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India IT Services
Tech bubbles and pebbles: New Engagement Models
(or non-linearity) is fast becoming a reality in Indian IT
- TCS leads this evolving game so far
• The New Engagement Model (NEM), a phrase coined and popularized by
Infosys, (or non-linearity) is fast becoming a reality in Indian IT: Indian IT
companies have long talked about incorporating non-linear delivery models to
break the linearity between revenue growth and people addition. However, on
this, we are seeing some notable success with the Big 3 — TCS, Infosys and
Wipro all of whom now derive more than 10% of their revenues from nonlinearity
(we acknowledge the difference in respective company definitions of
non-linearity).
• Where the Big 3 (particularly Infosys) have really made progress on nonlinearity
is in transforming the basic pricing model from competitive,
commoditisable rate card (T&M) to per transaction (in BPO), per device
(infrastructure management), per ticket (maintenance) and to some extent on
business outcomes (e.g., uptime, cycle time reduction, percentage of revenue
generated).
• Infosys is driving this with noteworthy aggression but this is still in the
funding stage and will not noticeably change the margin profile in
CY11/FY12: Infosys has converted nearly 40% of its client base to embrace the
less complex NEMs and is clocking almost 6% of its revenues from such pricing
mechanisms (excluding contribution from Finacle, its banking product) –
steady-state margins once normalized fetch on average 5-7% above companywide
margins. That said, this is currently still in the investment phase and is
below company-average margins. Contribution needs to at least triple, i.e.,
rise to 18-20% of revenues by FY14E to maintain current company gross
margins. This is possible if deal sizes in NEMs get consistently larger (today,
deal sizes are generally small with one-off exceptions). Thus, non-linearity as a
reasonable margin driver is still some time away.
• Proprietary (IP) platforms/licensable offerings (the highest level of NEM)
are still very small as a percentage of revenues and should continue to
remain so in CY11: These are still generally used to showcase domain
expertise to help open doors (incidental benefits exceed direct benefits of actual
sales). Unlike per-device, per-ticket, per-transaction based pricing which can
give above account-average margins within 12 months, the break-even period
for platforms is much longer (at least 18 months), largely because the vendors
have to set up the data-centre themselves, incur capex, license costs (SAP,
Oracle) and upfront expenses before clients adopt them on a monthly
subscription or on a pay-as-you-go model. This requires a threshold adoption
curve to register profitability as operating leverage on platform-based,
standardized solutions is high.
• True non-linearity is more than just a margin stabilizer: TCS takes a more
expansive view of non-linearity and also views it as a revenue driver that
operates on a new business model (e.g., its offerings for the SMB segment). In
relative contrast, we believe that Infosys/Wipro view NEMs as an instrument to
stabilize and manage margins for now. Thus, in addition to elementary NEM
(5% of revenues), TCS is playing the high-risk, high-return game in this aspect.
cumulatively net greater gains for it than for peers over a 3-year period. Infosys
is making good progress despite being a cautious and late starter in this game
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