Thursday, December 31, 2009

Asian Fab 50: The Fabulous Fabric of IT Outsourcing

Forbe’s Asia's Fab 50 list hit many headlines since September. India Inc. is clearly marching up to the front; - thirteen lucky picks, with three offshoring majors – Infosys, TCS and Wipro.

This is their fifth time in a row for Infosys, and it has been all those five years Forbes has done this listing. This is intriguing. What really makes up the fabric of these fabulous firms? Well, Forbes provided a succinct set of criteria: revenues, operating earnings, return on capital, recent results, movements in share price and future outlook. Future is fishy – where subjectivity could often dominate over objectivity. And, but for future outlook, rest of Forbe’s parameters are all current or backward looking.

As of today, Infosys commands a market capitalization close to $32 billion in NASDAQ, only comparable to Wipro and next to IBM in the IT services sector. Last seven years have been phenomenal; - as cricket buffs would put it - it has been a blistering six rocketing over the pavilion. Since 2003, Infosys revenues, income, profit-after-tax and market cap - all have grown six times, in absolute rhythmic proportion. Infosys continued to add new feathers in its cap. Infosys’ robust, flexible and modular global infrastructure claims 55 development centers around the globe, 105 thousand employees, and a capacity to train over 4 thousand people simultaneously. No wonder that Forbes found Infosys fabulous fabric noteworthy.

However, with all my admiration for this Indian giant, when I browsed through Infosys’ annual report, I found a few numbers interesting. Infosys operates in the IT services and outsourcing industry. It’s an industry where factors of production play a paramount role in the firm’s performance. Competitive advantage is resource based; - it is more inwardly focused, and the input markets – people, technology, and real estate – largely define the firm’s core competence. So, I tried to assess Infosys’ performance on return on invested human capital. According to Infosys’ FY09 annual report, since 2002, Infosys’ employee size has grown by an annual average of 35.4% whereas the revenues have grown by 35.8%. Roughly, if we define the Return on Human Capital as EVA/Labor, the trend of this ratio is frighteningly flat over the years. For firms in this sector, average capital employed is quite the same as average human capital employed. Between 2005 and 2008, Infosys’ Economic Profit (EVA) by Avg. Capital Employed steadily went down by 10% annually, before curving up in 2009.

This has a great bearing on the future outlook. Assuming no major shift in Infosys’ strategic direction to change this linearity, the firm would have to multiply its employee size by 12 to be able to earn the 2008 revenues of IBM Global Services. The company needs to have 1.3 million people, - which is about the total population of San Antonio. This does not seem to be sustainable.

Infosys’ upward movement in the value chain seems rather sloth. Since 2004, Infosys percentage revenue contribution from Consulting and Package Implementation has grown only by 7%. In this predicament, usually firms go aggressive on differential branding to penetrate deeper into the specific market segments. However, quite on the contrary, Infosys has spread its brand over the entire value chain, - which includes both its high-end management consulting wing as well as its low-end BPO subsidiary.

Frankly, I have not looked into the numbers for the competitors of Infosys (such as Wipro and TCS), - but it would be interesting to do so to assess the future of Global Delivery Model. Most Indian software outsourcing firms sell this model as the service; - GDM is a framework to deliver business solutions to clients by distributed resources, often with the sole objective to achieve cost effectiveness. At its core, GDM is a process, and some Indian firms pioneered it during the 90s, especially amidst the hues and cries around Y2K. For any established IT services firm, barriers to entry in the GDM market is fairly low owing to the high imitability of the model. So, very soon, GDM based services became commoditized, - and competitive advantage around GDM became rather a game of internal efficiency, which came with tightening of operational processes.

Generally speaking, process innovation lags quite a bit behind product innovation. However, in the case of GDM, the product itself being a process, they almost are curled together. So, if we analyze the core capabilities of most of the successful off-shoring firms with the competency pyramid, we would see that internal operational processes leading to cost leadership defines their core competence. When cost leadership become the primary focal point of a service organization, innovations that lead to differentiators suffer. And - without differentiators, it’s hard to move up the value chain, - at least, organically. Porter once coined the phrase “stuck in the middle” to describe this kind of position.

The “future outlook” of Forbes is about sustainability, and it’s about what a firm is doing now to carve its strategic roadmap looking forward. In his resignation letter from Satyam, Ramalinga Raju wrote: “It was like riding a tiger, not knowing how to get off without being eaten”. In a totally different context, Infosys and some other Indian outsourcing majors apparently are fixated in a similar predicament. Any shift from the status quo may entail a temporary beating in the stock market, - but then the shift is inevitable to foster growth in the long run. I believe the current recession offers them an opportunity to get off the resting lion and steer it in a different direction.

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