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Software: A new paradigm? - Views on News from Equitymaster
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  • Sep 8, 2005

    Software: A new paradigm?

    There was recently a big news for the software sector. TCS and Infosys, the country's largest software service companies, have won a deal from the Dutch banking giant, ABN Amro, worth hundreds of millions of dollars. The total size of the deal is US$ 2.2 bn and five vendors - Accenture, IBM, Infosys, Patni and TCS - have been chosen to service different 'parts' of the deal. IBM has got the largest chunk of the deal, worth US$ 1.8 bn for maintenance of the bank's IT infrastructure. The other vendors have got the deal for application support and development services.

    As far as Infosys and TCS are concerned, TCS' total share in the pie is US$ 260 m, while that of Infosys is US$ 140 m. This is the biggest deal won by both companies and is spread out over a period of five years. TCS has said that it expects revenues to start flowing in from 3QFY06. Thus, if we assume the same for Infosys, in terms of size and addition to revenues, this deal might not contribute that much. Back-of-the-envelope calculations show that TCS will earn around US$ 52 m annually over the period, while the figure for Infosys is US$ 28 m. Given that these companies are in the region of US$ 2 bn-plus, this would not make a significant difference to revenues. However, we need to look at the larger picture and see the overall trend in the industry. As the Indian software industry increasingly moves higher up the value chain, we take a look at what this deal could mean for the industry, going forward.

    Higher, faster, stronger
    This big order win by the two software biggies is a continuation of the trend that has been witnessed over the past few years in the IT industry. The number of million dollar clients (clients that give the company annual revenue in excess of US$ 1 m) as well as the clients in bigger buckets, such as US$ 5 m, US$ 10 m and so on has been consistently on the rise. At present, Infosys has 22 clients that give it revenues in excess of US$ 20 m and 5 US$ 50 m clients, while TCS also has 5 US$ 50 m clients. This deal will be an addition to this client base.

    However, as mentioned above, it is necessary to view this deal in terms of the trend that is visible. We need to understand one thing first. Earlier, companies used to hand out large, multi-billion dollar deals to the incumbents like EDS and IBM. These deals often involved takeover of employees as well as assets and infrastructure of the company.

    It should be noted that at that time, the trend of offshore outsourcing (offshoring) did not exist as it does today. With the advent of offshoring, a change in the handing out of deals in the IT space was noticed. Large companies started to break-up their IT outsourcing into 'parts', as ABN Amro has broken up its deal into infrastructure maintenance, application maintenance and application outsourcing. The companies started to hand out each 'part' to different vendors, which could do the best job in that domain. Thus, they resorted to 'multi-sourcing' or 'strategic global sourcing', often choosing as many as six to seven best-of-breed vendors for outsourcing their IT operations. This trend has favoured the Indian software players, since, unlike players like IBM, they cannot take on multi-billion dollar deals, as they do not as yet have the scale and size to do so.

    This deal is clearly a big 'YES' in favour of the Indian offshoring model. The concept of global delivery, pioneered and perfected by Indian software companies, has completely changed the dynamics of the global IT industry. The cost advantages, process discipline and execution ability of Indian software companies has led to redoubtable companies like IBM actually saying in recent times that competitors like Wipro are the ones that they will have to watch out for in future. Therefore, all the short-term 'noise' against offshoring in the US and Europe will remain exactly that - noise. The very fact that IBM, EDS, Accenture and Cap Gemini themselves are setting up offshore locations in order to serve their customers better is the biggest validation of the offshore outsourcing story.

    Another positive for the industry is that this is expected to speed up outsourcing from the European geography. This region has traditionally been conservative and a late adopter of outsourcing and the fact that this deal is coming from one of the largest financial services companies of Europe can help Indian companies' European revenues. Over the last few years, the Indian software companies have been increasing their revenues from Europe as a percentage of total revenues and this could accelerate that trend.

    This win could lead to more such deals in the future. The concept of 'multi-sourcing' seems here to stay. As Indian companies start winning more such deals in future, human resource management will become an even more critical issue. Such projects do take up a lot of resources, time and money and it is vital for these companies to be able to execute efficiently and effectively as they have been dong all these years. This is the major factor that the Indian players will have to address as they grow larger in size and take on more complex assignments.

    A bit about executing such deals
    Generally, when deals of such a size are won, it takes a bit of time for revenues to start flowing in. There are also concerns regarding the margins that companies make on such deals. Generally, in the first year, margins are below average. TCS expects margins to be normal from the second year onwards. Internationally, it has been observed that when MNC companies win multi-billion dollar deals, it puts pressure on margins and coupled with the fact that they take over employees and assets, margin pressure is exacerbated. Therefore, as Indian companies start winning deals of larger sizes, one must take this factor into account. Billing rates could also be lower, as companies resort to aggressive pricing to win these deals. The major factor here is the volume of work.

    Are we now in the big league?
    This deal win will certainly help put the Indian majors more into the limelight. It proves their execution abilities and their scalability. Going forward, given favourable trends towards offshoring and Indian companies continuously scaling up in order to execute increasingly large and complex deals, more such order wins can be expected. However, we are still some distance from joining the 'big league'. While this certainly puts us among the larger companies globally, companies like IBM are still in a different league.

    As poet Robert Frost puts it, " I have promises to keep, and miles to go before I sleep". Thus, there is a long way for Indian software majors to go before they can be counted among the IBMs, Oracles and Microsofts of the world. Once that happens, we could see an entirely different paradigm in the industry.



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