All the discussions about the Indian IT service industry and its future invariably end with a unanimous conclusion of “we must move up the value chain”. This is a strong argument which is hard to contradict.
The biggest challenge is that traditionally highly competent companies (for example McDonald’s) have pursued volume-based strategies to penetrate a market like India, and then slowly introduced high priced, high margin products to “move up the value chain”. However, Indian IT companies are not necessarily known for their technological prowess and have been playing this volume-driven low-cost game for some time now. But unlike McDonald’s they lack the competency to move up the value chain towards higher segment offerings such as system integration, IT consulting and system design.
What do these “higher end” IT services actually imply? Are they higher margin services than what Indian IT service companies are doing at present? Do they require higher technological, execution and delivery skills? Do they need better business understanding?
Before answering these questions we must understand that the most effective lever for Indian IT services companies working on the outsourcing/offshoring model is the movement of more outsourced work to offshore sites. The offshore margins despite being almost a third of the billing rates are more than twice the onsite margins. Moreover, moving 1% of work towards offshore sites increases the gross margin by almost 35 basis points. This lever is most effective apart from price hike in billing rates, blended mix of employees with experience and freshers, improvement in utilisation levels and productivity.
The Indian IT industry has spoilt investors with incredible growth over years and now 25% margins are being taken for granted. The MNCs listed in the US or elsewhere cater to more realistic market expectations. Though the revenue base of Indian companies is still almost half of the MNCs, 25% growth rate is not sustainable and the stock market must realise this. The management of these IT companies should learn to ignore the markets while they implement their “move up the value chain” strategy.
However this does not appear to be the case as Nasscom has predicted that 50% of incremental revenue for top-tier IT companies would come from testing and infrastructure management services in the coming years. Top IT companies are bullish on these two horizontals not only because they open a huge market but more importantly, they are higher margin business as they require lesser human resources with lesser capabilities and have a huge offshoring component. We can only hope that these IT companies are mixing their new higher margin lower end businesses with higher end lower margin businesses necessary for long term sustainability.
Now let’s come to the quintessential question. Does moving up the value chain make sense? Why should Indian IT companies move up the value chain? If we study the profit margins of high end IT companies like Accenture versus Indian IT service companies we would clearly see that Indian companies lead the pack in that parameter with considerably higher profitability. However, their per employee metric seems to be inferior as compared to the Accentures of the IT world. Accenture has almost 20% more earnings before interest and tax per employee compared to Indian companies despite having more than twice the number of employees. However Indian IT companies score better on market capitalization per capita metric. Comparing the net margins per employee does not make sense as the tax holiday in India has inflated the net profit margins of these companies.
Does a higher per employee metric on some account and lesser on another make a case for moving up the value chain? If it does then which per employee parameters indicate a declining business model and which ones indicate a higher end business model? Concluding that Indian IT companies should also have similar per employee metric like their higher-end MNC counterparts is a misplaced argument.
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The bigger question is: Which of these revenue models -- the volume driven high margin but low margin per employee or volume and high end service driven business with lower margins but higher margin per employee -- make more sense? The viability of any of these businesses is anybody’s guess. However, if historical trends hold any value we could clearly see that companies have to offer higher end services (despite giving lower margins) to develop a sustained business model. The risk of commoditisation and top players expanding towards the bottom is perennial.
Most of these higher end services require high calibre people and more onsite component which negatively impact a company’s income statement. On the one hand it increases the employee costs and on the other it distorts the conventional offshore-onsite mix. IT leaders are well aware that they need to break this linearity in their revenues if they really want to add value to the business. For the top 3 IT companies, that point of time may already have arrived. However, they are under the classical “prisoner’s dilemma”. These companies realise that if any one of them changes its business strategy to realign towards higher end services, it has to forego clients and market share during the process, which would impact the income and may fundamentally endanger the short term survival of the business whose sustainability forced them to take this drastic step in first place.
There would be tremendous amount of pain before Indian IT companies can serve higher end services as the stock market would punish them, and the MNCs would take advantage of the same talent pool and network delivery. MNCs have already exploited India’s cheap labour advantage and due to their internationally spread development centres, they already have near-shoring capabilities which is highly desired by the clients. Indian companies have international development centres in those places, which can provide similar tax incentives so that their overall cost structure of that development centre is similar to an Indian centre. This also shows their fixation on margins. Reduced margins would diminish the power to give higher salaries and hence talent poaching from industries like retail, financial services and telecom would increase.
The road for higher value would become tougher with STPI tax holidays being removed post FY10 which would increase tax rate by ~200bps and hence dent the profitability. The larger companies would take advantage of SEZs but the smaller companies would feel the heat and we may see significant acquisitions in the next three-four years. However, there is one silver lining in these dark clouds. Indian IT service companies have mastered the Global Delivery Model. Hence when it comes to services which need more onsite resources (system integration, architecture design etc), these companies with their proven expertise of mining workflows and identifying processes that can be offshored, have a better chance over MNCs. This would reduce the impact of onsite deployments and would make even higher end services to deliver better margins. However the most critical question is still unanswered: Even if Indians are desperate to move up the value chain, can they move up? Do they have the expertise, the domain competence and large scale complex project execution capabilities? Do they possess natural cultural alignment with the client organization? Only the time will answer those questions.
The writer has worked in the IT industry and is an MBA from IIM Ahmedabad. He can be contacted at yugaljoshi@gmail.com