Software exports: at the crossroads

On the face of it, the Union Budget had good news for the Indian Software industry. It did away with the hated Fringe Benefit Tax (FBT) and extended the tax holiday on export-oriented units (EOUs) by another year. That being said, most EOUs in the industry are already approaching the 10-year limit.

Moreover, there was a sting in the budget’s tail with Minimum Alternative Tax (MAT) going from 10% to 15%. As MAT applies to all income earned by software exporters other than that from EOUs (under Section 10A/10B), a 5% jump in MAT will directly hit their bottom lines.

Meanwhile, the industry has to gear up to face a plethora of challenges.

• Taxation: The software industry, which has hitherto enjoyed the benefits of a tax holiday on its EOUs, will soon have to confront the prospect of paying MAT on a larger proportion of its income and this would definitely erode its competitive position a bit. Today, Indian players enjoy a higher degree of profitability than their MNC counterparts do. That’ll change. In fact, the budget made things a bit easier for foreign IT/ITES players operating in India by simplifying the process of transfer pricing which has hitherto been a sticking point.
• Recession in the West: While India and China haven’t been affected anywhere as badly as the US and Europe, the latter are doing rather poorly right now and their recovery from the current recession will take at least two-three years. India's software industry has so far ignored the domestic market for the greater part preferring to go after the low-hanging fruit of exports. However, in a situation where the domestic market is growing at 14% this year and the global market is shrinking by 6% according to Gartner, how long can they continue to do so?
  Oddly enough, in the last two years, the share of exports in the Indian software/BPO pie has grown by two points from 64% in FY2008 to 66% in FY2009. (Source: Nasscom) Perhaps it is because of the following factor.
• The domestic market is no cakewalk: Competition is intense in the Indian market and exporters do not have the advantage of labor arbitrage here. Revenues have been almost flat over the past five quarters (from 3,017 crores in JFM ‘08 to 3,024 crores in JFM ‘09) for the biggest Indian player, HCL Infosystems. This is despite the fact that the Indian market has grown in the same period by 16-18% last year and will grow by 14% this year as per Gartner.
• Lack of scale: At roughly $6bn, the biggest of India’s software companies, TCS, is still a minnow when compared to an IBM or a HP both of which tip the scales at over $100bn. In the past, India’s leading software companies have acquired captive centers of (non-IT) MNCs but there’s a limit to growth through domestic acquisitions. Some of them have started acquiring companies abroad and this is a good move but most of these buys have been small (on the global scale a 500mn pound or dollar deal such as the HCL Tech acquisition of Axon or TCS’ of CGSL, while on the right track, is a blip. Truly global deals are in billions of dollars.).
  It will take big bets for these companies to grow quickly to the point where they can be credible global alternatives to the biggest MNC players and those could be risky which is why none of India’s software majors has attempted a truly humongous deal yet. These companies show a lack of appetite for risk when compared to our Steel and Telecom players who have taken on the world with gusto. They should start looking at mergers with equally large entities or do multiple, targeted acquisitions.
• The fluctuating Rupee: The Rupee has gone from 40 to 52 against the dollar and back to 48 in the last two years. During the same period, it has gone from 55 to the Euro to breach the 68 level and then back to 60 and now it’s once again hovering around 68. These fluctuations will continue to put a crimp in the profit margins of Indian software exporters. TCS cited forex losses on revenue hedges as one of the key reasons for lower profitability in FY ‘09.
• Low productivity: If you measure employee productivity in terms of $mn of revenue per employee India’s software giants come up short. Where Microsoft has a per employee figure of $0.64mn, HP has a figure of $0.37mn and IBM one of $0.26mn, TCS and Infosys, to take two examples, clock in figures that are less than a fifth of IBM’s. Admittedly, Microsoft’s software business is high-margin and HP has its lucrative printer business and IBM Software is one of the largest software companies in the world taken on its own but the numbers of Indian companies are still worrying.
• The specter of protectionism: Already we have seen caps placed on H1B visas and election-time rhetoric about jobs flowing overseas. Historically, the United States tends to ignore imports until they go beyond a tipping point whereupon it starts seeing the nation with which it has an adverse balance of trade as a threat and devalues the dollar in relation to the concerned nation’s currency. This was what happened in the US-Japan trade wars where the US allowed Detroit to be brought to its knees by a flood of inexpensive Japanese imports before it acted but when it did the Yen went zooming up from about 300 to the dollar to about a 100 at which level it has stayed ever since. The result was that manufacturing in Japan became so expensive that Japanese manufacturers had no choice but to establish factories elsewhere in Asia or in the States and the Japanese economy went into a slump from which it has never recovered. The only reason the US hasn’t acted against the bogey of Indian Software/BPO is that, for all the hoopla, India’s software/BPO industry is still tiny on the global scale. As per Nasscom estimates, India accounts for just over 4% of worldwide technology related spend and until that goes into double digits the industry will be safe from protectionism but that will change even if the present (slower) growth rate continues for another four-five years.

prashant.rao@expressindia.com