IT: The way ahead

When the stock market rallied last year, IT stocks were rank laggards and barely moved. Even long-term investors who have been holding on to stocks of frontline IT companies for many rued the missed opportunity in switching to sectors like power generation, oil refining and infrastructure – where stocks doubled and trebled in value in less than a year.

The market was treating technology stocks almost like PSU oil retailers that are saddled with huge subsidy burdens. Even after the crash that followed, technology stocks continued to under-perform.

Lately, the mood seems to have changed. Technology stocks have been among the best performers in recent months, buoyed by hopes of some of the dark clouds which hovered around their business environment, now fading away into the horizon. The rupee has slipped again while the US economic slowdown has not led to any loss of business. The government, after prolonged obfuscation, sprang a pleasant surprise by extending the tax break under STPI scheme for another year. Suddenly, technology is hot again. But, is it for real?

Will the US slowdown bite?
The last US recession in 2001 was triggered by the technology bubble burst, and accentuated by the effects of the 9 / 11 terrorist attack on businesses. This time around, when growth has slowed down substantially and the US economy may slip into a recession – or may be already in one, the question everyone is asking is whether the technology sector will escape the fallout. After the excesses of the last technology bubble, the industry has undergone a catharsis and has emerged stronger. The big companies in the sector are all financially stable, with strong cash flows, unlike in the past when industry bellwethers didn't even have a business model; forget about cash flows!

The main reason for optimism is the theory that the slowing economy will encourage businesses to boost productivity by investing more in technology and also by outsourcing more processes to third party vendors. This belief is backed by the strong results posted by large global technology services companies like IBM and Accenture for the Jan – March quarter. The technology stocks in the US have also benefited in general from strong performance by hardware manufacturers like Apple and Research in Motion, the company behind Blackberry.

One of the main drivers of the strong numbers posted by IBM and Accenture in recent quarters was that both companies have significantly scaled up their operations in India. This has brought down their cost base and had a positive effect on margins. Coupled with firm demand for outsourcing from the US, their increasing footprint in India has helped them post better than expected numbers.

How far do these factors hold for the large Indian companies? Except for a recent deal won by TCS, none of the big five Indian IT service companies have announced a trophy contract in recent quarters. True, they are winning smaller deals and adding new customers too. But, the theory that the economic slowdown will force US companies to turn to outsourcing in a big way is yet to be proven - at least in terms of big deals. If the theory is true, then only the likes of IBM and Accenture appear to be benefiting.

Most Indian companies have confirmed that deals have become more difficult to come by. Clients have become more indecisive about giving out new contracts as none of them have a clear picture of the economy. Infosys CEO Kris Gopalakrishnan recently said in an interview that the clients are telling him 'they need time to figure out how to respond' to the economic slowdown.

While recent data and forecasts indicate that the US economy may probably evade a recession, at least for now, any recovery is likely to take a long time. The swift and extraordinary measures by the US Fed have prevented the credit market crisis from developing into a meltdown. The risks to economic growth from the credit market crisis seems to be declining, but the risk of declining consumer spending and inflationary risks are steadily rising.

It will take time for consumer behaviour to react to rising fuel prices. There are reports that American consumers have started skipping weekend trips to the big malls, to save petrol. While this is yet to reflect on retail sales in a big way, it will certainly hurt if oil prices remain high. 

A short recession, followed by a swift recovery, is any day preferable to a slow and grinding slowdown. High fuel prices and a housing market which is still down in the doldrums may mean that the US economy is headed in the latter direction. That means more uncertainty for businesses, which won't be good news for the Indian technology services companies.

Employee cost pressures
In recent months, there has been a flurry of media reports about rising retrenchment in IT services companies.  It started with reports of TCS asking 500 of its 'underperformers' to leave. Though the company clarified that this was a normal process and the numbers were similar in previous years too, industry analysts took it as a sign of companies buckling down to face a bleaker business environment. This view gained credence when other companies followed suit and fired employees, deferred the offers made at campuses or stopped campus recruitments altogether.

Some analysts saw this as a positive development for the industry. This trend will lead to smaller pay increases and bonuses this year and will help the companies protect their margins when new business is uncertain, they said.

True, the average pay hikes by frontline companies have been smaller than in recent years. Variable pay in companies like TCS were also lower on the ostensible claim that internal profit targets were not met. But, the positive impact on margins is hardly noticeable.

The fact remains that, despite the slowdown in business and hesitancy to hire more people, talent shortage remains a big issue in the industry. All the IT service providers know very well that it is not easy to retrench now, if it comes to that, or let employees leave and hope to hire them back when business picks up. Hence, companies have kept the pay hikes reasonable enough to satisfy employees and retain them. At Infosys, for instance, the pay hikes have been on an average between 11 and 13 per cent this year. The company has gone ahead with the hikes even though its margins will be impacted by nearly 2.5 percentage points during the current quarter.

The rupee will help
Last year, the appreciating rupee was the biggest headache of IT services companies. As the dollar nosedived against major currencies, the rupee climbed more than 11 per cent against the greenback last year – most of the appreciation coming in the second half. Surging capital inflows and increasing willingness on the part of RBI to let the currency appreciate, to curb inflation, were the main reasons behind the rise.

However, the rupee has already reversed a good portion of last year's gains this year. The currency has gained nearly 8 per cent against the dollar so far this year. It is estimated that every 100 basis points decline in rupee value against the dollar will positively impact IT margins by up to 30 basis points. By that measure, margins should improve by over 2 percentage points in the current quarter – from the currency effect alone.

That is unlikely. Reason – aggressive hedging by the big IT companies during the last quarter. Stung by the rupee rise during the last calendar year, they decided to pay it safe and hedged their exposure. Most of the IT companies which give guidance for the coming quarter had given an exchange rate of around 40 rupees to a dollar. It is likely that that is the average rate of their hedges and their currency gains for the current quarter will be limited to that extent.

Is value-based pricing the way out?
Most Indian IT companies, including the big five, still follow a cost-plus pricing formula – a legacy of an era when body shopping ruled. These companies have now matured way beyond simple maintenance services to complex solutions and even technology consulting. Maybe, it is time for these companies to have a fresh look at their pricing models.

Management guru C K Prahalad, of the Ross Business School at the University of Michigan, Ann Arbour, prescribes value-based pricing as a solution. In his new book 'The New Age of Innovation', co-written by M S Krishnan, Prahalad urges IT service providers to move to a pricing strategy which is based on how much the service is worth to the customer – rather than how much it costs the provider to deliver it.

That sounds intuitive, but may take a long time to achieve. The main reason is that, unless a service provider can separate itself from the pack with a superior set of service offerings, it cannot demand superior pricing. When there are three or four large companies, all capable of providing a wide spectrum of services on a similar cost base, it is difficult to achieve pricing discipline. Or else the big players have to collude, which is again difficult as global players like IBM and Accenture have expanded their presence in India and are now more cost-competitive.

The way out is to move up the value chain and develop the ability to bid for entire the contract in large deals, rather than parts of contracts like most Indian companies do now. Most big companies are doing that, by expanding their high-end offerings in technology consulting. They may need to move faster and scale up by aggressively pursuing strategic acquisitions. With the level of maturity they have achieved and the resources at their disposal, the Indian IT companies can do it.

They have come so far, there is no reason why they can't go further!