The sub prime mortgage crisis and weakening of dollar has given severe shocks to the outsourcing industry. Indian companies were especially hit as the Rupee appreciated by 10.9% in the last 12 months (14.2% in the last 15 months) against the US Dollar. Investors, analysts and the media have been speculating about the impact of margin pressures, risk of business loss in the US, further Rupee appreciation coupled with domestic inflation, etc.

Despite worries on the margin front, outsourcing growth expectations stand tall. As a result, companies are gearing up to face the year with aggressive plans coupled with some innovative strategies to fight margin pressures. Either way, 2008 promises to provide plenty of action for the outsourcing industry.

Key trends that will impact the outsourcing industry:

Small BPO operations to be hit hard: Smaller BPOs with low-end, commoditized services are worst affected by margin pressures and the worst is far from over. These players will find it difficult to raise prices, and will be unable to pay enough to retain the best talent. Small Indian vendors will be forced to innovate with a focus on “differentiating” their services. In 2008, this will become critical not just for sustaining competitiveness but also for the very survival of smaller vendors. The vendors that succeed in differentiating their offerings and thereby climb higher up the value chain will see new growth or exit options open up via better access to funding and M&A activity by larger players. The others, who are unable to get out of the low-price, low-cost game, will start fading away from the competitive landscape.

Rigorous cost cutting by vendors: The larger companies may hedge forex exposures in the near term, but cannot disregard the threat of lower competitiveness in the long run. Large global vendors and focused, niche providers may be able to raise billing rates, but this will not compensate for the entire exchange loss, and will need a parallel productivity increase to prevent margins from weakening further. Cost rationalization will be inevitable for Indian vendors – whether small or large! The most obvious impact will be on wage hikes and executive perks. Recruitment too is expected to slow down marginally until mid-2008, as vendors push up utilization rates aggressively. But we expect recruitment to pick up again in the latter half of the year as the slack gets wrung out. The impact on attrition rates will also be interesting to see, as poaching may not earn employees a large premium. Apart from the obvious cost heads, companies will also look to optimize various administrative or marketing costs. Traditionally, the weak Rupee has meant that margins were never threatened for Indian IT and BPO service providers. This has led to considerable slack, in areas like transport costs, procurement, travel, telecom, etc. In the past, management attention was focused only on growth, but now, the quality of growth will matter more.

Smaller cities will shine brighter: The cost and talent pressures will drive vendors to smaller cities at a faster rate. With improving attention to education across India and State governments’ recognizing the potential of the outsourcing sector, companies are finding themselves almost spoilt for fresh location choices. Proximity/connectivity to larger cities and good education infrastructure seem to be guiding the discovery of Tier III destinations like Udaipur, Bhopal, Vishakhapatnam, Nagpur, Chandigarh, Ahmedabad, Nashik, etc. The emerging hot spots are also offering:

Competitive talent at lower wages than the preferred locations·
Infrastructure and realty advantages·
Lower attrition·
Lower operating costs

Vendors to aggressively diversify client base: The focus on the US market is already going down Analysis shows that US-based buyers made up for 56% of the total BPO & KPO contracts in 2007. Nasscom analysis shows that for IT outsourcing, the share of US-led business was about 67% in 2006-07. We believe that this will reduce further in 2008 for several reasons. First, a probable US recession is making vendors aggressively de-risk their sources of business. Secondly, growing maturity of buyers in Europe, Middle East and Asia is opening up new, untapped markets. Thirdly, vendors are maturing rapidly and have acquired the financial, managerial and operational capabilities to build and run centers at multiple locations around the world. All of this is driving the “global sourcing” movement in the industry and 2008 will see this playing out further

Domestic business will be hot and happening: The Indian domestic market for IT and BPO has typically not interested the large companies, which are traditionally export focused. All of a sudden however, they’re waking up to the potential opportunity in this hitherto neglected, but rapidly growing market within India. A few large IT deals in the past two years, especially in BFSI and telecom helped spark the interest. Ironically, many of the largest domestic deals, especially in telecom, have gone to multinational vendors. But as the Indian economy grows rapidly, new opportunities are emerging in retail, manufacturing, media & publishing, for Indian vendors to tap.2008 will see a lot of noise around outsourcing in the domestic market. High growth rates, Rupee denominated contracts and better utilization (day shifts) will grab the attention of small and large Indian exporters. We expect that large IT/BPO companies will look for acquisitions in the domestic space to acquire specific capabilities and client relationships.

Greater focus on the mid-market opportunity: The mid-market segment in the US and Europe has been traditionally underserved for a variety of reasons, including lack of knowledge of Offshoring, unattractive deal sizes for the premium vendors, etc. However, rising outsourcing maturity of early buyers amongst mid-market companies is driving their propensity to deploy the more expensive services of larger vendors. At the same time, intensifying global competition is encouraging the larger vendors to look beyond Fortune lists.






* ValueNotes Analysis