All is not well in India’s IT ecosystem notwithstanding stock market euphoria

India’s IT sector is the toast of the markets with investors making a beeline for tech stocks as a safe haven at a time of rising economic gloom. Brokerages such as Edelweiss Securities are adding to the upbeat mood promising even more upside. With the S&P BSE IT Sector Index up over 8 percent in just the last one month and with the Happiest Minds IPO receiving a thumping response from investors, it is easy to see where the optimism is coming from.

However, are there enough grounds for this optimism? Have Indian IT firms suddenly discovered the code to crack the global shift in spending on IT?

The increasing adoption of digital technologies, the move to shift processes to the cloud along with the commoditisation of data fuelled by the use of smartphones was already in play long before COVID-19 came calling. After the pandemic struck, it is an unstoppable wave. Sectors such as education and medicine have joined the likes of banking and finance in embracing digital technologies.

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Sadly, barring a handful of them, most of India’s IT services companies, dependent on older revenue streams from their global clients, aren’t in any position to capitalise on the unfolding opportunity. On the other side of the world, companies such as Globant, EPAM and Endava, are earning 100 percent of their revenues from digital services. India’s hottest new IT script Happiest Minds also falls in this category, but isn’t in the same league in size.

By contrast, most of the big Indian IT firms are still heavily weighted in favour of legacy IT services. Data shows that companies with a higher proportion of revenues from digital services also have a higher growth rate in terms of revenues and profits. US-based EPAM, for instance, posted a compound annual growth rate (CAGR) of 26 percent since 2015 while closing 2019 with revenue of $2.29 billion. In the same time UK-based Endava grew a staggering 36 percent. At home, market leaders TCS and Infosys, have a CAGR of 10 percent and 7.8 percent respectively over the last three years while even a smaller-sized company such as Mindtree grew at a CAGR of 14 percent in the same period.

Once upon a time global corporations based in high-cost economies zeroed in on outsourcing as an effective tool to take advantage of labour arbitrage and process efficiencies. Today, these same companies have a new set of objectives: finding innovative solutions that address specific requirements. This means that India’s once-successful IT services companies need to rejig their own business models to take on the new digital reality.

A shocking inability to innovate barring the occasional global delivery model, or Agile, which defined newer ways of providing the same software services, has meant that growth for most has been linear. Add to that missteps and a failure to make bigger bets in the pursuit of exponential growth. The examples abound. Through the first decade of this century, Amazon, Google and later Microsoft stormed the cloud computing space and have come to dominate it. Indian IT firms, fresh from their windfall gains following the Y2K scare and committed to doing more of the same, failed to spot the potential that cloud services presented. The opportunity loss: in 2019, Amazon’s cloud unit Amazon Web Services (AWS), founded in 2006, generated $35 billion in revenue for the company.

Similarly five years ago, Accenture, a market leader in the IT services business, realised that many of its clients were moving their advertising spends to digital platforms creating opportunities for design studios and digital marketing companies. Through a combination of acquisitions and organic growth, Accenture muscled its way into that market and today Accenture Interactive, as the new business was christened, pulls in $10 billion in revenue for the company. That’s an entire Wipro added to its topline in just five years.

It takes this kind of audacity and chutzpah to break through the growth ceiling.

The big worry is that even the newer IT companies in India, born in the digital era, don’t look capable of changing the narrative. At a minimum there was the opportunity of building on the strengths of their predecessors and using their work processes to spot possible niches that could be exploited. Take Synk, a London-based start-up founded in 2015 and listed in Computerworld’s pick of the hottest enterprise tech startups to watch in 2020. The company, which helps developers automatically spot vulnerabilities in the open source code they are running, is now valued at $2.6 billion after a recent round of funding. Given the millions of lines of code Indian programmers have been writing over the last 30 years, a Synk should logically have emerged from the Indian IT ecosystem.

Sure, India’s IT champions have grown steadily, stayed profitable always and given hefty returns to their investors. Why fix it then if it ain’t broke? The problem is, the IT industry is rife with examples of well-proven business models being dramatically upended almost overnight.

For years Intel was the semiconductor king of the world. Then along came an upstart that dared to compete with the reigning giant not just with its products but with its entirely new and seemingly heretical business model. Arm, recently sold to Nvidia for a cool $40 billion, doesn’t manufacture anything. Instead, it licenses its processor technology to other companies who then use it to make their own chips and microprocessors. That changed the well-established rules of the game and in July, with the company’s market cap down to near $50 billion, CEO Bob Swan conceded that Intel was looking to outsource the manufacturing of its chips.

We live today in an era where a startup or at least an idea is being conceived every moment. The frightening velocity of technological change means that the danger to existing players is manifold.

At the same time, spending on technology across the world is going up. Worldwide IT spending is projected to total $3.9 trillion in 2020, an increase of 3.4 percent from 2019, according to a forecast by Gartner Inc. Of this, software will be the fastest-growing major market this year, reaching double-digit growth at 10.5 percent.

Based on its three-decade-long track record, Indian IT firms should actually be aiming to up their share of this growing market. Instead, it appears doubtful if they will even be able to maintain the current share. That’s because they lag in key emerging technologies such as Artificial Intelligence and machine learning, blockchain and cybersecurity, areas where annual growth is expected to be 20 percent over the next five years.

A few of India’s market leaders will make the internal changes both strategic and tactical, to focus on the new opportunities even while they maintain their older businesses. It will be a delicate balance, but surely companies such as TCS and Infosys will walk that tightrope skilfully.

For the industry at large, however, it will be a struggle since it will mean walking away from assured but low-margin business such that the organisation’s competencies and resources can be directed to projects higher up the value chain.

Sundeep Khanna is a senior journalist. Views are personal.