THE STAR OF INDIA, VERSION 2.0
Infosys is one of the most successful technology corporations in India. So what will company managers - including finance chief Mohandas Pai - do for an encore?
By Sethuraman Dinakar

It was hot in Washington, DC during the summer of 1998 - unusually hot. Temperatures routinely topped the 100 degree mark, and the near drought-like conditions forced local officials to severely restrict the use of water - an unheard of move. Not to be outdone, several members of the US Congress attempted to regulate other resources as well. Members of both the House of Representatives and the Senate introduced legislation to increase the number of H-1B visas issued each year. The proposed increase of work permits for foreign labor touched off a firestorm of debate. Union organizers held rallies proclaiming that the legislation would cost Americans their jobs. Engineering groups released statement decrying the evils of cheap foreign labor. At the same time, proponents of the legislation - mostly US software companies - argued that without imported engineering talent, the vaunted American technology juggernaut might grind to a halt. In the end, Congress sided with big business, voting to increase the number of H-1B visas over the next several years.

Half a world away, in the Bangalore, India headquarters of Infosys Technologies, news of the vote was met with relief. Infosys, which develops and maintains customized software for cross-border clients, generated about US$118 million in revenues last year. Of that, fully 82 percent came from US customers, including marquee companies like Goldman Sachs and Dell Computer. And while the bulk of the company's programming is conducted in India, then transmitted to cross-border clients via leased lines and satellite - a business model the company pioneered - Infosys regularly sends project leaders to work with clients on-site. In fact, by the third quarter of 1998, Infosys had already gone through its allotment of H-B1 visas for the year.

If that shortfall says something about US immigration policies, it says even more about the volume of business at Infosys these days. The offshore software developer has been on a heady roll of late, registering a compound annual growth rate of around 66 percent over the past five years, with net income rising 65 percent. During this period, Infosys maintained a gross margin above 40 percent.

Given that performance, it's hardly suprising that analysts rave about Infosys, using words like visionary and world-class when describing the company's management team. Says Pawan Sachdev, a fund manager with SBI Mutual Funds in Mumbai: "Infosys has the best possible management - financial and otherwise - that one can find in the country."

The Infosys finance department, headed by Mohandas Pai, has focused squarely on shareholders. The company's annual report is a monument to detail, and includes company financials recast according to the Generally Accepted Accounting Principles (GAAP) of eight countries. The Bombay-listed shares of Infosys are about as hot a commodity as you'll find: since going public in 1993, and accounting for stock splits, the share price has risen 24,632 percent (the company is reportedly considering another stock split). The market capitalization for this US$118 million in revenues company stands at US$5 billion - or about 12 percent of the entire capitalization of the Bombay Stock Exchange 30 Index. Says Bob Austrian, managing director at Bank of America Securities in San Francisco: "Infosys is the IT star of India."

The question is: can Pai - and the rest of the Infosys management team - keep the star from burning out? While Infosys reported record revenues in fiscal 1999, nearly 20 percent of the company's sales came from Y2K-related work. What's more, the company's five biggest clients account for over 28 percent of Infosys's turnover. Some observers also believe Infosys's competitive advantage period is fast coming to a close. Software development is becoming big business in India - it's likely to top the US$4 billion mark this year - and local rivals like Satyam Computer Services and Wipro are eating into the company's market share. Further, global powerhouses like Microsoft, Oracle and Baan have set up their own software development centers on the subcontinent. That will threaten Infosys's employee base. Meanwhile, other countries, particularly the Philippines, are eagerly jumping into the offshore services game. Says one banker familiar with the company: "Infosys has some real challenges ahead. This may be where the road forks."

Upgrade

Sitting in his office on Infosys's 28-acre headquarters on the outskirts of Bangalore, a former Army garrison town, Pai doesn't seem daunted by the challenges. The one-time lawyer and chartered accountant, who repeatedly mentions the company's "conservative, south Indian, middle-class values," has a good idea where the company needs to go. "We are trying to push the envelope," he says. "We are trying to move to higher value-added services."

Indeed, analysts say Infosys, version 2.0, could be a significant upgrade. Rather than slogging it out in the cutthroat custom software and systems reengineering sectors, Infosys is moving boldly into the Internet services arena, where margins are high and contracts lucrative. "Their operating margins are going up, and they have gotten into e-commerce (software) in a big way - which is a higher margin business than the others," notes Srividya Rajesh, a software analyst at Sundaram Newton Asset Management.

For his part, Pai notes that in the latest quarter e-commerce projects generated more than 10 percent of revenues, while those from Y2K-related contracts fell to less than 10 percent of Infosys's total sales. If the Infosys plan plays out as laid out, e-commerce services will become the cornerstone of the company's revenues. Already, one Merrill Lynch analyst predicts Internet services will account for a quarter of the company's turnover within a mere two years.

Such white hot growth in a quicksilver industry, however, has its dangers. In the headlong rush up the technology food chain, it's easy to make mistakes - or get eaten. That's where Pai comes in. "My job," the Infosys CFO says flatly, "is to derisk the business."

It's a job he takes very seriously. To help attract long-term investors in a market noted for volatility, Pai has dramatically raised the standards of financial reporting and corporate governance at Infosys. The company has voluntarily published audited financial statements since 1997. Besides the eight GAAP calculations, the Infosys annual report - roughly the length of War and Peace - is crammed full of metrics and scorecards, and includes extensive chapters on risk management, corporate governance, human resources accounting, brand valuation, EVA and intangible assets. Says one fund manager in Mumbai: "Transparency is Infosys's sex-appeal."

Last spring, that meticulously cultivated transparency helped Pai diversify the company's funding. In March, Infosys raised US$71 million through a listing of American depositary shares (ADS) on Nasdaq, the US exchange. The offering was a groundbreaker - the first ever listing of an Indian corporation on Nasdaq. Like the company's Bombay-traded shares, the Infosys ADSs have skyrocketed: from US$34 per receipt at the offering to US$205 as of press time - a 600 percent increase in ten months.

Even rivals marvel over the investor reponse to Infosys. Says Vadlamani Srinivas, CFO at India-based Satyam Computer Services: "One of the reasons why Infosys enjoys high valuations is because of its clean financial reporting."

The company's balance sheet is spotless, that's for sure. Infosys carries no debt on its ledger. In fact, Pai has managed to fund Infosys's recent expansion almost exclusively with internal cash - and that includes setting up nine new development centers in the past five years. "We Indians are traditional people," explains Pai. "We avoid borrowings and believe in savings."

Lots of savings. Despite the company's expansion, as of September 30, 1999, Infosys was sitting on about US$87 million in cash. That's 77 percent of the company's sales. "We need that cash because we want to make sure we pay vendors on time," Pai explains. What's more, nearly 40 percent of the company's expenses come from salary and employee-related costs - items that can't be defered.

Even so, not leveraging the balance sheet means not getting the full wallop out of a company's resources. "While a conservative financial strategy is no doubt an asset, it also hampers Infosys's propensity to take risks," says R. Sukumar, a portfolio manager at Kothari Pioneer Mutual Fund in Chennai. "I personally wish they were not so risk averse."

But Pai defends Infosys's zero-debt philosophy, pointing out that revenue authorities in India do not tax profits from exports. "We make our money from exports and don't have to pay taxes on them," says Pai, noting that about 90 percent of Infosys's revenues are in US dollars. In addition, Pai believes the frenetic nature of the technology sector rewards nimble players - those with little debt and plenty of cash. "With the kind of growth rate that we have, and operating in a high-tech area, there are business risks to the model," explains Pai. "Why add a financial risk by borrowing?"

That's a lesson some of Infosys's managers apparently learned the hard way. Sources say that in the late 1980s, officials at state-owned Canara Bank threatened to pull the plug on Infosys when the company was unable to repay either the principal or interest on a loan. The software developer had been founded in 1981 by Nagavara Ramarao Narayana Murthy and six associates, who kicked in a total of US$300 in seed capital. Reportedly, Murthy decided to start Infosys after being asked to commit an unethical act by a previous employer. "We brought in a set of mutually exclusive but collectively unexhaustible values," says Murthy.

Invasion of the Body Shippers

What Infosys didn't bring in, however, was customers. The domestic market for software development simply was not there. Further, government tarrifs limited the types and amounts of computer equipment local companies could purchase. "The government did not understand software," says Dewang Mehta, the president of Nasscom, an Indian software and services industry association. "They wanted us to use Russian computers."

Things got so bad at Infosys, in fact, that in 1990 company managers thought about packing it in. But in the summer of 1991, Infosys got a break. Reforms promulgated by the government of Prime Minister Narasimha Rao ended the restrictions on what Indian companies could export or import.

Suddenly, the country's burgeoning technology sector was thrown wide open. Scores of local software companies began sending workers to the US and Europe to write rudimentary code cheaply for large companies - a practice called body shipping. But rather than follow suit, Murthy fixed on a different tactic. He decided to go upscale.

Infosys began courting engineers from top schools like the Indian Institutes of Technology (IIT). "They hired large numbers from premier institutes to work in India when competitors were busy shipping low skilled staff abroad," says Pawan Sachdev, a fund manager at SBI Mutual Funds in Mumbai. Hiring, however, required cash: from 1993 to 1994, the company raised US$12 million from an IPO on the Bombay exchange and a private placement. Around that time, Murthy convinced Pai, who was working at a financial services company, to head Infosys's finance department.

Soon after Pai arrived, Infosys took a huge gamble, pouring almost all its excess capital into constructing a US$6 million complex in Bangalore. The facility would train, house and generally look after Infosys's employees - called Infoscions. The employees, in turn, would develop custom applications for cross-border clients, implement the software and maintain it - all from Bangalore. The offshore software development model, Murthy's brainchild, was born.

Posh Space

It was a brilliant move. Executives at US companies - companies that had suffered through years of soaring IT costs - beat a path to Bangalore. From 1994 to 1997, revenues at Infosys nearly tripled. Despite the success, however, both Murthy and Pai knew that skilled programmers would soon become a hot property in India. Infosys's future, they reasoned, lay in retaining staff.

Thus, Pai introduced an employee stock option plan (ESOP) in 1994 - "the first time ever by an Indian company," says Shiamak Dalal of Paradigm ESOP Consultants in Mumbai. The plan has made some Infoscions very rich - the company now has 100 millionaires on its payroll. "They have a rare ability to hire, train and retain staff," says Bank of America's Austrian. "That is their USP." That unique selling point has led to an employee turnover rate of about 12 percent, less than half the industry average.

While such loyalty is impressive, some observers believe it will become increasingly difficult for Infosys to hold onto its employees. With more local rivals starting up, and with global powerhouses opening shop in India, competition for the best workers will surely heat up. What's more, the average starting salary for an engineer in India is about US$6,000 a year. It's ten times that in the US and Europe, where demand for software specialists far outstrips supply.

Managers at some Indian software companies have tried to prevent employee job-hopping by poshing up their corporate facilities - Satyam's includes a golf course - and by signing workers to longer term contracts. But Pai believes making owners out of employees is still the best way to keep them around. In fact, Infosys is currently planning another ADS offering, with half of the shares earmarked for the company's ESOP (currently, 40 percent of Infosys employees hold company stock options). The software specialist also offers employees interest-free home loans and marriage loans. And it continues to provide workers with cutting-edge training. That's crucial: in a recent Lucent/Gallup MBA survey, tech employees said their number-one concern was keeping up their skills, not compensation.

Stair Masters

Such a concern may explain why Infosys received 75,500 job applications last year - for 1,550 positions. Still, observers note that Infosys recruits from among the top 20 percent of technology graduates - the types of prospective employees who can demand higher wages. Not surprisingly, the boom in the software sector has touched off a bidding war for engineers in high-tech havens like Bangalore and Pune. Since 1995, salaries for software professionals in India have jumped 25 percent annually.

Infosys is getting squeezed on the other end as well. The recent entry of the Philippines into the offshore software development market could force Indian software developers to hold the line on prices. But Pai doesn't see this as a big threat: "Our aim is to deliver our services ... from countries where it is most cost competitive. As such, we contstantly scan the environment around the world."

Translation: there is nothing to keep Infosys from setting up shop outside of India. The company is already building an offshore development center in Canada. And if Infosys is facing increased competition these days, it seems to be giving as good as it gets. It now ranks as the sixth largest technology company in India. Moveover, by moving into higher margin businesses, the company should be able to cope with rising salaries. "In the past, the growth in per-capita revenues has more than offset the growth in manpower costs," Pai says. "Our aim is to continue this trend by going up the value chain."

Climbing those stairs should also help Infosys get the most bang out of its stockpile of cash. Pai reports that the company generated a 64 percent return on average capital employed in 1999. That's about double the return in 1995.

But critics say that Infosys, and other Indian software companies, lag global rivals in expertise. That shortfall can be partly seen in the prices that Infosys charges customers: US$47,000 per consultant compared to $182,000 by US rival Cambridge Technology Partners. In October, three IIT professors published a report stating that Indian software vendors lacked the know-how to develop industry-specific, whole applications.

The assessment calls into questions Infosys's ability to move up the value ladder. In fact, back in 1993, Murthy predicted that the company would eventually earn 30 to 40 percent from software products alone. Infosys launched several applications, including Banc2000, a financial services program. None of the new offerings lit up the tote board.

To make it in the off-the-shelf application business, Infosys will have to get better at marketing and distrubution - not core competencies right now. But Murthy, like Pai, remains confident. "Soon, we will learn about brand equity. We will learn about sales, we will learn about distribution," he says. "And we have the financial muscle. It will happen."

If so, Pai will carry his conservative, south Indian, middle-class values onto the world stage. "We believe in simple living," he says, "and high thinking." It's worked so far.

Sethuraman Dinakar is CFO Asia's Singapore bureau chief