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July - 2008 - issue > Cover Feature
Mid-tier Miseries
Jayakishore Bayadi
Tuesday, July 1, 2008
After the dotcom bust in 2001, though all thought India’s IT ascent was over, it regained its lost glory creating a poignant image for Indian IT in the world map. Now, again debates are rife on whether India is on the verge of loosing its ‘IT grandeur’ as a most preferred destination for outsourcing due to globally volatile and cyclical economic circumstances such as the continuing U.S. recession, fluctuating rupee against dollar, and surfacing domestic challenges like intensifying fixed and operating costs, and the mounting wages of professionals. All these certainly send across a creeping sense among Indian IT of loosing their survival battle.

Despite all the advantages on their side, India’s top tier IT services companies too are sensing the pinch due to impending global and domestic challenges. However, it’s India’s mid-tier IT service companies, which are sandwiched between global as well as domestic issues, which are badly affected. Though many of these are not really keen on sharing what they are experiencing, it’s quite evident by trends like consolidations gaining momentum, decline in talent hiring, and desperate attempts to move to non-U.S. markets to remain in the game. In fact, most of the mid-tier firms registered minimal Q-o-Q growth or dip in their earnings (See table). Besides, they also have to cope up with apparent domestic issues like crumbling infrastructure and skyrocketing real estate costs, leading to mounting frustrations among the mid-tier IT fraternity.

How They are Feeling the Pinch?
No doubt, the vendors in Banking Financial Services Insurance (BFSI) space are the people who are feeling the most heat of the ongoing U.S. recession. However, an important trend that is putting down mid-tier companies is that the outsourcing companies in the U.S. prefer the BIG 5 Indian vendors over mid-tiers as they have an established brand value, flexibility, access to huge resources, marketing and financial muscle, capabilities in terms of scalability, having a global network, and other facilities compared to mid-tier counterparts. And since recession is leading customers to consolidate their outsourcing deals as well, it is clearly creating pressure on mid-tier companies. Today, the deals that could have come to the mid-tier pure-play services are being taken away by the big players because of their capabilities and offerings. Hence, opines V. Srinivasan, MD and CEO, 3i Infotech (Head count - about 5,500), “Coming times will be really tough for mid-tier companies to cash in on the wave because of their limited resources. It can be an opportunity for the BIG 5.”

However, many key mid-tier companies such as MindTree (Head count - around 7,500) and Zensar (Head count - around 4,500) see it more as an opportunity than as a threat. “We are witnessing a trend wherein customers are willing to give more business to us. We can see lots of deals or contracts flowing in during later part of this year as firms in the U.S. are under severe pressure to cut costs. The expectation was that this year the Industry would register a growth of about 28 percent. But it may come down to 24-25 percent,” opines Ganesh Natarajan, CEO, Zensar and Chairman, NASSCOM.

An interesting fact is that the impact of recession is undoubtedly higher on small and medium sized enterprises (SMEs) in the U.S., whose bottom lines are increasingly getting squeezed due to lack of spending by consumers. These SMEs have now started waking up to cash in on the outsourcing wave, so as to survive, and explore a market opportunity that their larger counterparts have already made use of. “Especially the SMEs in the U.S. are under severe pressure to increase profitability and business margins. This will force them to outsource and even have M&A arrangements with Indian firms,” says Arup Roy, Senior Research Analyst, Gartner.

As a testimony to this, according to NASSCOM, in the first quarter of 2008 India had received SME outsourcing deals worth $7 billion from the U.S. as against $6.2 billion in the same time frame the previous year. Will this help mid-tiers? No. Because, though these SMEs prefer mid-tier companies for their specialty services, in the times of slowdown they may prefer big companies that have begun looking towards such companies to get deals though it is of lower margins in order to increase their revenue stream. Certainly, this will push the mid-tier companies out of the picture.

Moreover, recession is creating a lot more opportunities for M&A activities and consolidations in India. Since the mid-tier companies don’t have deep pockets to take on the current challenges which are ultimately denting their competitiveness resulting in a spurt in the large-scale consolidation activities which has become a hot trend in the market nowadays, the latest instance being the acquisition of 32.57 percent share in Aztecsoft (Head count - around 2,100) by MindTree. Due to the tough economic conditions, analysts say, industry may witness mergers among the mid-tier companies as well as takeovers of mid-tiers by large players.

Hence, unless one does not have a key-differentiating factor to offer, surviving single handedly will be quite tough for mid-tier companies. In fact, these days, many such companies are eagerly looking for being acquired by someone in order to grow. If we consider acquisition of Aztecsoft by MindTree, here, promoters of Aztecsoft have accelerated exit plans just because the company has not been able to establish dominant position in the segment it operates in, which is very critical for a mid-tier company to succeed in the current competitive market. “In addition, the tightening macro environment for the IT sector can also be the reason,” says an Analyst.

Ganesh Natarajan thinks that the companies with an established differentiator and unique value proposition are not likely to feel much heat. Mid-tier firms like MindTree, which has very strong hold in its domains, especially in BFSI, are doing well despite the worst conditions. Mastek (Head count - around 3,200) has adopted partnership as a strategic route to enhance its credibility and bring in more business. Mastek markets itself through alliances and more than half of its business comes from partnership-driven projects. “Thus, though analysts predict this will be a tough year, I can only say that it would be a slow year,” he opines. However, it will be difficult for all mid-tier companies operating in this space. “So, tough times loom large for companies without a differentiator,” adds he.

It’s indeed a trend that many of them are diversifying their services to non-U.S. and domestic markets. For instance Polaris (Headcount - around 10,500), after its merger with OrbiTech in 2002, decided not to have only the services agenda, but to have a hybrid model of products and services business as they foresaw that the cost arbitrage model would affect them in the long run. “Today, we also have a balanced revenue mix from diverse geographies, 35 percent from the U.S., 35 percent from Europe and the Middle East, and 30 percent from Asia Pacific. This helped us to do well despite adverse market conditions,” says Padmini Sharathkumar, Sr. VP, Corporate Marketing and Communication, Polaris.

Though Polaris has done that, will the same be easier for all mid-tiers? Points out Roy, “Because of their financial constraints, it will be a real challenge for all of them to diversify their services towards emerging markets like Asia-Pacific, Eastern Europe, Latin America, or the U.K., though they are pretty hot locations.” And such firms, which are operating in a dreadfully thin margin, are bound to face the nip of ongoing U.S. recession. Because, observes Srinivasan, “Most of the companies in the U.S. are deferring their decisions, and putting a cap on the IT budget.”

Another substantiating factor that gives a new dimension to the impact is that hiring across companies, especially among the mid-sized, has entered a lull and it is estimated that overall hiring is down by 40-50 percent compared to last year. “Mid-sized companies are not being very proactive in their hiring plans,” says Amitabh Das, CEO, Vati Consulting. Previously, when economy was booming, candidates were never concerned about moving to a mid-tier company. However, now, employees of large organizations are very reluctant to move to a mid-tier company, which is making the mid-tier companies’ situation even worse.

Rupee fluctuation against dollar was a major concern for vendors, as it ate up 3-4 percent of their operating margin. In 2007-08, when margins were under pressure as the rupee appreciated by about 12 per cent against the dollar, it compelled vendors to renegotiate their contracts with their customers. Though, many companies adapted the strategies like their overseas income through forward contract to tackle rupee fluctuations, the real acid test is for mid-tier companies that do not have a big established full-fledged treasury department. Many mid-tier companies burnt their fingers due to this. But, reckons Padmini, “We adopted a strategy of price increase through negotiation with the customers and billing them in their local currencies. As currencies other than the dollar have not undergone depreciation. Also, through operational efficiency, product license, and on-demand sourcing strategy we were able to maintain our margins.”

Focusing on Domestic Markets
Many believe that a focus on the domestic market mean having to work with tighter margins. But it’s not so. “The margins and deal-sizes are getting better,” said Krishnakumar Natarajan, President and CEO, MindTree, recently. According to a NASSCOM estimate, the domestic market has reported gains by growing at 44 percent in 2007-08 to touch $23 billion, mainly driven by the hardware segment.

Yet, domestic market has its own sweet challenges. Crumbling infrastructure and skyrocketing real estate costs have added fuel to the crisis, making margins on revenue further thinner. According to Shankaran P Raghunathan, President, ITSME Association based in Chennai, “On an average, about 10 percent of our revenues are spent on rentals. We pay more than $1 for a square foot of office space here. In Kuala Lumpur the same costs less than $1 and I will get class A infrastructure. Big companies that raise a hue and cry over infrastructure have not really paid for it. Smart ones will move out soon.”

SEZs Not Meant for Mid-tiers!
The export-oriented Special Economic Zones (SEZs) now cropping up in India offer a five-year, 100 percent tax holiday. And so larger companies are already pursuing their SEZ plans aggressively. But, since one of the clauses in the rules stipulates that to set up an unit in an SEZ a company should buy a minimum of 25 acres, the SMEs find the SEZs virtually prohibited for their entry as they normally do not need such a large plot of land. Hence, many mid-tier companies have deferred their decision to move to the SEZs. “While we still look for SEZ space, we don’t have any urgency to move into an SEZ,” says Ganesh Natarajan.

Certainly, Indian mid-tier IT companies are going through a dreadful phase. With India is growing at the rate of 8 percent a year, indeed it has a huge advantage in some key areas such as talent and infrastructure over its neighboring countries. Of course, even top-tier companies also can enjoy them.

However, if we look at the mid-tier companies currently operating in the industry, only those who have established a niche differentiator are able to post growth in the current conditions. Hence it is imperative that one should be able to become a unique player with distinctive competencies, which could conquer the competition and palpable challenges. And such companies, no doubt, will survive to make a mark in the industry. Current ‘mid-tier miseries’ teaching Indian IT the same lesson.
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