Subcontinental drift in offshore outsourcing

Offshore outsourcing: from the corridors of Whitehall to town halls around the country, it is the business phenomenon that dare not speak its name.

Just ask officials at the Department of Work and Pensions. No sooner had alleged plans for the offshoring of some of its operations been leaked to newspapers in January 2006 than senior officials were shooting strenuous denials in all directions. “We have not moved any of the department’s jobs offshore and we have absolutely no intention of doing so,” was the official line.

Naturally, tensions run high when civil servants decide that to save taxpayers’ money they need to fund jobs in India or other far-flung, low-cost locations. However as businesses assess the first, decade-long wave of offshore outsourcing some clear lessons have been absorbed – and some firm stances are being taken.

NatWest bank now makes a virtue out of the fact that it services credit card and banking customers from UK-only call centres, making the policy a core message of its advertising. Nationwide and Royal Bank of Scotland are also quick to stress their distance from offshoring customer service.

But for many others the opportunity to drive out operational costs is simply too compelling. And the IT function has been at the vanguard of such developments, as forms processing, application development and testing, and distinct IT-enabled business processes have joined classic call centre operations on the Indian subcontinent, which remains offshoring’s hotspot.

"Indian outsourcers are quite open about talking of 30% margins. But as a customer, what does that tell me?"

Paul Coby, CIO, British Airways

For India’s IT services companies – Wipro, Infosys, Tata Consultancy Services (TCS), HCL, Patni, Satyam and many others – dealing with misgivings about the model is a daily routine, even when those involve public sector organisations.

“Clearly there are a lot of contracts being awarded by the public sector [that could involve some element of offshoring], but we understand the sensitivities around these,” says Keshab Panda, head of European operations at Satyam Computer Services. “There are huge pressures to reduce operating expenses in the public sector, so we feel we have an opportunity.”

Seeing a large public sector outsourcing contract go to an Indian provider would be a landmark change for the entire industry – but political sensitivities mean it is an event that is unlikely to happen any time soon. However, the ability of the Indian services companies to spur a change in thinking should not be underestimated. If the public sector is still reticent, then the private sector has dropped most of its earlier reservations.

Take the example of the Dixons Group. In January 2006, the high street electronics retailer (whose stores also include Currys, The Link and PC World) signed a five-year, £150 million deal with HCL Technologies for system development, application delivery and infrastructure maintenance.

The deal was notable because Dixons had several months earlier pulled out of a similar agreement with European IT services company LogicaCMG.

“To all the remaining doubters out there [among European services providers]: HCL has just whipped away your comfort blanket,” says Eamonn Kennedy, an analyst at IT industry research group, Ovum.

Global competitor

Such developments underscore the growing confidence in and of Indian IT services companies. That confidence is born out of the fact that even when indigenous suppliers in the West can match them on prices (as a result of their own offshore and near-shore delivery), the Indian companies can compete and win – to the point where they start to become ‘tier 1’ players in IT services.

Such dominance is best demonstrated by analysing the outcome of competition between the Indian services companies and today’s global IT services giants, the likes of Accenture, IBM, EDS, Atos Origin, Capgemini and Computer Sciences Corporation. According to outsourcing advisor TPI, in contracts for European businesses worth between e40 million to e160 million during 2005, Indian companies won over 90% of the deals when competing against the ‘big’ global companies.

Is this simply a reaffirmation that Indian providers can compete fiercely, but only at the mid-to-low end? Hardly, says Peter Allen, managing director of the global practices unit at TPI.

The lower value contracts inherently favour providers that can compete on price, Allen says, explaining why Indian companies have such a strong track record. But the Indian providers have typically “started on low-level contracts, building client confidence,” he says. “They have a strong record of converting foothold relationships into something much bigger.”

It is an approach that has served the Indian outsourcers well. The so-called ‘mega deals’ often come with a high degree of asset transfer, and may not provide the kind of return on investment that has fuelled the dramatic rise of the Indian outsourcers. “Running the [IT] assets for a global company isn’t something that has much value,” says Mrinal Sattawala, executive vice president at Patni Computer Systems.

Patni typifies how the India operators work: it competes fiercely for (relatively) low-value contracts, and then expands. “We have a number that are now worth over $100 million, but the deals didn’t get done as a big one: they started out small.”

Step down a level in the value of outsourcing contracts and the Indian providers are still formidable: for deals worth less than e40 million Indian companies won 83% of contracts (when going head-to-head with one of the big six), according to TPI.

Such is the current strength of the Indian providers that traditional outsourcing giants could theoretically become acquisition targets: the market capitalisation of Infosys ($42 billion), Wipro ($21 billion) and TCS ($18 billion), for example, means that they could feasibly use that currency to absorb ‘tier 2’ outsourcing companies – if they so wished. After all, EDS’s market cap stands at an anaemic $13 billion.

But there are reasons why this is unlikely. Firstly, while all the Indian providers are looking to grow both in size and in the strength of their consulting services, any large services acquisition would come complete with a large number of employees based in Europe and the US – wiping out the cost benefits of using lower paid workers in India and elsewhere.

Secondly, and even more importantly, large acquisitions would seriously dent the Indian providers’ ability to maintain current margins levels – typically Indian providers operate with gross margins north of 30% and net margins of 20% to 25% (helped by the fact that the Indian government does not charge corporation tax on IT service exports) – levels European and US services companies can only dream of, even when they are profitable.

Subramanian Ramadorai, CEO of TCS dismisses such concerns. “Analysts believe that acquisitions will drive our margins down. But we haven’t seen much of the story of how our practices can help drive margins up in acquired businesses.”

The issue of margins is likely to become increasingly important. Much of the infatuation with Indian providers currently felt by investors can be attributed to the impressive profit margins. But the ability to generate such returns plays less well with customers. “They’re quite open about talking of 30% margins,” notes Paul Coby, CIO of British Airways. “But as a customer, what does that tell me?”

What the TPI deal figures do not show clearly are the type of services moving offshore. The term ‘outsourcing’ encompasses a vast range of different operations: from call centres and technical support, to application development and IT-enabled business process outsourcing in such areas as healthcare and insurance claims processing, HR and finance administration.

Consequently, there can be a high level of misunderstanding about what services can be offshored appropriately, says Tony Virdi, global sourcing director at Atos Origin. “Talking to some clients, it’s clear that a ‘me too’ mentality exists: they’ve heard competitors are cutting costs through outsourcing, and want to do the same. And that’s dangerous. You need to adopt a holistic view of what your goals of outsourcing are going to be.”

Indeed, while call centre operations, some back office functions and application development may all have seemed ideal for offshoring, Indian service providers have much broader and deeper goals. “If we can already consider offshore application services as a given, 2006 is shaping up to be the year of offshore infrastructure management,” says Ovum’s Kennedy.

Global services

Through blending the use of onshore, nearshore and offshore operations, many of today’s highest profile enterprises are using a global service model.

Global models are an extension of what Capgemini christened as ‘rightsourcing’ back in 2003. The underlying idea is striking the right balance for global delivery.

Analysts believe acquisitions will drive our margins down, but we don't hear about how we can drive the margins up in acquired business.

Subramanian Ramadorai, TCS

And the competition from nearshore locations is becoming ever more intense. Not only have countries such as Russia and the Czech Republic started to push their abundance of cheap IT skills, other locations including Wales and Spain have been active in fighting the offshore trend. The Welsh Development Agency, for example, has convinced a number of IT services companies including EDS, IBM and LogicaCMG to site operations in with Wales with the help of significant subsidies.

A good example of this blended approach is the development of new ‘shopping basket’ features added to the British Airways website in 2005. The concept was developed at BA’s headquarters, the software development work was done by TCS in Chennai; the project was managed out of BA’s site in Newcastle. “I’d be losing control of how it all fits together if I outsourced the design to Chennai,” says BA’s Coby.

But this blended approach is complex, creating a matrix of outsourcing management. It is not clear whether users need one company capable of coordinating all aspects, or whether contracts should be written with local suppliers.

Certainly the Indian providers believe they can become the ‘one-stop shop’: witness the expansion of Wipro, TCS, Satyam and Patni into China, Eastern Europe and South America and their ‘cherry-picking’ acquisitions of niche vertical industry services companies and ‘boutique’ consultancies.

Moving as rapidly as they can in the opposite direction, companies such as IBM, EDS, LogicaCMG and CSC have all been busily building up their operations in India and other distant facilities.

Coby, for one, shows an overt mistrust of ‘global’ providers. By dealing directly with the local services companies, he believes he can save more.

“For global businesses, it makes sense to have a local team to supply local services,” says Virdi of Atos. “But if you’re talking about a componentised delivery model, it relies on your global process management being absolutely brilliant. If it’s not, this model isn’t for you.”

Offshore economics

Bangalore dreams: LogicaCMG's 2,500-seater Technopolis (artist's sketch)

European IT services company LogicaCMG has been forced to respond to the growing threat to its business from the Indian IT services companies, and like many of their European and US rivals, its senior management know that there is almost no chance of being able to compete against the Indian companies without a presence on the sub-continent.

LogicaCMG’s 2,500-seater ‘Technopolis’ in Bangalore is situated almost a mile down a mud track; due for completion in the spring of 2006, its opulence and sophistication is a marked contrast to its surroundings. But Logica is not alone in having to build capacity first, and wait for some elements of the infrastructure to arrive later.

One resource it is not short of is skills. In November 2005, when it sought to recruit 400 new graduates, it had its pick of 17,500 applicants. Clearly, attracting talent is not a problem, says Rahul Patwardhan, chief executive of LogicaCMG’s Global Delivery Centre in Bangalore. But he knows that Logica is not the only employer looking for talent: IBM, Microsoft, Oracle have all built Indian bases, making competition for the best employees intense. “Retention is becoming an issue, but it is one affecting everyone here,” says Patwardhan.

In terms of graduates, India produces 400,000 engineers every year – many of those going into IT. The idea of an impending skills crisis in India is absurd, says Keshab Panda, head of European operations Satyam. “The education system has been planning to produce this level of graduates for years. There is no other country with that level of skill.”

There is some debate about the potential for skills shortages – much of it generated because predicting demand for offshore services is difficult. Using predictions of a growth rate of 25% per year for the next five years, business consultancy McKinsey reports that there could be a shortfall of 500,000 IT staff over that time.

But according to Iain Smith, director of HR consultancy Diaz Research, the move to Indian outsourcers has not progressed at the breakneck speeds that some predicted. “The real issue is wage inflation. It’s a significant problem for the Indian companies. We predict that within five years, it could offset the savings from going offshore.”

Mrinal Sattawala of Indian services group Patni, recognises that wage inflation is an issue. “It is something that affects us all,” he says. “But while many critics are happy to point out the problem, they do not seem to recognise that we still have a lot we can do through increases in productivity.”

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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