TIGERS AND TITANS
India's upstart IT services companies are challenging their giant rivals in the West with a highly disruptive business model. A bloody battle lies ahead.
By Justin Wood

Eleven floors above the heat and noise of Mumbai's busy streets, Seturaman Mahalingam sits in the air-conditioned offices of Tata Consultancy Services (TCS) sipping tea. He looks relaxed, sanguine even, as he discusses his role as CFO of the biggest IT services company in India. Before long, he says, TCS will be among the biggest in the world.

Six hundred miles to the southeast, in a suburb of Bangalore, Mohandas Pai looks out over the lush green campus of TCS's rival Infosys and is equally confident. As the firm's finance chief, he talks excitedly of growth and profitability and overseas expansion.

It's a similar story just 20 miles down the road at the headquarters of Wipro. In an oasis of palm trees and ornamental lakes that defies the arid scrubland of the Deccan plateau, Wipro's finance director, Suresh Senapaty, sketches a bold and bright future for India's burgeoning technology sector.

And who could blame these CFOs for their optimism? After all, the stellar performance of India's rising IT stars is well known. Take Infosys. "In 1994, we were a US$10-million company. In 2004, we'll have revenues of more than US$1 billion," enthuses Pai. "We've grown 100 times larger in ten years."

The record at Wipro and TCS is just as impressive. Indeed, almost all of India's big IT services firms - the likes of Satyam Computer Services, HCL Technologies, and Mphasis Group among others - can boast similar achievements. Figures from India's National Association of Software and Services Companies (Nasscom) show that the country's IT industry grew from US$5 billion in 1997 to US$16 billion in 2002.

But scratch below the surface of the industry and not all is as rosy as it seems. Indeed, some observers fear that the Indian IT dream is in danger of becoming a nightmare. Among the many challenges facing the industry: an appreciating rupee, chronic wage inflation, and the growing ire of US politicians over jobs moving offshore. Most dangerous of all, though, is the threat of competition from long-established global IT and outsourcing consultancies like Accenture, IBM Global Services and EDS. Over the past 18 months, these Western behemoths have grown acutely aware of the threat posed by India's IT tigers and are now squaring up for a bloody showdown. It's too early to say who will triumph, but the fighting will be fierce and fatalities will certainly follow.

India Shining

Many of the Indian IT services players began life in the early 1980s, but it wasn't until 1991 - when India began to liberalize its notoriously protected economy - that the IT industry really started to gather steam. Foreign firms saw the potential of India's highly educated and English-speaking workforce and sent coding assignments to the sub-continent where they could be handled for a fraction of their cost in the US or Europe.

At first the work was simple and centered on writing the proprietary software that companies used to automate their internal processes. But as the Indian firms grew larger and honed their project management skills, the work grew more complex.

Plummeting telecom costs during the 1990s made "offshoring" even cheaper and soon Western businesses were relying on India not just for writing programs but also for installing software packages like SAP, providing IT consultancy, and even conducting research and development for new products. Most recently, these companies have added business process outsourcing (BPO) services to their menu of capabilities, and now handle all manner of back-office functions from staffing customer call centers to analyzing tax returns. As Senapaty at Wipro explains: "We want to capture as much of the budget of our clients as possible."

The problem is that Wipro and its peers have done rather too well, notes Pramod Gupta, an analyst at ABN AMRO Securities. While India's IT players have enjoyed compound annual growth rates of between 50 and 60 percent over the past decade, the IT services industry as a whole has grown only at a more sedate 5 to 6 percent. "The whole Indian IT services story has been about taking market share [from Western companies]," says Gupta.

At first, the big Western multinationals didn't mind too much. After all, the Indian upstarts were concentrating on low-end, low-value work in the field of application development and maintenance. Over the past three or four years, however, India has moved up the value chain into the core businesses of their Western rivals - areas such as designing the architecture of IT systems, and acting as IT and business consultants..

A Quiet Revolution

"It happened in a stealthy fashion," observes Jayant Sinha, a partner in the Delhi office of McKinsey, a strategy consultancy. For a long time, he says, the likes of IBM, Accenture, and EDS ignored the Indian IT services companies as "simply capturing the labor arbitrage between India and the West". Then came the technology and dot-com bust of 2001 and 2002 and the Western giants became preoccupied with their own survival. "They took their eye off the ball and when they looked up the Indian companies were suddenly right behind them," says Sinha.

Today, he adds, "these companies are really starting to inflict some hurt on the global multinationals." The pain is being felt in several ways. On the one hand, the Western firms are losing direct revenues to their Indian competitors. More importantly, though, because TCS, Satyam, Mphasis and the others are largely run from India, they're inflicting huge pricing pressure on companies based in the US and Europe.

"What we do is very disruptive for the global majors," grins Pai at Infosys. "It's a disruptive business model."

Other commentators agree, for the Indian firms have done much more than simply harness cheap labor. In particular, they have developed a new generation of project management skills that allows work to be carried out from many locations in different countries simultaneously. The core to this so-called "global delivery model" that links on-site engineers in the West with cheap labor in India is an almost religious belief in quality standards.

Take TCS. Currently it has 17,000 engineers - more than any other company in the world - whose qualifications and skills have been assessed at the highest level of Carnegie Mellon University's SEI-CMM scale, the industry benchmark for software quality. Other companies in India are equally devout in their worship of SEI-CMM as well as other quality standards such as ISO and Six Sigma. The result is often not just a cheaper service in India, but a better and more timely one, too, compared with what the US and Europe can offer..

East vs West

Of course, now that the Western firms have woken up to the threat coming out of India, few are wasting time in responding. Mostly that means scrambling to build their own cheap back-end in India and other low-cost locations. Just look at EDS, a US-based IT services company with US$21 billion in annual revenues. Speaking at a Lehman Brothers investor conference on March 10 this year, the company's CFO, Bob Swan, acknowledged the pricing pressures that EDS faces.

"We need to take 20 percent out of our cost structure over the next three years É not in order to expand the operating margin but to improve our win rate for new business," he explained. And how does EDS plan to cut costs? By ramping up its "Best Shore" strategy, whereby it locates workers in low-cost countries. Currently, EDS has 8,700 staff in offshore centers - a quarter of them in India - but plans to increase that number to 20,000 over the next 18 months.

At Accenture, a US$13.4-billion-a-year rival to EDS, it's a similar story. Speaking at the same conference a year earlier, CFO Harry You said of his Indian counterparts that "on a cost basis" he plans to "stand toe-to-toe and we are very aggressive." To that end, in December the company announced that it is increasing its headcount in India from 4,300 to 10,000 by the end of 2004.

Also in December, IBM announced that it will move 5,000 software development jobs from the US to India this year. And at Bearing Point - formerly KPMG Consulting - the company revealed in February that it is developing its own offshore delivery model called "AnyShore" and plans to hire 2,000 staff in India over the next two years.

The Sincerest Flattery

It's all very flattering for the Indian firms, but equally it's worrying for it means that they're likely to lose their edge in the cost battle. At Mphasis, CFO Ravi Ramu acknowledges the issue. "The fact that the global multinationals are coming to India certainly means that some, if not all, of our cost advantage will be whittled away," he concedes.

Nonetheless, Ramu remains confident that his firm, and others like it, will prevail against the Western invasion, and that's thanks to the global delivery model that Indian firms have perfected. "Offshore isn't just about hiring a bunch of guys, putting them in a room and getting them to write code or answer phones," Ramu says. "It's a completely different way of working, of selling a service. It's a business model that's very alien to Western consultancies." Getting a firm grasp of that new offshoring model, reckons Ramu, will take the Western multinationals three or four years to master - a valuable window in which the Indian firms can grow and gain critical mass.

At Wipro, Senapaty is equally confident. He points to the organic nature of his company's development. "Because we developed our project management skills and our commitment to quality while we were small, we've grown up with it," he says. "It's in our DNA."

But it isn't just the entry of foreign firms into India that threatens to erode the offshore advantage. In particular, an appreciating rupee is also causing headaches. At WNS Global Services, a pure-play BPO company based in Mumbai, managers are certainly worried. "A rising rupee would have a serious impact on profitability," admits Neeraj Bhargava, CEO of WNS. "And there are certain scenarios that suggest the currency could rise a lot further from now."

Then there's the question of rising wages. Thanks to the rapid growth of India's IT industry, companies face huge demands in hiring new staff. At Wipro, for instance, the firm hired 10,651 new staff in the six months leading up to December 2003, increasing its workforce by 65 percent. Inevitably, such large-scale recruitment has led to rampant wage inflation for certain jobs, especially experienced project managers. India's Nasscom trade body reports that the average salary for an IT project manager rose 50 percent in 2003 over 2002.

Put it all together, says ABN AMRO's Gupta, and "the cost advantage for Indian firms won't last for long. The advantage is getting diluted." He's calculated that the labor arbitrage between the US and India has already fallen by 18 percent in the past two years.

To make matters worse, Indian firms themselves have started putting pricing pressure on each other. At the low-value end of the market, a raft of "tier-two companies" have piled into the IT outsourcing business, sending prices tumbling. Venu Reddy, research manager in Asia Pacific for IDC, an IT market research group, observes: "The traditional offering of Indian vendors - application development and maintenance - has become a commodity and prices are falling."

Indian Irony

It's in response to all these challenges that India's leading firms are desperately trying to move into the higher-value-added areas of IT services, and hence into the territory of the Western firms. For example, the likes of Infosys, Wipro, and TCS are starting to mix broad industry consulting skills with IT expertise in order to deliver "business outcomes" rather than just IT services.

The irony, of course, is that while Western firms rush to create a cheap offshore delivery capability, the Indian companies are racing to build a sophisticated front-end consultancy in the West. Each wants what the other has. Many industry watchers foresee tough times ahead for the Indian firms. For one thing, the global majors are well established in their markets, they have a worldwide presence capable of serving multinational clients, and they have size on their side - the turnover of IBM Global Services alone, for example, is US$43 billion, or almost three times as big as India's entire IT sector.

Just as important is the question of "domain expertise". In order to provide high-end consulting services, companies need to have a deep understanding of what makes particular industry sectors tick. Western firms have this expertise while Indian ones do not - at least not yet. But gradually that's changing. Thanks to a policy of hiring away "rainmaker" consultants from Western rivals, the Indian companies are starting to build up the knowledge and contacts they need to succeed.

For the same reasons, many Indian firms are hotly pursuing acquisition opportunities too. In March this year, TCS bought Aviation Software Development Consultancy from Singapore Airlines to further its penetration in the transport sector. In June last year, Wipro bought US-based NerveWire, a specialist consultancy serving banks and insurance companies.

Partnerships are another way of gaining much-needed knowledge, such as Infotech Enterprises' five-year tie-up with US jet-engine-maker Pratt & Whitney that is helping the company develop skills for the aerospace sector.

Indian firms are also busy building out a global footprint in order to diversify their revenue streams away from the US, to provide a more global service, and to make use of other low-cost centers. In December, for example, Infosys bought Expert Information Systems, one of Australia's leading IT service providers. And in the same month it announced plans to set up a 200-seat software development center in Shanghai.

Clearly the Indian vendors are moving in the right direction, but Gupta at ABN AMRO suggests the pace may be too slow. "The progress on anticipated growth drivers - ie, domain expertise, services breadth, and geographical diversification - remain less than satisfactory for most," he says. Pooja Narayanan, an analyst at BK Securities in Mumbai, highlights another problem. "Crucially, these companies will need to fight the perception that India and Indian companies are only good for low-end, low-value, low-risk jobs," she warns. "Brand-building will be central to that effort."

Chief Fighting Officer

Inevitably, the CFOs of the Indian firms are set to play a crucial role as their companies engage in the coming battle with the West. Of central importance will be the need to pay close attention to operating margins. Traditionally, many firms have enjoyed margins of as high as 35 percent, not to mention enviable return-on-capital figures - at Infosys it was more than 50 percent last year - but that looks set to change.

For one thing, prices at the low-value end of the IT services market are being squeezed tight, thanks to stiffening competition within India. Meanwhile, as the likes of Infosys, Wipro, and TCS move into higher-value services, they will also need to invest heavily in building new capabilities - a fact that will add further margin pressure.

All of which creates something of a paradox, argues Sinha at McKinsey. "There is a weight of expectation around existing margins from investors," he says. "And yet it will be difficult for the Indian vendors to make the necessary investments to survive without diluting those margins." With CFOs typically managing not only the investment appraisal process but also merger and acquisition work and investor relations, the next few years will be tougher than any yet experienced by those in the IT industry.

At TCS, Mahalingam acknowledges the growing margin pressures. "A big part of the game will be about efficiency," he says. "It's vital to work out the optimum utilization rate for the people in your organization so that you have the maximum number working as a billable resource without ignoring the need to train your staff and build for the future." Mahalingam states that his target is to have 78 percent of all staff working on billable assignments at any one time.

Just as important, he adds, is the need to drive out cost and continually improve TCS's project skills and internal processes. To that end, of the remaining 22 percent of staff not working for clients, a good number are employed building software tools that TCS uses internally to operate faster and more effectively. Equally, Mahalingam oversees a program of activity-based costing that examines every project TCS undertakes to see where money is spent and where it could be saved.

Whether such moves will help TCS survive the coming battle and fulfill its vision to become one of the world's ten biggest providers of IT services by 2010, only time will tell.

Justin Wood is managing editor of CFO Asia based in Singapore.