Has India Software Inc. lost its sheen?

With Wipro and Infosys admitting intense pricing pressures and disclosing that their operating margins have declined, it’s time for a reality check. Pankaj Mishra analyses the pricing dynamics of offshore outsourcing and discovers that the Indian offshore story has now entered a commoditised era where there are no ‘brand premiums’

When Infosys chairman N R Narayana Murthy declined projects from GE in the mid-nineties, citing low billing rates, Infosys became a darling of investors and a poster child for the Indian software industry.

Cut to today. It’s a completely different story now. The very same Infosys faces stiff competition from its Indian counterparts as well as the MNC brigade, which has set up offshore bases in India, and in times like these ‘brand premium’ sounds like the stuff fairy tales are made of. Infosys in fact reflects the true face of the software services industry, which now enters a commoditised era. Offshore vendors are mainstream players in India today, with IBM Global Services, EDS, Accenture, CSC and Cognizant ramping up fast to take Indian players head-on.

Shrinking margins
Operating margins enjoyed by leading Indian companies like Infosys and Wipro were always in the range of 30-40 percent, much to the dismay of MNC vendors who have been living with below-20 percent operating margins for a long time. Accenture’s corporate average operating margin is 13-14 percent. But the quarter ended March 31, 2003 saw both Infosys and Wipro announcing lower margins. While Infy’s net margins dropped from 30.9 percent in Q4 last year to 25.4 in Q4 of 2003, Wipro’s margins declined from 33 percent to 28 percent during the same period.

Wipro’s margins dipped 4 percent sequentially. One of the alarming worries is whether margins will now go below 20 percent. “While margin pressures are likely to stay, we don’t see it going below 20 percent,” insists Suresh Senapaty, chief financial officer at Wipro.

Pressure on margins is coming from existing clients asking for lower billing rates, but more so thanks to the presence of MNCs having offshore facilities in India, who are quoting competitive rates. “One of the reasons for low margins is the hybridisation of BPO and software services rates, or blended pricing,” says Jayesh Chakravarty, India and APAC business head at MindTree Consulting. BPO is a low margin business and if clients ask for bundled contracts the blended margin will be low.

Both Wipro and Infosys have experienced volume growth in the last quarter, but margins are dragged down further because new projects are coming at lower rates. Moreover, the ramp-up with existing clients is happening at renegotiated rates, which are lower as well.

Apart from pricing pressures, there are other factors contributing to eroding margins. With the rupee appreciating against the dollar, the revenue guidance of many companies has been affected. Moreover, as Indian companies invest more in strengthening sales and marketing capabilities in markets abroad, overheads also shoot up.

While margin pressures are likely to stay, Wipro doesn’t see margins going below 20 percent, says Suresh Senapaty

Billing rates
Analysts believe that offshore billing rates have declined in the range of 10-20 percent during the last quarter. A $20 per man-hour rate is today considered as a good rate, while there are large projects being executed at much lower rates. Pressure is coming both from new and old clients.

“Wipro is facing two kinds of price pressures—one from clients who say that if they don’t get a reduction they will go elsewhere, and the other from existing clients who are asking for a price discount in lieu of a volume hike,” explains Senapaty.

So does it mean these companies were actually overcharging their clients in the past? “Yes, most Tier 1 players have been enjoying offshore rates in the range of $30 per man-hour. When outsourcers looked to reduce costs by talking to multiple vendors, they found that many vendors were ready to execute projects at $20, or even less,” says the chief financial officer of a Bangalore-based software company who does not want to be named. “As the external environment is very tough, clients who are under pressure are looking to their vendors to reduce costs,” said Infosys CEO, MD and president Nandan Nilekani during the announcement of the company’s results.

“There was never a sustainable brand premium,” Chakravarty admits, referring to the Tier 1 players. Interestingly, the latest results of Wipro and Infosys don’t reflect actual billing rates because old projects being executed at ‘good’ rates. But this is destined to change now as outsourcers get aggressive in terms of inviting bids and renegotiating old rates. To make matters worse, Tier 1 companies are forced to take many low-end projects today for the sake of volumes.

“Many areas within software services are commoditised now. There is a compelling need to seek other areas,” says Prashanth Prakash, chief founder and strategy officer of NetKraft. Offshore rates are expected to stabilise at $20 on an average, but some of the larger projects may come at rates even below $20.

Ravi Ramu says that system integration and project-based assignments help firms in insulating from pricing and margin pressures

Sacrificing premiums
Infosys has been enjoying a premium of almost 15 percent over its competitors. With offshore becoming mainstream, this premium came under scrutiny by its clients. Operating margins enjoyed by the company were also much higher than Accenture, which has now established an offshore presence in India. The price decline in Q4 for Infy was a steep 5.1 percent. Today, the new outsourcers are inviting bids from large offshore players and are not ready to pay any premium.

“With the MNCs now practising global offshore delivery from India, there is no reason why their operating margins should be lower than a company like Infosys or Wipro,” says an analyst with a foreign brokerage firm in Mumbai. An industry source indicates that today offshore billing rates quoted by Accenture are in the range of $20-$25, which are quite competitive.

Is there a way out?
Moving up the value chain to offer consulting services can definitely help Indian players to command better rates, with premiums. Another initiative can be to move towards productised solutions. Having garnered enough domain expertise in verticals such as the banking and financial services industry (BFSI), telecom and energy and utilities, it is imperative to seek product opportunities.

Readymade components in the hi-tech areas of telecom can also help in moving up the value chain. Increased exposure to system integration can also help in mitigating the margin loss. “System Integration and project-based assignments account for over 50 percent of our revenues, which helps us in insulating ourselves from pricing and margin pressures,” says Ravi Ramu, chief financial officer, Mphasis.

Is Indian IT’s sheen lost?
If unsustainable margins and premiums were contributing to this ‘sheen’ the Indian software services industry had, the answer to the question posed above is a definite yes. Today, the Indian offshore story is no longer about ‘pure’ Indian players like TCS, Wipro and Infosys. Having an offshore presence, especially in India, is now imparting a competitive edge to many MNC players like Accenture, EDS and CSC. India as a destination is at the helm of the offshore revolution, spearheaded by a mix of Indian and MNC players. Shrinking margins and declining rates are dragging the industry to more realistic levels, which will lead to a maturer offshore environment. Which may not be such bad news, after all.