Reality Check for India's Software Industry

The soaring sector gets a jolt from growing pains

National calamity. Horror show. That's the catastrophic language Indian investors are using to describe what just happened to the country's vaunted software sector. First, on Apr. 10, Infosys Technologies Ltd., India's premier information-technology company and the Bombay index' bellwether stock, announced a lower-than-expected 11.8% earnings growth forecast for next year. Barely a week later, software-services provider Wipro Ltd. announced weaker-than-expected earnings of $170 million and projected a mere 4% revenue increase for the current quarter. The shares of Wipro and Infosys swooned. One Bombay technology analyst went so far as to compare venerable Infosys Chairman N. Narayana Murthy with Saddam Hussein, saying that what the war against the Iraqi tyrant couldn't do in a month to upset India's stock markets, Murthy did in a day. The benchmark Bombay Stock Exchange Sensex sank 4.7% as commentators declared the end of India's tech boom.

Is all this an overreaction? No doubt. Investors in Indian tech stocks, many of them foreigners, had grown accustomed to year after year of racy 70% revenue growth and dizzying 40% operating margins. They should have known that the party was eventually bound to end. More sober analysts view the hammering down of the sector as a long-overdue correction of sky-high valuations. The forward price-to-earnings ratio of Infosys, after all, had hit 140; it's now 20.

Yet the heyday for India's software industry is hardly history. Its main attraction--legions of supersharp engineers offering quality, low-cost service--remains in place. Investors, though, are on to something, since the sector is certainly facing new challenges as the global economy struggles and clients grow more demanding. "India's software industry is going from infancy into adolescence," says Frances Karamouzis, a software services analyst with Stamford (Conn.)-based consultant Gartner Inc. "It has to shift from being opportunistic and entrepreneurial to being strategic."

The challenges are coming from several directions. Existing customers for companies like Infosys and Wipro, whose main business is IT consulting and services in the U.S. and Europe, have been pinched by three years of slow growth or outright recession. As a result, penny-pinching customers are demanding lower prices. A year ago, India's Big Three--Wipro, Infosys, and unlisted Tata Consultancy Services--charged an average of $40 an hour for their services. Now they charge $35 on average, and Bombay broker SSKI Securities predicts a further 5% to 10% decline in prices later this year. Smaller companies, such as Satyam Computer Services Ltd. and HCL Technologies Ltd., will see even greater price declines. "When people move to India, pricing is top of mind, obviously," says Vivek Paul, chief executive of Wipro. "It's a competitive game out there."

Pricing isn't the only issue. Customers are demanding more sophisticated services from their Indian outsourcers. That includes advice on how to reduce costs, increase sales, and raise profits through better use of information technology. For clients in, say, financial services, that means developing deep knowledge of the insurance or banking business. The problem is that Indian companies are traditionally better at solving tech problems than business problems. For years, all Indian companies did was coding--writing software for projects to specifications given by a company's chief information officer. The only worry was which software language to use. Now, says Rohit Sipahimalani, an IT specialist with Morgan Stanley in Hong Kong, "it isn't just the chief information officer who has an IT focus, but also the chief executive who is looking for business solutions."

As Indian companies scramble to expand their services, multinational competitors like IBM Global Services, Accenture, and Electronic Data Systems are nipping at their heels--helped by their own new staffs of Indian engineers. By yearend, IBM will have 7,000 staffers in India, Accenture will have 2,500, and EDS will have more than 1,000--all sharp rises from two years ago. They're using their Indian operations to offer clients everything from software development to call-center operations, all at low rates, sometimes even matching those of Indian companies. What's more, says Jay Davis, Asia Pacific director for EDS, with the big U.S.-based IT consultants, "the talent pool is much deeper."

The software-manufacturing companies are also getting into the act. Oracle Corp., for instance, is not only doing product development in India but also customer support. It now has more than 2,500 Indian employees and expects that number to rise to 4,000 by next year. Even Microsoft Corp. is ramping up its Indian operations, hiring engineers to develop new products.

None of this is news to Indian companies, and they are determined to stay in the game by creating "end-to-end services," which they hope will put them on a par with the global consulting giants. Wipro, Infosys, and TCS are all hiring consultants around the world to help them build expertise in specific industries like financial services.

But the conservative Indians are still a bit slow off the mark. For instance, the first major overseas acquisition by an Indian software company came last October, when Wipro paid $26 million to buy the power and energy division of consultant American Management Systems Inc. And in April, Wipro paid $18.7 million for NerveWire, Inc., a Newton (Mass.)-based tech consultant. Infosys is sitting on more than $350 million in cash, prompting one analyst to report an earlier charge that Murthy is "studying acquisitions to death" without making substantive moves.

The Indians are girding for the challenge, though. "This is a crucial time for our industry," says Nandan Nilekani, chief executive of Infosys. "The real test will come over the next two to three years." In the short term, some business will return when fear of the SARS virus wanes, the Iraq crisis winds down, and the U.S. economy turns up. But in the future, Indian players will have to battle increasingly with global majors like Accenture and EDS, who are trying to annex their strategy of delivering services at low costs. Most Indian software execs are confident they can compete. But the easy gains are a thing of the past.

By Manjeet Kripalani in Bombay, with Bruce Einhorn in Hong Kong

— With assistance by Bruce Einhorn

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