IT industry focuses on non-linear growth to boost margins

With high growth and handsome profits, the going has been good for the IT industry, the jewel in the crown for the India Inc.

The year 2011-12 is expected to be a landmark year for the Indian IT-BPO sector as the total revenue of the industry is slated to cross the $100 billion mark and the export revenue is expected to touch $70 billion.

But despite a phenomenal growth, making India the largest player in the world in IT outsourcing, our home-grown IT companies are embarking on major initiatives that will give them non-linear incremental growth in the future, stated a industry report by UBS Investment Research. 

Non-linearity basically means decoupling revenue growth of a company from headcounts.

It also means that a company achieves non-linearity when it increases its revenue and operating income by a higher rate than the rate of growth in manpower addition.

The action time

In the past few years, there has been an increase in the level of investments by Indian IT services vendors in non-linear revenue models that could help de-link revenue growth from headcount increases and reduce pressure on operating margins.

The UBS report found that Infosys has launched a new strategy, Infosys 3.0, which aims to generate 33 per cent revenue contribution from innovation-led non-linear initiatives in the next six to seven years, while TCS targets 10 per cent annual incremental revenue from its non-linear initiatives. Currently, both vendors derive less than 10 per cent of revenue from non-linear revenue models.

From the beginning, the revenue growth in IT services has been directly proportional to headcount, with revenue and headcount addition closely following each other. As the hiring in Indian companies have already reached gigantic proportions, TCS currently employs 1.70 lakh people and Infosys 1.43 lakh, the capability to keep hiring and training are proving to be highly stretched. Also with the downward trend in per capita revenue and gross profits, Indian IT vendors are beginning to invest in non-linear revenue models that should help prevent revenue commoditisation and operating margin decline.

“According to our channel checks, most Indian IT companies derive less than 10 per cent of their revenue from non-linear models. However, some of them have set aggressive targets of 15-30 per cent revenue contribution from non-linear models in the coming years,” said the UBS report

Decelerating growth

There are several reasons for the proactive companies to go for strategies to achieve higher revenue growth. Slowing revenue growth, the dollar revenue growth for Indian IT companies, according to UBS report, has slowed from the 2004-08 highs of 30-35 per cent to between 13 and 19 per cent currently, driven by slower end-user demand and high-base effect.

Also the commoditisation of traditional services offerings such as ‘application development & maintenance (ADM)’, which accounts for nearly 45 per cent of the revenue of top 5 Indian IT companies, are pulling down the margins.

UBS also mentions that lower-margin competition from vendors such as Cognizant in the last few years have reached critical mass and now compete more aggressively with large Indian vendors. “We believe this has added to competitive pressure and made market share gains more expensive, as vendors have to spend more resources on client-facing operations,” said the report. Rising wage costs with annual increases touching mid-teen in the past several years is another pressure point to increase productivity.

Another interesting indicator is that the gross profit per employee has gone on a steady decline for large companies (except HCL Technologies), indicating that per capita cost of revenue continues to increase faster than revenue productivity for the sector.

Non-linear models

To breakout of the proportionate relationship between hiring and revenue, Indian companies are adopting the following  growth models as non linear: Cloud-based offerings and services, Platform-based BPO (business process outsourcing) or platform BPO and Products and IP (intellectual property)-based solutions.

Among all there is no doubt that the successful software products offer the maximum incremental revenue. The global product company examples like Microsoft, SAP, Oracle, Adobe etc, prove the point. But, unfortunately, Indian IT companies have poor track record in successful product development.

Similarly, global models also show that platform BPO vendors (Automatic Data Processing, ADP) currently operate at significantly higher per capita revenue and operating margins than traditional IT services vendors (Accenture).

Yes, the cloud-based services are in the early stages of adoption, but this also has tremendous potential to create mass users market without adding much to the wage cost.