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Testing Times At Infy

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S.D. Shibulal is unlikely to forget Friday, 13 April 2012, for a very long time. That day, the Infosys CEO and managing director had the unhappy task of announcing to incredulous analysts, investors and business journalists that the company had missed its revenue forecasts — for the quarter and the year as a whole. He also forecast another slow year, with a growth estimate lower than what the industry was estimating as a whole. The last time something like this had happened was in 2004, when the IT market globally was going through enormous churn. As Shibulal announced the results, the market reacted with shock; the Infosys stock was mercilessly hammered. Before the day was out, close to $3 billion of shareholder wealth had been wiped out. A couple of days later, Nimish Joshi, an analyst with brokerage firm CLSA, took the unprecedented step of writing an open letter to Shibulal raising several concerns. Many brokerage houses and research firms put a ‘sell' notice on the Infosys stock. (A few are putting out ‘buy' notices now, after the stock has fallen almost 16 per cent in a fortnight.)

Was the reaction a little extreme, given that Infosys had still clocked an annual growth of almost 16 per cent, showed a net-profit margin of close to 25 per cent on revenues of $7 billion, and was sitting on a cash hoard of $4.1 billion? Perhaps it was. But for some time now, there is a growing feeling among some investors that the company that was routinely called Indian IT's bellwether is slowly losing its grip on the market as more aggressive rivals take the lead. For the past five years, its bigger rival TCS has grown faster than Infosys. Indeed, five years ago, TCS was a $4.3-billion revenue company, while Infosys was at $3.3 billion — merely $1 billion behind. Today, TCS is a $10.17-billion firm compared to Infosys's $7 billion. Worse, another rival, Cognizant Technologies, which was a little over half Infosys's size five years ago, is now on the verge of overtaking it, having clocked a revenue CAGR of 30 per cent over the past four years, compared to Infosys's 17.6 per cent. A recent analysis by CLSA Asia-Pacific markets pointed out that Infosys was the worst performing stock in the past four years, against its peers Wipro, HCL, Cognizant, TCS and Accenture. Even over various intervals like the previous six months, 1, 2 or 3 years, CLSA analysts argued, the Infosys stock delivered sub-par returns.

KRIS GOPALAKRISHNAN MD & CEO from April 2007 to August 2011. Credited with maintaining growth and profitability during the global financial crisis (BW Pic By Bornali B.)

S.D. SHIBULAL CEO & MD since 21 August 2011. The global delivery model is passe. Infy misses its revenue guidance. Competition gets closer  (BW Pic By Jagadeesh N.V.)

For a company that is considered the poster boy of IT entrepreneurship, and which built its reputation for under-promising and over-delivering quarter after quarter and year after year, this is not a happy position to be in. In its best days, Infosys routinely beat the overall market growth rates and boasted of industry-leading margins. The second part still holds, but the firm is increasingly lagging in the growth race.

What is going wrong? Is this a mere temporary bad patch from which Infosys will quickly recover? Or does it point to a long-term malaise? A clear-cut answer is not easy, but Infosys watchers say almost all its current problems can be traced to two issues — both ironically the reasons for its successes. The first is the formula that made Infosys the market leader in the old days, and second, its fabled culture and systems. Analysts say the world outside has changed drastically, but Infosys has failed to keep pace with those changes.

To understand why yesterday's success is partly responsible for Infosys's current troubles, consider all that made it Indian IT's most famous company. Throughout the 1990s, and the first decade of the new century, Infosys set the benchmark because of its sharp focus. It had perfected and put its faith in the global delivery model (GDM), even though many of its peers were sceptical. It concentrated on the US and Europe. It focused on becoming a champion in just a couple of sectors — BFSI (banking and financial services), manufacturing and telecom, and it delivered excellence in a few areas of IT services — application development and maintenance (ADM in industry parlance), package implementation and testing. It was helped by the fact that it was a pioneer in many of these fields. There was a demand opening up in all its focus areas as clients abroad looked at cutting costs. And finally, its costs were much lower than those of global IT service providers. That, and the excellent quality of its work, helped it gain a sterling reputation and charge a premium.

Click to read an interview with S.D. Shibulal

At the same time, the then CEO and MD, N.R. Narayana Murthy had developed a conservative organisational culture that showed up in the company's operations. There was tight control on everything from the headquarters in Bangalore. There was a focus on maintaining margins and shunning businesses that were not very profitable. There was also a strong belief in conserving cash and growing organically.

Those attributes helped the company grow smoothly and fast — and even more important from the market point of view, predict its growth extremely well. There were occasional hiccups, mostly because of external factors. For example, Infosys faced a bit of business turbulence after the dotcom crash, and in the wake of the 9/11 terrorist attacks in the US. Again, it had to batten down its hatches post the Lehman Brothers crash. But in all these cases, Infosys generally performed better than most of its peers.

Unfortunately, say analysts, many of  Infosys's earlier virtues do not matter as much in the new world. The US and Europe, two key markets from which Infosys gets nearly 80 per cent of its revenues, have been in the doldrums for the past four years. While these are the biggest markets for all Indian IT firms, many of its peers have diversified into other geographies faster to reduce dependence on these markets.

Then, the $850-billion global IT services market is likely to remain stagnant or witness marginal growth. In such a scenario, contracts coming up for renewal are crucial. Krishnan Chatterjee, vice-president and head of strategic marketing at HCL Technologies, says in an environment where fresh IT spends are not growing, the big opportunity lies in the churn of existing contracts. This, however, needs a differentiated business model. As per outsourcing advisory IDG's numbers, of the $207 billion worth contracts up for renewal in the next five years, only $33 billion are in ADM; $74 billion are in IT infrastructure services and a gigantic $100 billion in total IT outsourcing. "The world is a vastly changed place. While global corporations are improving profits, they are shrinking expenditure. At the same time, the transformational ask from IT is only increasing as enterprises innovate to boost revenue growth." This is a market that HCL in chasing. TCS and Cognizant and many small firms have started focusing on these, but Infosys is a bit behind.

Trading Margins For Growth?
Infosys has long prided itself in its industry-leading margins, with Ebitda (earnings before interest, taxes, depreciation and amortisation) in the range of 30 per cent and net profit margin of 24.5 per cent. Most other Indian IT vendors have lower margins and several multinational players have either high single-digit or just about double-digit margins. Infosys for long was able to pull this off having pioneered the GDM. But now, everyone has adopted it. Admits Basab Pradhan, head of sales and marketing at Infosys, "GDM alone is no more a competitive edge." It is not just other Indian IT players, but even multinationals IBM, Accenture and HP have grown their respective India numbers. In 2000, Accenture used to have 300 people in India and IBM employed 1,900. Accenture now has about 65,000 people here and IBM is closer to 100,000 even as HP has a large presence through MphasiS. Others such as Capgemini and CSC, too, have ramped up.

Sid Pai, partner and managing director of the Indian operations of advisory firm TPI, says, "For all Indian IT majors, the relatively easy, low-hanging fruits in global IT services have been plucked. Indian IT needs to reinvent itself. I don't see a pricing premium for any player."

Accustomed to a pricing premium, Infosys is likely to face tougher times than others. "In the name of different and superior business models, they are putting themselves in this tight corner by emphasising margins above all," says a senior executive of a large Indian IT firm. "Look, all of us visit the same colleges, recruit from the same pool, work with more or less the same set of clients, and our cost structures are similar. They used to get a pricing premium because of better systems and processes, which is the norm now. Everybody has caught up. Already their volume growth is decelerating, which will only go down." Meanwhile, competitors such as Cognizant and HCL, who aggressively chase orders even at the cost of Infosys, have an edge here.

  • After years of outperforming, Infosys misses guidance
  • Margins protected, but growth is slowing dramatically
  • Decision-making concentrated in a few hands in Bangalore
  • Senior exits, such as those of Mohandas Pai and Subash Dhar, are having an impact
  • Basic businesses such as ADM, testing, IMS and BPO falter
  • Wage hike freeze is affecting morale
  • Its $4.1-billion cash pile is lying unutilised
  • Guidance of 8-10 per cent revenue growth is lower than industry growth projections of 11-14 per cent
  • Lower investment in sales and marketing compared to TCS, Cognizant or HCL
  • Visa problems in the United States

Is Infosys losing the plot? A recent report by JP Morgan says it is, because of its "inability to walk the ‘pricing versus volume' tradeoff constantly and lamely blaming the environment for the volatility in its performance, weak positioning in bread-and-butter service offerings such as BPO, testing and infra management, insistence on a pricing premium in engagements where flexibility is of the essence".

Shibulal begs to differ. "Pricing is a portfolio-based approach, based on each customer. Margin is a function of the value we deliver to the client. In the auto industry, there are people who sell luxury cars and utility cars. The margins in both cases are not the same." Chirajeet Singh, research director at Everest Group, however, says businesses such as ADM, testing, infrastructure services, while large and stable, are almost fully commoditised. "It is hard for any player to get a premium in this."

Infosys's cash hoard has grown 12 times in the past nine years to $4.1 billion — twice that of TCS. But this earns a mere 6-7 per cent. With no debt, it has to find ways and means to use the cash better. While it has been sitting on its cash hoard, TCS, Wipro and HCL Tech have been far more aggressive in acquiring firms to build skills and break into new markets. While Infosys did try to buy Axon, which eventually HCL swooped in and plucked away, it has been cautious in M&As. Shibulal says that just because money is available, he will not spend it.


The Wise Men In Bangalore
Sudin Apte, principal analyst at Offshore Insights, says Infosys's poor performance in the past quarter is symptomatic of a deeper issue. "Make no mistake, it is still an excellent company. However, they have undergone massive restructuring in the recent past, key departures at top level with top leadership yet to fully settle down, witness the swapping of portfolios between B.G. (Srinivas) and Ashok (Vemuri). Unfortunately, capital markets, their strong suite, have been impacted in the US; and finally, the margin question. All this definitely has had an impact (on performance)."

Poor performance in the crucial US market and specially in the BFSI segment — from which the company gets a little over a third of its revenues — meant that Srinivas, who looked after the manufacturing and engineering business, swapped his portfolio with Vemuri, who used to head BFSI. While the firm said it was just usual internal reallocation of responsibilities, it was not lost on the markets that manufacturing — which Srinivas looked after — has done relatively well. Increasingly, Srinivas is seen as the first non-founder who could become the CEO.

Click on the graph to view an enlarged version

Departures of old hands such as Mohandas Pai, the former human resources and finance head, and head of business innovations Subhash Dhar, apart from the stepping down from an operational role by Murthy and K. Dinesh — two co-founders — also seem to have affected the company. Shibulal dismisses such talk and points out the company has a deep bench of talented leadership and workforce. "I consult everybody, but at the end of the day we have clear roles and responsibilities," he says.

Infosys has always been known as an efficient but tightly-run ship. But what worked for it when it was smaller might not work when it has 150,000 people. Competitors and analysts claim the firm is still run by a bunch of "wise men in Bangalore, who need to delegate more decision-making authority to those on the bleeding edge in the markets". The firm is quick to note that it already did so, when four different profit and loss heads were anointed with the mandate to decide on issues such as margins, hiring and kind of clients.

Shibulal himself asserts Infosys is fully decentralised. Strategic business unit heads can take key decisions within the overall ambit of the company. An analyst points out that unlike HCL, Cognizant or even TCS, which have ramped up their sales and marketing spend in the recent past, Infosys has been more slow in upping that expenditure. "We have hired 250 people in sales and marketing in the past 12 months, increasing our headcount by 25 per cent," says Shibulal.

For long a workplace of choice and topping workplace surveys, Infosys has, however, had to face turbulence on that front too. With the announcement that for now there will be no wage hikes and it will only be reviewed if market conditions change, it may be putting itself in a vulnerable position where competitors cherry-pick talent. Infosys says its attrition is down and its workforce understands realities of the marketplace. This year, it intends to hire 35,000 people, including 13,000 for BPO, indicating it expects a net addition of just 6,000 employees. With relative low utilisation, Infosys might be signaling it is ready for higher attrition.

In the important US market, Infosys has come under regulatory scrutiny for its use of B1 visas. An HR analyst, who has in the past consulted for the company, however, says, "It is unfortunate that Infosys has been needlessly picked on in this issue. It is a politically sensitive time with presidential elections and a gloomy economy in America. I am sure, Infosys will emerge out of this issue as it has done no wrong. The worry is, it let things spin out of control, which would never have happened in the past."

Click on the graph to view an enlarged version

Infosys 3.0
The company is clearly aware of the market demands, which is why it has started emphasising the attention it pays to consulting and system integration, as well as creating its own products and platforms. For Infosys, the period of transition, however, is likely to prove painful. Says Shibulal, "Apart from consulting and integration, we are investing in products, platforms and solutions (PPS). We have articulated that over a period of time, we want to get a third of our business from PPS and cut our dependence on plain vanilla IT services."

While reducing dependence on low-margin, commoditised services is welcome, analysts fear that during the period of transition, Infosys is neglecting business IT services, which still form 70 per cent-plus of the market. "Not really," avers S. Swaminathan, the CEO of Infosys BPO, pointing out that his unit had one of the best quarters and years recently. "We are now $500 million in size, and have around 22,000 people. Our margins are better than some of the IT vendors. We have made smart acquisitions, too."

Cracking the consulting and system integration pie will not be easy either, with entrenched players such as Accenture, IBM and Capgemini enjoying greater mindshare. Says a general manager of an MNC, "Our C-suite relationships, industry and domain expertise have been built over decades. For companies accustomed to executing orders cheaper, it requires a mindset change to understand a client's business and advise them. Also, for most Indian vendors, irrespective of GDM, offshoring means India. But for us, it can be best-shoring, depending on where the client is most comfortable."

To redress this as early as 2004, Infosys made a headstart by hiring expensive rainmakers and spinning the consulting business into a separate subsidiary before merging it back with the main company. The MNC general manager says that Infosys has had limited success in pure-play business and strategy consulting, which is why it has stopped reporting standalone consulting numbers. The company has also been making investments in creating its own intellectual property (IP). Sanjay Purohit, senior vice-president, global head of PPS, says Infosys's IP-based strategy is being addressed from two perspectives. One is how to develop intellectual property that can be used to improve quality and productivity of services across consulting, systems integration as well as IT services. Second is how to use its intellectual assets and intellectual property to actually create new products and platforms that "we can take to the market as outcome-based offerings to our clients".

But this will take time to pay off. The business needs strong investments to go in first, before returns start. Shibulal is emphatic that the Infosys 3.0 vision and strategy will pay off and that it will not be changed due to setbacks in one quarter.

Right now Shibulal says his focus is on executing strategy. "Even earlier, people questioned our model. They said why don't you just bodyshop, instead of building GDM. History has shown who is right. I am confident that when we have a conversation in a few years, those who question our vision would have their answers."

However, with a volatile market, greater dependence on discretionary spending, nimble and more aggressive competitors trying to eat its lunch and a company in transition, Shibulal and team have a big job on their hands. Infosys after three decades is still an extremely profitable company growing at a good pace. But it shows signs of middle age. It has been knocked down from its pedestal. The company needs to burnish its credentials again, show hunger for growth, increase its risk appetite and, above all, execute its own strategy. So when the first non-founder CEO inherits the firm, it will be the Infy of yore.


(This story was published in Businessworld Issue Dated 07-05-2012)