Trouble for Indian BPOs

IT and ITES companies already buffeted by strong headwinds from a worsening economic outlook in key markets, could be in for more trouble as a new anti-outsourcing backlash gathers momentum in the US.

Several states in the US, which accounted for more than 60% of the $40.4 billion (Rs1.76 trillion) India earned in software and service exports in the last fiscal, are proposing legislation that would restrict market access for Indian information technology (IT) firms. Industry and policy analysts are concerned that rising focus on economic recession and unemployment could boost the anti-outsourcing campaign by legislators following this year’s US presidential election. That would be a repeat of what happened after the presidential election in 2004.

“Detractors of off-shoring, whose tribe has been shrinking, could fuel opinions by putting forth apparent notions of job losses in the forefront to deal with socio-political problems,” says Srinivas Vadlamani, chief financial officer at Satyam Computer Services Ltd, the country’s fourth largest software services firm.

During 2003-04, as many as 200 Bills were introduced to prevent American jobs from being off-shored. Following that, states such as New Jersey, Indiana, North Carolina, Tennessee, Alabama, California, Colorado, Illinois, Maine and Maryland have put in place laws that restrict outsourcing. According to a report, Anti-Outsourcing Efforts Down but not Out, released in April 2007, by a Virgina-based policy research and analysis institute, National Foundation for American Policy (NFAP), 191 anti-outsourcing Bills were introduced in 2005-06 in various states and 41 such Bills were moved in 2007. NFAP executive director Stuart Anderson, in an email response to a Mint questionnaire, confirmed that these Bills are pending at various stages.
“These types of Bills may force Indian companies to adjust their business practices and could raise the cost of doing business,” says Anderson. Some states such as Arizona, Colorado, Connecticut, New York, Pennsylvania, Vermont and Virginia have pending Bills to restrict government agencies from purchasing goods or services from outside the US. Others such as Georgia, Massachusetts, Minnesota, Nevada, North Carolina and Oklahoma have pending Bills that would restrict offshore call centre operations.

Relatively low labour costs and a vast pool of engineers have enabled IT firms to win work from clients in the US and other countries, gaining India a reputation as the world’s back office over the past decade. Typically, after they win an outsourcing contract, Indian firms tend to send the bulk of the work to low-cost destinations such as their own home base.

Efforts by Indian IT firms to combat the anti-outsourcing backlash by near-shoring (having delivery centres in or near the customers’ operational base) were constrained by high costs and lack of availabilty of skilled professionals. Policy analysts at NFAP pick out two Bills they say have a good chance of becoming law—House Bill 1127 in Indiana, which would restrict sending certain medical-related information outside the US, and House Bill 4100 in Michigan, which requires reporting of goods or services purchased by the state from outside the US. The New York state senate in June passed a Bill that would require all utility firms supplying electricity, gas and municipal services to locate their customer call centres within the state. It will become law after the state governor’s signature.

India’s business process outsourcing (BPO) industry, which last year earned $10.9 billion in revenue, will be hurt by such legislation. Most of the pending anti-outsourcing legislation relates to preferential treatment—through tax breaks and incentives—to the US firms that create jobs in their respective states or across the US. Some Bills also seek to ensure that only US citizens are authorized to work on data pertaining to the identity of US citizens. Indian companies are likely to miss out on huge public sector contracts and risk losing business even with private entities that have business relations with governments. Several Indian IT firms act as sub-contractors to large US firms.

In their 2008 annual reports submitted to the US Securities and Exchange Commission, Bangalore-based Infosys Technologies Ltd and Hyderabad-based Satyam Computer Services acknowledged that with increasing political and media attention on the growth of outsourcing and unemployment in the US, there is a risk of change in existing laws or enactment of new legislation that restricts outsourcing.

Infosys chief financial officer V. Balakrishnan is hoping that the impact on the company will be minimal because of its low exposure to US government contracts. “Most of the large US companies are lobbying for greater access to the global pool of talent as there is a tremendous short supply of high quality people required for this industry,” he added.

Because of the election, some sections are focusing on the “perceived negatives of off-shoring”, said Satyam’s Vadlamani, adding that such efforts are not likely to succeed. Outsourcing is no longer just a way for US firms to save on costs by sending work to low-cost destinations such as India, but also a way of overcoming a shortage of sufficient talent at home, says Som Mittal, president of the National Assocaition of Software and Service Companies.

“If the US does not have sufficient skilled human resources, then they have to get their work done in countries where there is sufficient resources,” he said. “Further, studies have shown that outsourcing has only increased economic activity in the US.” The Indian IT industry has weathered such efforts in the past, especially during 2003-04, and the pending legislation isn’t likely to have “any significant impact”, Mittal said.

Viral Thakker, director of sourcing advisory services at audit and consultancy firm KPMG India, links the posturing against outsourcing to the upcoming presidential election.
“However, assuming everybody understands the business reality, it is unlikely that new legislation with significant impact on global sourcing will be enacted.” Thakker said. “But such laws could pose hurdles for Indian companies to requiring them to restructure their businesses to work around market restrictions.”

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