline. The major reason for this is again tax holiday—though only new business is eligible for SEZ tax benefits. Says R. Chandrasekaran, President and Managing Director, Cognizant: “SEZs will allow us to participate in tax holidays well into the future.” Argues Karnik: “Tax holiday should be extended since the big companies can avail of benefits anyway through SEZs.”

It’s evident why the Indian vendors are worried about taxation. Slimmer profit margins will not only lead to a correction in the valuation of their stocks, but also make it harder for them to compete against their larger foreign rivals. Already, the IBMs, EDSes and CapGeminis of the world are buying their way to a larger India base. “We have two decades of experience in running process and cost-efficient offshore centres and MNCs can’t buy into this,” says Infosys’ Balakrishnan.

There’s no doubt the larger players will make course correction and sail through the storm. Whether they can sustain their high growth rates isn’t so certain.

(Additional reporting by Rahul Sachitanand in Bangalore, T.V. Mahalingam in Mumbai, Nitya Varadarajan in Chennai, and E. Kumar Sharma in Hyderabad)

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