India's software industry has grown by leaps and bounds over the past few years. It has been the poster-boy of the services sector, being among the fastest growing industries in the country. In FY05, as per the industry body NASSCOM, India's software services exports hit US$ 12 bn, up from US$ 9.2 bn in FY04, while IT enabled services/BPO exports hit US$ 5.2 bn. Combined, it was a growth of 34% over FY04. This was the fastest growth recorded since the dot-com bust happened in 2000. Top tier software companies like Infosys, Wipro, TCS and Satyam, as well as niche players like i-flex solutions and Geometric Software recorded strong growth in revenues as well as profits.
So, is it all 'hunky-dory' for India's software companies at the moment? Certainly not! There are challenges faced by every company in every sector and software is no different. So, what is the one major challenge faced by India's software companies? Is it a slowdown in growth? Well, total IT spending was in the region of US$ 600 bn in 2004 and is expected to grow in the mid-single digits for the next few years, as per major analyst firms like IDC and Gartner. India's share was a mere 3%! Given the strong offshoring environment and an increasingly favourable attitude to offshore outsourcing by US corporations as well as European companies, there appears to be tremendous potential to grow for the next ten years, let alone the next year! Therefore, concerns about a possible slowdown are unfounded. This was the major concern after Infosys announced 'conservative' guidance for FY06 and TCS' profits fell dramatically in 4QFY05. As we have indicated in the past, there is no reason to panic on this front.
Could the challenge be in the fact that India's cost advantage is reducing? Global software companies such as Microsoft, IBM and Accenture are realising the advantages of global delivery pioneered by Indian software companies and are themselves setting up global development centres in India. As a result, the cost advantage enjoyed by India is slowly but surely reducing. However, India's labour costs are still much lower than those in developed countries such as the US and given the fact that Indian software companies are slowly but surely moving up the value chain in order to move away from pure cost arbitrage, this issue appears to have been addressed for the time being.
Then, is it competition from alternative offshoring destinations such as China? Well, as per Chinese government sources, a mere 0.05% of China's population speak English and out of that, just 10%-20% can actually converse fluently! What is more, it is expected to take at least two decades for the number to inch up. Given that English-speaking outsourcing accounts for as much as 85% of the offshoring market, as per Gartner, it is quite evident that China is definitely not going to catch up in a hurry with India. Also, Chinese software companies do not have any meaningful scale. Almost three-quarters of them have less than 50 employees and a mere five of them employ over 2,000 employees. In contrast, India's software biggies employ tens of thousands of employees and have already built significant scale. Moreover, Chinese software companies do not have any major international experience, and a mere 10% of revenues are earned from exports, compared to nearly 80% for the Indian software industry. Therefore, as of now, China is definitely not a threat.
So, what is this 'major threat' that we are talking about? Well, in one word – people. Quite clearly, software is a people-oriented industry. People are the raw materials that drive the industry. There is a need for skilled people by all software companies. Given the need to scale up at a rapid pace, software companies are hiring left, right and centre. Now, one needs to understand that people are a scarce and finite resource. Therefore, quite clearly, there is competition among the Indian software companies for talent, particularly at the entry level, where recruitments take place on engineering campuses around the country. Compounding this problem is the fact that software MNCs are also in this game. This only heightens the competition.
The end result is, that the demand for people is greater than the supply. Basic economics tells us that whenever such a situation arises in any industry, then the prices of the 'scarce goods' will rise, as the 'buyers' are willing to pay a higher price for them in order to ensure that they get the 'goods', rather than their competitors. Thus, it follows that employee costs are constantly on the up for these companies.
We will just try and illustrate this by an example. Every year, around 135,000 graduates pass out of Indian engineering colleges (Source: Statistical Outline of India). These 135,000 people would be highly in demand from not only India's IT companies, but also the Microsofts and Oracles of the world. Add to that, around 187,000 science graduates and assume that all of them opt to join the IT industry. Add to this, 38,000 science post-graduates. The total adds up to around 360,000 people. The total employment in the IT industry is nearly 700,000. Given competition from companies within the sector, as well as competition from other industries, such as the fast-growing telecom sector, engineering, power, energy and capital goods, this makes for a difficult proposition indeed. Also, given a higher level of attrition in the ITES-BPO industry, training costs will also surge.
As can be seen from the adjacent chart, in virtually every year, for all the three major companies, employee costs as a percentage of sales have increased. Of course, as regards individual company's circumstances, the percentage depends upon factors such as onsite-offshore mix, utilisation rates and proportion of freshers/experienced people recruited. But the overall direction of the trend is quite clear and that is upwards.Going forward, given the ever-increasing need to scale up at a rapid pace, demand for employees will remain robust and as a result, engineering graduates, particularly in the higher-rung institutes, will remain a pampered lot. Good quality employees are a strategic resource for any software company and they must make al efforts to retain them. The figures that we have given in this write-up are only an indication – they may not be exact figures, but the general trend is quite evident.
For investors, apart from revenue growth, profit growth, operating margins and other such metrics, it is equally important to keep an eye out on the kind of attrition rates that software companies experience, for this is the major lever on which these companies are going to fight the battle for supremacy.