Industry pros: Indian IT model is broken and needs re-inventing

After TCS issued a profit warning today, fears have again come to the fore that the IT industry increasingly finding itself at odds with the fast-changing world of technology.Analysts believe that a combination of slowdown in IT spending on traditional services such as application development and maintenance and emergence of new technologies such as artificial intelligence, cloud, analytics and big data are mortal threat to many companies' revenue streams.In an interview with CNBC-TV18's Prashant Nair, Reema Tendulkar and Shereen Bhan, former Zensar Technologies CEO Ganesh Natarajan, Offshore Insights CEO Sudin Apte and former HCL Tech CEO Vineet Nayar talked about the challenges facing the industry and explain why there is an urgent need for IT companies to re-invent its business model.Below is the transcript of the interview.Prashant: What do you make of the commentary coming in from Tata Consultancy Services (TCS)? The other IT biggies have done a similar thing over the last one month.Apte: The industry is realising the client mood and where the industry or the spend is heading. We had been saying this in a sense, so I am not surprised with what is happening in the market though I do believe that most of the leading companies as well as some of the mid tier companies had overestimated the growth for current fiscal year. As they are getting into the year and seeing the deals flow coming slowly, sizes of the deal being little smaller than they anticipated and also that part of the digital opportunity not coming India's way. So, multiple of these reasons are making them realise that the year is not as positive, as rosy as they thought at the start of the year. So, this is more of a resetting expectation than anything else.Reema: It is quite clear that FY17 growth is going to be lower than what we saw in FY16. Do you believe that the problems will spill over to FY18 which means that incrementally every year for the IT companies we are going to see lower growth?Natrajan: We are at a complete inflection point because it is a fact that the traditional services model is under threat. So, I would think that a few providers and I would definitely rank Accenture one of them and quite a few others because people who are able to change from a pure services model to what we call cloud + platforms or micro services model, they will benefit. However for the large mass of traditional IT services and BPO providers, there are warning bells. It is not going to improve in FY18 or FY19, you have to change your business model.Prashant: In a way when you said that you were not surprised, you are suggesting that IT companies themselves were being too optimistic. Could that be possible, because they are on the ground, they are working with the client they get feedback all the time?Apte: I don’t want to comment on how they arrive at that number, but very clearly if you look at just the commentary that Offshore Insights has been putting out -- and our report which we published on January 20 -- we have been saying that (that growth will be lower). Maybe at that time we were the lone voice saying that the year will be difficult and our numbers were lower than what industry as well as industry association Nasscom said.I believe that as the year progresses, people are realising the pace of the business and how much money they will get. That’s point number one. Number two, I think there is a little disappointment to the industry on the pace of the growth of the digital business. Here I mean true digital business -- Internet of Things, mobility or big data -- not application migration and modernisation project, which some of them call digital. So, if you really look at the core digital work, I think lot of companies were very optimistic that they were coming India’s way and that would win the deals.We always realised especially based on the clients’ feedback that some of that business will not come Indian IT companies' way, like Ganesh said. I am borrowing his term, traditional IT services companies, so the firms, which are traditional IT services companies, which have not transformed themselves to the new age, don’t have made enough investments on domain capability, business process sophistication and so on, I think those companies will not get the pie of digital transformation spend that clients are actually spending.Reema: But the spate of bad news has just picked up just in the last 2 or 3 months. In your feedback from clients, have we seen the situation incrementally worsen for the Indian IT. What has changed that we have seen so many companies come out and give profit warning?Apte: No, don’t get me wrong, I don’t think there is any negative change on the market side, whatever way the market was expected to behave based on how companies have set up their budgets during their budgeting time -- Fortune 500 companies typically set their budgets in November-December timeline. So, if a Fortune 500 company had set up its budget for their calendar 2016, the spend is actually happening as per that only. There is no incremental bad news, except possibly Brexit, and that was was hanging on entire industry, the European business, not so much so on IT alone. So that is the only incremental loss. And our assessment is Brexit-driven pure loss will be in a range of USD 350-400 million in current fiscal year for Indian IT industry. Except that, we are not really seeing any incremental bad news. From my perspective, market hasn’t worsened, it’s just companies who were optimistic about this fiscal year are resetting their expectations to reality.Reema: Do you think incrementally Indian IT companies have to brace themselves for lower margins because digital which has higher margins is still a small portion of the overall revenues?Apte: Margins will continue to drop. If I were to use the analogy that Infosys used to use a few years ago - "flat world" -- and when world gets flat, it gets flat from all sides. So, when you work in a globalised economy, your growth as well as margins will be inline with the global industry and that would mean a further flattening of margins.There is one more reason than just a simple competitive landscape and client pressures. I think the differentiation is fading away. When differentiation fades away, your ability to get the pricing premium lowers. That is another stark reality most Indian IT companies if not all are facing. So, I expect that just like what has been happening in last 5-6 years will continue to happen: a slow drop in the margin band for most of the leading IT companies.Prashant: Does this entire thing have anything to do with people postponing decisions because of US elections? That is also being suggested. So, it is not really demand destruction in any way but is just a bit of status quo.Natrajan: I don't think so at all. It is nothing to do with the elections. I think it is a complete change in the buying pattern. In fact you would probably find that people are spending a lot more on cloud solutions, on security, on digital of course. Probably the reason you are seeing this correction is many Indian companies have not really made the transition to having 30-40 percent of their revenues coming from digital.Prashant: It was also suggested when the US banking financial services space was going through a bit of turmoil and there was change in regulations, many IT company honchos suggested that that was an opportunity. It wasn't going to lead to a lesser buying, lesser demand but it created new opportunities because banks needed to be more efficient as the revenue streams came under pressure. That clearly doesn't seem to be true now.Natarajan: The fact of the matter is that any worthy CIO is no longer looking at buying services in bulk. So, what they are really looking at is that if they are moving our stuff to the cloud how can I much better, much cheaper avail it on a software as a service (SaaS) basis. I disagree with Sudin to a certain extent that margins would always come down because there is no reason for fearing that there will be a secular decline in margin. What you will find that people who are dependent on the old model, their revenues may come down 15 percent, margins by as much as 20 percent than people who are transiting to the new models, which is cloud, platforms, micro services. You will find that their gross margins can be as high as 40-45 percent. So, what I am trying to tell you is that there is a new breed of providers which will emerge. Those breeds may not be as large and people-intensive as the current breed and some of our existing companies will make the transition but the new model is happening. The new model will be firmly in place by FY18 and you have got to look out for these winners.Shereen: We have heard a bunch of things, we have heard that there are individual sectors for instance in the TCS case that BFSI is seeing more headwinds than normal at this point in time and hence the cautious commentary from the management. But we are also hearing about discretionary spending not being as strong, Brexit and the implications of that as far as the Indian IT sector is concerned. Given what we are hearing today, how much of the problem that the sector is facing, is because of global uncertainties and the global slowdown and how much if it has to do with the fact that the Indian IT services sector business model requires a change, requires disruption?Nayar: I think to answer that question, we need to step back and ask ourselves a couple of fundamental questions. The total spend in IT technology across the world is increasing. The percentage of spend on technology as a percentage of revenue is increasing and therefore why are we talking about headwinds?That is because there are 3 trends which we need to keep track of. The first is that every single company is trying to become more and more efficient in the back office. This trend started in 2008, where every single person wants to cut their back office cost by 10 percent per annum. They want to redeploy that money in front office, which is in analytics, reaching the customers and deploy that money so that they can grow their revenue faster and the third is there is a churn in customer base which is taking place. So new companies, new technology companies, new fintech companies -- Uber, AirBnB -- all these companies are coming up and taking awat share of wallet from the banks and the traditional companies.If you are a company which is boxed into, what I call "old customer and back office service”, you will see a headwind. If you are with old customer in front office you will see a tailwind. If you are with new customer in new services you will see times and opportunities as never before. So the reason we are seeing various kinds of commentaries coming in is because companies have finding themselves in different shapes and forms with portfolio in different zones, because of which they are either facing too much headwind and they have not done enough to try and get into areas, which have tailwinds. That’s the reason you are seeing different kind of commentary coming in. But the trends, which we are seeing today there is nothing new in those trends. Shereen: But what will be the consequences of these trends as far as the Indian IT sector is concerned. What will be the implications on the margin story for instance is it time to say goodbye to the 25-30 percent kind of margin picture that this sector has enjoyed. What is it going to mean in terms of inorganic growth perhaps much more aggressive inorganic growth to try and up the capabilities in this area. What will be the consequences of these top 3 trends that you just articulated for us?Nayar: I think Indian IT is at crossroad as it was in the past and the answer Indian IT gave in the past is to create a new industry called remote infrastructure management, a new industry called business process outsourcing and because of these two new industries getting created their margins were intact, their growth was intact and therefore they could manage it. So, unless Indian IT focuses and creates a completely new market which is not lip service but actual revenues in front office, actual digital revenues, capabilities, acquisitions, feet on the ground and restructuring their business to be more front facing and less delivery focused, to be less cost focused and be more revenue focused, to grab market share in newer customer areas [there would be a problem].Unless Indian IT does that, I am afraid what they did with remote infrastructure and BPO, we would not be able to do that in future. However I am optimistic that the same leadership in Indian IT which could manage the storm for so many decades [will do it again]. I think this is a wakeup call and they would. I am sure there are some things cooking in each kitchen in various degrees of flame and they will get rolled out. I am pretty sure that Indian IT has something cooking in the backyard and they will come out with great investments in these new sectors. That is the only way out otherwise you are boxed in like Dell, EDS, HP abd IBM were -- into a reducing cost structure. So, price will keep going down, your costs can go down for some time but nor forever. Therefore you have to become out of the box. It has to be a certain percentage but you have to get into a new box, which needs new skills. I am hoping and I am confident that Indian IT will get into that box and therefore we will have high teen growth rates and good margins.Shereen: This new box that you are talking about, what will it take for the Indian IT sector to get out of this box and into that new box? I am not going to ask you about what the stock markets will make of valuations and so on, that is a quarterly phenomenon that will play out in the market but from a strategic perspective, from a long term perspective, what are the choices that Indian IT will need to make today?Nayar: I think the word transform means changing the form of something permanently. The word permanently is underlined. So, the first thing Indian IT would have to do is to give up its obsession for cost and price. So, to say that I am going to jump off the cliff, if they don't have that then they will keep on putting their best and brightest in the old box. So, the first thing they need to do is put their best and brightest in the new box.Second, they need to shift their entire investment away from automation and cost reduction into revenue generation and becoming more relevant for relevant customers.Third, they have to demonstrate tremendous amount of urgency because the market gaps are closing very fast. Like Indian IT took EDS and HP by surprise, there could be lots of companies and I know a lot of companies, I have worked with them, that they will take Indian IT by surprise if you are not urgent, if you do not demonstrate that urgency for investment, urgency to move your best and brightest and the urgency to adopt to a new business model, which is completely different to our old business model. We did that with remote infrastructure management, we did that with BPO, I am hoping we can do it with this also.