Indian IT companies' margins may slip to 15 per cent

John C McCarthy, vice-president and principal analyst at Forrester Research, has predicted and analysed some of the biggest shifts for the global technology industry, including his famous 2004 study, which claimed that 3.3-million white-collar American jobs (500,000 of them in IT) would shift offshore to countries such as India by 2015. In an exclusive interview with ET, Mr McCarthy says profit margins of India’s top tech firms TCS, Infosys and Wipro will drop from high twenties to around 15% over the next 2-3 years, as customers seek to work with fewer vendors at lower rates and newer delivery models such as cloud computing and software as a service squeeze the pricing further. Excerpts:

How sustainable are profit margins of top Indian tech firms?

I think the Indian companies are going to come down to around 15% margins over 2-3 years. Their operations are getting much more complex. They are not just an Indian company anymore. They are in India, China, Brazil, trying to sell in all these alternative geographies. Not that it’s not going to be a great business — don’t get me wrong. They would certainly be more profitable than some of the infrastructure players.

The pressure on their margins is going to continue. They are not going to operate at twice of what everybody else in the industry does — no way. Accenture is here, IBM is here, why are they operating at a different level? They are going to make investments in front-end sales and marketing, more non-linear investments, they have got wage inflation issues, attrition is going through the ceiling.

That’s the short- term problem everybody is facing. With the business coming back, some of these numbers are just insane, it’s as bad as I have seen it here. Attrition is in that sense, a short-term ‘cloud’ on the horizon, not some five-year technology shift.

With more customers adopting software-as-a-service (SaaS) model and avoiding heavy implementation projects, what challenges do TCS, Infosys and Wipro face?

From an infrastructure as a service point of view, that’s (cloud computing) really a small part of the equation, and that’s going to be a slow burn for clients. I think the bigger impact is the emerging SaaS as an alternative to the traditional package work they have been doing for years. We are seeing more and more companies looking at these SaaS-based deployment models.

They are buying it new, replacing an existing system and developing new. For example, salesforce.com, that is replacing Siebel. I met one of the vendors last night, and they are saying because the SaaS deals are less implementation heavy, they are not showing as top deals. They are smaller, much more iterative, so a $4-million contract becomes a $250,000-contract. It’s not a threat, but when you lower price like that you are going to explode the market.

‘Not all small and mid-tier IT cos are likely to be acquired’

The underlying factor for the technology business is price elasticity — if I cut the price by 50%, I grow the market by 300%. I think the volume will make up for it, though it’s a different business model, different cost structure, and that will be a challenge.

Despite being the world’s second-biggest IT market, Japan continues to be a tough market for outsourcing and offshoring. Will this change anytime soon?

The only people who have been successful in Japan are IBM and HP because they have huge hardware relationships with the Japanese clients. Japanese companies are so conservative, and so behind in terms of technology practice point of view. Some of these companies cannot even outsource their processes to somebody down the street in Tokyo, let alone in China and India. The project management, IT governance and other practices are much less sophisticated — very fragmented operations. It will be a slow, painful burn in terms of opportunity.

What lies ahead for mid-tier and smaller Indian tech firms?

Not all of them are going to get acquired, a lot of them are owned by conglomerates like L&T and they think they can still have a go at it. So, whether they are acquired or not, they will definitely try and focus better on their value proposition than they have done in the past. You need to look at the ownership structures of some of these companies, and the financial situation. Some of these guys are struggling mightily.

Their numbers have gone backwards — 20% — because they weren’t differentiated, they had no focus, they were playing ‘a mini TCS thing’. When consolidation happened, many customers got rid of them. Yet, there are some vendors like KPIT Cummins, ITC Infotech which have focus and have established themselves as premier specialists in particular domains and verticals.

You can’t be waiting for customers to leave TCS and Infosys — when was the last time you saw an article in the Harvard Business Review that said ‘second-hand’ clients are a viable business strategy? And this is what these guys are talking about. They can’t just go on saying that we are a smaller version of bigger firms. The clients are not going to be looking at them for generic skills anymore.

It’s the top five now, and then there is rest of the world. There is subtle differentiation, even though they are all in the same space, largely competing for outsourcing services, development and maintenance of package work. Wipro has got more product development, HCL better in infrastructure services, Cognizant mostly in financial services with some life sciences business and less diversified services portfolio and so on.

Does high repeat business mean companies are unable to find as many newer customers? Are there risks involved with being stuck to same customers, year after year?

Look at what happened with the portfolio over the past three years. There is a whole depth and breadth of services that you are selling to the customers that they did not buy seven years ago. And clients wanted to take advantage from more services, not just application development and maintenance, but data warehousing, package implementation and in some cases even BPO.

Ask yourself a question. If you are a financial services customer spending 10% on IT, do I want to keep mining that account, or go after a manufacturing company that spends around 1.5% on IT? Any sales book on this planet will tell you that it’s much easier to sell to your existing customers than to newer ones, particularly in an economic environment, which is the worst in 70 years. A lot of vendors could win a business, but always failed to grow them.