IT Services: Which Margin is the Best Margin

How do you assess the profitability of an IT Services business? Some of the performance parameters are the same as any other business in a different industry – Gross Margin, Operating Margin, Net Margin, EBITDA margin or EBIT margin.

But these are generic profitability parameters, uninformed of the structure of the IT Services business.

While not the only one, in most situations, the best profitability parameter to use is Billed Margin or Project Margin. This is the % profit from billed hours – revenue minus the direct cost of these billed hours.

I should quickly add that if you are an investor evaluating a company you should absolutely look at all the generic profitability parameters. You may not have a choice anyway because no public company reports Billed Margin, to my knowledge.

But if you run the company, Billed Margin is a very important way to assess the profitability of your services and accounts.

Billed Margin differs from Gross Margin in a crucial way – Bench Costs. Companies differ in how they compute Gross Margin, but Bench Costs always come before Gross Margin.

Billed Margin boils down the two most important aspects of an IT Service business – Prices and Wages – and the difference between the two. You could say that it captures the net effect of the two markets that the business operates in – the market for its services and the market for talent.

Why is it important that Bench Costs come after Billed Margin? For a couple of reasons.

Bench Costs, in an IT Services company, is the oil that greases the skids. It can help the company staff client projects faster than competition, enter a new account with a skill set that they desperately need, or even enter a new country.

Unfortunately most of the industry has seen Bench Costs as an undifferentiated blob of inefficiency – to be shrunk as much as possible. The same CFOs who hate missing quarterly estimates, treat Bench Costs like the plague. Which is ironic, because a healthy bench can make a huge difference within a quarter.

There is another important way in which Bench Costs can be strategic – in starting new services. Expanding the footprint of new services is essential to maintaining the company’s Billed Margins. For many years Enterprise Solutions played this role.

New services are always going to need creating a pool of resources before you can ramp up revenue from the service. You don’t want to assess the performance of a new service based on Gross Margin, because it is going to be low, even negative for a while. At the same time, you want to make sure that the business that is being built has the right price/wage relationship. Which is why Billed Margin makes sense.

Billed Margins are structurally ‘hard’. Prices and wages are difficult to change. If Billed Margins are going down, that is a sign of long-term decline in the fortunes of the business and must be addressed immediately. Unfortunately, the response to declining Billed Margins, or ‘commoditization’ in the industry has often been to cut Bench Costs, which has made it even harder to arrest the decline.

The truth is that you cannot build a Digital practice without a serious injection into bench costs. Many of these consultants will be onsite. And they will be expensive. You are not going to sell a whole lot of business to a CMO with resources trained in Java in a common bench in India.

My sense is that the big companies in the industry, which are giant lumbering public companies will find the shift very difficult. They will find it very difficult to invest in creating new higher margin services when margins in the core business are declining. Long-term planning can’t rely upon the decline in the rupee. They will have to acquire their way into new services.

The exception to this is of course, Cognizant, which among other things, has used its Bench Costs, and subsequently lower Operating Margins, as a strategic weapon. They are on the right path and have been for a while. That’s the company to beat.

Dark Data is a Big Opportunity for Services Companies

Why is Big Data big? Obviously not because someone invented a new statistical method of data analysis that can explain everything. It’s because there is a lot more data spewing out of business processes where there were none before. The questions haven’t changed – as a business manager I still want to know how to forecast sales or understand which levers to apply to improve my business outcomes. But where there was once no way to answer these questions, today there actually is data that can be analyzed to provide some of these answers.

So far all the attention has been on business problems whose answers lie in the copiously flowing data from associated business processes. Marketing, for example, where all Marketing is getting subsumed into Digital Marketing which, as anyone will tell you is a data gusher.

But there are innumerable questions in business that need answering where the data just isn’t there to analyze. Or rather, the data is there but it is unusable, just beyond reach.

I am part of a non-profit theatre company in the Bay Area. Theatre companies live and die by their ticket sales. All costs are fixed. Once you decide to stage a play your costs are all locked in. Your revenue, however, is completely variable, by the number of tickets you sell.

In such a business, it would be crucial to understand where one stands on ticket sales. In other words, you should be able to answer the following question at all times “Based upon the ticket sales today, X days before opening night, we are on track to fill Y% of seats”.

Almost all ticket sales are online. Which is a good beginning. The online ticket selling service that we use sends us a daily email with our cumulative ticket sales till that day. But, and here’s the nub, they don’t store a time series of daily ticket sales. So if I wanted to draw a graph with number of days to opening night on the X axis and cumulative tickets sold (by show, of course) on the Y axis, I’m out of luck.

This is not a unique situation. I’m sure you can think of many such examples in your business where you know the data is created but it isn’t kept, or it isn’t in the right form.

Then there’s a form of data that is not captured but can be, with just a little work. At Infosys, when I was trying to wrap my head around how to implement CRM in a company which hadn’t used one for years, I thought that it might be too much to expect the field force to make notes after every client meeting. But perhaps, if they could just log every client meeting, that by itself would be very useful. It would be a measure of business activity which we may be able to correlate to deal value and perhaps, could serve as a rough, early warning forecasting system. There are so many opportunities for squeezing a business process for meaningful data. Analyzing this data, typically doesn’t need Hadoop clusters, but the business outcomes could be quite significant.

Think of data as fossils in sedimentary rock. The fossils in the upper layers are newer, better formed and easier to interpret. The ones in the lower layers are just the opposite. But they are just as important to understanding and improving your business.

IT Services companies will see a lot of opportunity in Big Data and Analytics. But software companies will take away most of the value in the top sedimentary layers. The lower layers will be messy. And straightening out messes, is where IT Services companies thrive.

Meanwhile, I’ll be trying to sort out my ‘messy’ ticket sales data using Google Script. If anybody knows of a script that will help extract a number from an email that follows an identical string of text, please send me a note. Thanks.

The Trouble With Powerpoint

A couple of weeks ago, I was walking someone through a Powerpoint deck on the phone. The discussion was going well. But every now and then she would skip ahead. I’d be on slide 12 expounding some gory detail of our actions in Q1 and she would say “I have a comment to make about XYZ on slide 14”. Just a little unsettling.

So I thought about it. I had sent the deck to her the previous evening. It had a lot of detail – stacks of bullets and in places, full sentences. I wanted her to be able to understand the slide deck by reading it without my voice over. She did exactly that, and then the next day, I subjected her to my voice over anyway. No wonder she was skipping slides.

The number one problem with how Powerpoint is used in companies is that the same deck is used for different purposes. And it doesn’t work. Dual-use powerpoint decks are the single most important reason why the powerpoint slides used in stand-up presentations are so terrible.

IT Services companies are the worst perpetrators of the dual-use crime. We make illustrations with lots of boxes and arrows and inscrutable terms and acronyms. We put them in proposals. Then we take the same illustration and slap it onto a slide. In all its 14 point font glory. During the presentation we will actually turn towards the screen and read the whole thing out. Or sometimes you’ll hear “I won’t take you through all this information, but…”. Well then, why put it on the slide?

Dual-use crimes occur in other ways too. At Infosys, with globally dispersed teams across vastly different time zones, it is very common to exchange powerpoint files with the expectation that the other party will read the powerpoint and understand its contents. A typical email might read “Please find attached a deck that explains XYZ. Let me know if you have any questions.” You open the deck and it’s the same boxes-arrows style of presentation. Sometimes its useful because you already have the background and this is incremental information. At other times, you don’t understand a thing, or even why it was sent to you.

When you want someone to understand a document without a voice over, an email or Word document might work better. Because unlike a few paragraphs of a long email, a Powerpoint slide with boxes and arrows has no narrative thread.

I hand-wrote my transparencies at b-school, at my first job and even for my interview for Infosys in 1994. When Powerpoint was introduced, or rather when I was introduced to it, I thought it was an amazing invention. It completely changed the process of preparing for a presentation. The text on the slides was crisp, clear without having to send the slides to be done by an agency. Editing was so much easier. You could make changes right to the last minute before the presentation. You could draw diagrams and mix them with text easily. Later, we got fancy looking transitions too.

Powerpoint radically changed the overhead presentation. But somewhere along the line, it took over all forms of communication within business. The long form of writing just went away. I don’t know if we are unique at Infosys, but I don’t see much use of MS Word. It is all Powerpoint or Excel.

Dual-use is not the only reason why Powerpoint is overused and misused. The truth is that Powerpoint has become a crutch for the overworked modern-day employee. Its use makes it acceptable to not write full sentences, paragraphs or in fact, have a narrative at all.

As a consultant Powerpoint comes in handy in other ways too. If you aren’t sure about how a client will respond to some parts of the proposal why spell it out in detail. A brief bullet in the deck allows you wiggle room that you use based upon the body language of the client in the meeting.

Consultants also regularly create too many slides and too many words on each slide. This is a universal phenomenon. Why this is so, is not clear to me. It’s as if they are OK with any outcome in the meeting including the client passing out from sheer boredom. But god forbid, they should ever be accused of not working their butts off on the presentation.

Engineers are of course far worse at this than consultants. Most of us receive an education that equips us to solve problems, not communicate the solution to someone else. The engineering school I went to put a high premium on getting the funda (fundamental principle). Explaining how you figured it out was just wasn’t our thing.

Then we join a company where we see consultants flinging out decks with 50 fancy box-and-arrow slides. And we say, we can do that too. Thereafter all slides have boxes, arrows and 14 point text. And of course, tons of jargon and acronyms, because we engineers love them. It makes us look smart. All our formative years have been spent yearning for those small shots of dopamine to the pleasure center of the brain, when I get something that you don’t. Or when I say something that forces the listener to ask, “What does that mean?”. Now suddenly, you’re asking me to communicate simply. That just fries my circuits.

And of course it is also well known that most engineers are color blind. So our 50 box-and-arrow slides in 14 point text display all colors of the rainbow. The final product can be quite awesome to behold. Something that can kill a domestic pet at 20 paces. Clients are advised to wear protective eyewear.

In Indian IT Services companies I believe this is now a crisis. Not just the use of Powerpoint but all of business communication. And with the SMS generation now getting into mainstream business communication, the future doesn’t look too gr8 either.

ET Article

This article was published in the Economic Times on Apr 20, 2012.

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Four Myths About the Indian IT-BPO Industry

From zero to over $50 billion in 20 years. That’s been the meteoric rise of the Indian IT-BPO industry. For an industry of such significance, to India and the world, it is not very well understood outside the industry. Perhaps because it doesn’t manufacture a physical product. Or perhaps because it is such a new industry. After all, 20 years isn’t very old as industries go. The automotive industry is about 120 years old. Even the mobile phone industry, at about 30 years old, is older.

Whatever the reason, there exist a number of myths about the industry. Here are a few that deserve to be busted.

Myth #1: The industry is doomed because wages are rising rapidly and the labor arbitrage is going to go away.

This myth implies that labor arbitrage—the difference between the wages in India and advanced countries like the US—is the only thing propping up the Indian IT-BPO industry.

In 2009 the average US IT worker’s annual income was $77,200 in 2009 (Source: Janco Associates) versus $ 12,100 for an Indian IT worker (Source: ZDNet). That is a pretty big gap. Since then wages in India have grown, no doubt, but the rupee has also fallen against the dollar, mitigating the wage increase to a large extent.

Just to give you an idea of how big that gap is, assume that the US IT worker’s salary will remain constant. Also assume that the Indian IT worker’s salary in dollars will increase by 10% every year. It would take almost 20 years for the gap to be closed.

Of course, it is wrong to assume that wages in the US will stagnate and wages in India will keep rising interminably. Wage increases in the labour market, like any other market, are driven by demand and supply of IT workers. As the galloping growth in the Indian industry settles down to a steady trot and as private engineering colleges increase the supply of engineers and other IT workers, the acute shortage of workers may become a thing of the past.

Myth #2: China/Vietnam/Philippines is going to usurp India’s services throne.

As India becomes more expensive, are other countries going to undercut us and gain market share?

For sure, India is no longer the only act in town. The Philippines, particularly, has done quite well predominantly in voice-based BPO services. In 2010 it did $7.2 billion in IT-BPO services, which was 4.5% of the country’s GDP. The same number for India was 3.7%.

That said, The Philippines and Vietnam are relatively small countries, smaller than the single Indian state of West Bengal. They don’t have the scale to threaten India’s preeminence in the industry.

China has the scale. And its government would love to get the higher wage IT services jobs. But India has some inherent advantages—the most important one being a higher education system that is largely English-based. And it has a more subtle advantage in how comfortable clients feel with level of IP protection in India as compared to China.

Myth #3: Indian IT companies are no good because they don’t make products.

Actually they do. My company, Infosys, has a core banking product—a classic licensed software product—that does quite well. But, in the larger scheme of things, it is true that there is no Indian IT company that derives significant revenue from products.

I don’t think this bothers most companies. They have a solid business model —high growth and profitable. Why should they get distracted with what is really a different business? The enterprise software business requires entirely different skills, not just in product management and engineering, but also in executive row.

The financial model for enterprise software requires big upfront investments in product, sales and marketing. IT Services is not a high capital intensity business. The two don’t mix very well, which is why you will rarely find both business models in equal measure in the same company. IBM is an exception to this rule, but then IBM Software runs like an independent company and has the scale to be successful by itself.

While salvation for the Indian IT industry may not lie in building a licensed software business, that doesn’t mean that it should just stick to ‘work for hire,’ where all IP is created for and retained by the client. There are opportunities where retained code or other IP go into Solutions or Platforms which allow the service provider to differentiate itself and increase average bill rates.

Myth #4: There is no innovation. Indian software companies just keep flogging the offshore model.

In the 90s the offshore model itself was new. Before 1990, the SDLC (software development life cycle) was never broken up and allocated to people in different time zones. (Well, almost never. Texas Instruments was an early innovator in this area that we mention in our book.)

Today, an SDLC that spans many time zones is commonplace. But in the early 90s the pioneers of the offshore delivery model were breaking new ground. They were innovating.

Today, the offshore delivery model is embedded in many enterprise services. Every new service that is offshored has its own challenges and requires its own innovation. Startups like iYogi (consumer tech support) and Indegene (marketing services for pharma companies) are successful because they brought innovative approaches to offshore new services.

That said, in core enterprise IT services, the offshore model is showing its age. All service providers offer offshore application development and support or SAP implementation services in an offshore delivery model. Given how much of the revenue comes from these core services, they cannot afford to have them commoditized.

Innovation and owned IP is the only way to stave off the dark forces of commoditization. Indian service providers are investing in buying or building IP and capabilities to address big business problems from digital marketing to managing closed book annuity operations.

Why This is Emphatically Not the End of India’s IT Services Story

Fred Giron at Forrester has a provocatively titled post out Is This The End Of India’s IT Services Success Story?

Thankfully it is not the end. Once you get past the title, Giron’s post itself does not point to a doomsday. And I doubt that his eventual research note on this subject will either. Mostly because it just isn’t true.

Giron describes the impact of IP based Solutions on the industry as ‘transformational’ and even ‘disruptive’. I think we can safely say that it will not disrupt the industry. At least not in the new-business-model-hollows-out-old-business-model sense that Clayton Christensen used the word.

I don’t even think that it will be very transformational.

The composition of revenue in the IT Services industry changes slowly. While the frontier along which value is created and companies compete, shifts quickly, the bulk of the revenue will still come from a set of slowly commoditizing services. IP-based Solutions will form that frontier but there will be other services there as well. And while the action will be thick on the frontier, requiring new skills and capabilities, back in the heartland, it will be business as usual.

What that means is that even though there may be great value created by IP based Solutions it will take a long, long time before it has any effect, if at all, on the growth rates or employment generation by the industry.

In our book we take a pretty close look at the challenges faced by the Indian IT Services industry from commoditizing services and rising client expectations and do some prognostication of our own.

In a chapter called “The Quest for Higher Bill Rates” we closely examine the different ways a Solution can create value for the clients and the service provider. Also, what does it take for a service provider to be successful at selling Solutions.

In another chapter “New New Thing” we take a look at the trends in Enterprise IT – Cloud, Big Data among others – and their impact on the industry, both negative and positive.

The central problem to solve for the industry is how to stave off commoditization. The solution to this problem, in one word, is Innovation. Sometimes innovation will come in the form of IP-based Solutions. Sometimes it will be in the form of a new Service, say marketing services for pharmaceutical companies. And sometimes it may be a new way to serve a certain market (Japan, anyone?)

Offshore: The Book is Out

My book on the offshore services industry, co-authored with Gaurav Rastogi, is now out in both print and Kindle versions.

In India a print version of the book, published by Penguin, is available in major bookstores and online at Flipkart. In India the book is called Offshore: How India got back on the Global Business Map.

Outside India the Kindle version of the same book, but with a different sub-title, is available from the Kindle website. Offshore: India’s Services Juggernaut

The Facebook page for the book can be found here.

When Does a Services Company Need Products?

Never.

That is, according to Mark Suster who has a superb post on TechCrunch

They [a services startup] have created two internal technology “products” and wanted to figure out how they could turn their services business into a product business that could be financed. This team is talented. They wanted advice. And probably some money.

I gave them advice I don’t think they were expecting from a VC,

“Don’t raise venture capital for this business. Ever. And stop effing around trying to create a product company.”

The post covers a lot of ground, much of which will be of interest to services startups. But some of it applies to big services companies as well

I saw this first hand. My first career was at Andersen Consulting (one of the largest services businesses in the world). We built a hugely successful global services business yet we never got over our product envy from watching our tech clients. So we created internal software projects and all of the internal consultants on those projects became blowhards who thought they knew how to create software product businesses.

We stunk at every product we ever created. We had no sense for gathering real customer requirements. We over-spec’d products. We built for our over-intellectual selves. I can’t think of any great software tools ever created internally by Andersen Consulting. We were a great services business. Period.

Most of the bigger offshore services companies have some kind of active strategy to acquire a stream of non-linear services. Some people expect this to comprise of product-like revenues. In our forthcoming book we argue that tech products are a very different business from services. And given their lack of skills and management experience of the products business, services companies are going to find the going tough.

Fortunately, services companies don’t need to be “rescued” by products. They have ample opportunity to differentiate themselves within the ambit of services itself. The role of retained or developed technology IP doesn’t have to be wrapped up into a product to create value. The beauty of a services business is that there are so many ways in which you can extract value from a client, as long as you have something that they can’t get from the next company.

And yes, some of it, might actually be license or subscription fees. But hopefully, you’re not banking your company’s future on it.

Genpact Acquires Headstrong

Genpact acquired Headstrong for $550 million in cash.

Headstrong revenues for 2010 were $217 million. Genpact’s were $1.26 B. So unlike iGate’s acquisition of Patni, this isn’t remarkable in the minnow-swallowing-whale fashion.

Nevertheless, the acquisition is a sensible one. It is largely complementary in that Headstrong is mostly about IT Services to Capital Markets. Very little overlap with Genpact. Again, unlike iGate-Patni, this was about complementarity, not about achieving scale.

Genpact had to bulk up its IT Services business. IT Services offers both higher margin and higher growth. Both of which Genpact has not been able to deliver, at least to the satisfaction of investors whose expectations are benchmarked to the early days of the IT Services industry.

Genpact’s sophistication in BPO means that most of their growth comes from solutions where IT applications must be implemented or reengineered. Headstrong will bring them a lot more credibility, especially with custom applications.

And finally, even if the IT and BPO work are not joined at the hip in the same solution, having both offers cross-sell opportunities.

A few months back I had written about Cognizant’s rumored interest in Genpact. Eventually, nothing came of it. But I thought that that would have been a very good combination. Sort of a dream team – the fastest growing services company and the best BPO company.

Obviously, I don’t know whether the rumors were true or not, or what transpired if indeed there were serious discussions. But if I were to go out on a limb, I would say that they did have discussions. Maybe they didn’t agree on the price, maybe there were disagreements about the future of the combined company. Whatever the reason, the deal did not go down.

Which left Genpact in the position of being the leader in BPO, an industry that was very promising in the future, but an underachiever in the present. They had to do something to fix that. And so they acquired Headstrong.

This is a good time for bankers in the Offshore services industry. More transactions are to be expected. Watch this space.

Indian IT Services: Quarter’s Roundup

Yesterday Cognizant announced their results for the quarter and the year. That rounded up the quarter for the major Indian IT services companies.

I pulled some data together for the past five quarters. The results were pretty interesting.

First, I wanted to see what was happening to growth. I built an indexed chart which just shows growth for each company over its revenue in QE Dec-09.

Revenues for the previous quarter are in the same ballpark – between HCL’s $800 M and TCS’s $2 B a quarter. In that range, the size of the base should not impact growth much. Also, there were no major acquisitions during this period.

Cognizant is clearly pulling ahead of the pack. Wipro is falling behind a bit. HCL has upped its game and is keeping pace with Infosys and TCS.

What can we expect in the future? It’s hard to say. I think Cognizant will continue to lead the growth tables in the near term. The rest is anyone’s guess.

The long-term is a different matter. IT Services companies have a lot of inertia. These companies are like rolling, massive boulders. Changing speed or direction takes a lot of effort. And time. The companies that want to take the lead two years from now, better start making changes now. Managing results quarter to quarter, isn’t going to hack it.

The other interesting thing is the spread in margins in the industry.

The margins range from 10% for HCL to 25% for Infosys. (Wipro does not report net margins for its IT Business separately.) It is uncommon in an industry to have four similar sized companies in the lead with such a wide range of margins. Especially, in an industry where there are no entry barriers of technology.

My take is that this range of margins will narrow in the long term. Since Cognizant is now the growth leader, it can afford to stay put. But Infosys, TCS and Wipro will find it difficult to stay where they are.

If they execute well, these companies will be able to gradually up their spend on the things that matter and protect pricing. If they don’t, their pricing power will erode.

Protecting price levels is all about reducing competition. Superb account management and client service can do that. Investing in solutions that create measurable value for clients can do that. And new services and IP can do that.

Yes, a strong brand will also help, but the leverage from better marketing today, with five major players in the market, is not what it used to be. Good marketing is now table stakes.

On a related note, fellow EI, Ray Wang, who is just back from a NASSCOM conference, has a great post on how Indian services companies can start leading.

iGate acquires Patni

iGate announced its acquisition of a majority stake in Patni.

iGate with Apax Partners, will acquire 63% of the company for the final price of Rs. 503.50 effectively valuing Patni, the company at $1.5 Billion. By Indian law, iGate will have to make an open offer to acquire an additional 21% of the company.

With that, a company with revenues of about $200 million in 2009 acquires control of a company with revenues of about $650 million. Even by market cap, iGate is a third smaller than Patni. You won’t see this python-swallows-an-elephant acquisition happen too often in any industry.

What made it possible was the difference in the growth in earnings. Which in turn is because of the difference in how well the two companies are managed (see last year’s stock performance below). Based upon yesterday’s price, Patni’s P/E is around 10 and iGate’s is around 22. The difference is big enough for any private equity firm to drive a truck through.

About a year back I had wondered why the offshore services industry wasn’t consolidating. I had argued the case for scalar acquisitions

But a scalar acquisition strategy – basically bulking up – can make a lot of financial sense. If you are a well managed company with a P/E that is higher than the industry, an active acquisition strategy can make sense.

First, if you can negotiate a price for the target that is somewhere at or below your P/E, you are already looking good.

Second, acquiring a company with a similar business, has fewer integration risks.

Third, this industry, even though it has low entry barriers, is a business of scale. Visibility, brand, lower sales costs and overheads – all come from scale.

When I wrote that piece, I didn’t quite have this python-swallowing-elephant kind of an acquisition in mind. But this is, in fact, a scalar acquisition. Although the integration on this one won’t be easy.

Indian law makes it difficult to outright acquire a company. Mahindra Satyam and Tech Mahindra are still separate companies. Until Patni is fully acquired, integrating management is difficult. Eliminating costs is difficult. Benefitting from having a common brand and go-to-market is not going to be possible. But I’m sure iGate and Apax would have carefully thought through these issues. It’ll be interesting to see how the integration takes shape in the coming months.

Nonetheless, this is a big deal with lots of potential to create value. If there is someone who can pull this off it is Phaneesh Murthy. He’s done superb job with iGate. Congratulations, Phaneesh! And good luck.

Congratulations also to Shashank Singh at Apax Partners for a very significant deal.