Polaris Software CMD Arun Jain: His is one of the tier-II companies taking a shot at the IT big league

Last week of august, when baring private Equity Partners India (BPEB) called off its four-month long effort to sell its 35.6 per cent stake in MphasiS BFL, there was palpable relief among the employees and management of the Bangalore-based software company. Freed from the worries of an imminent change in ownership (the abortive sale had become a media circus, with daily speculations on new suitors and jilts; see Baring's Plan B on page 24), the Rs 766-crore-in-revenues company could get back to business.

But with the relief came an ominous realisation about the lack of oomph of Indian IT's tier II, to which MphasiS belongs. Says N. "Subbu" Subramanian, a partner at Baring, which recently moved to a new office in Gurgaon: "We started on a good note with both the financial as well as strategic investors, but every time we sat down to sort out the nitty-gritty, they would cite mid-tier IT's lack of growth as a reason to beat down the price far below what we thought was a fair valuation."

It's a fact that most of the mid-sized IT companies have been quoting at 13 to 14 times earnings, compared to 32 and 33 multiples of the big IT companies such as Infosys and Wipro. Their growth is also not likely to be more than 20-30 per cent in the near future, compared to the 50-60 per cent rate expected of tier-I companies. So the question is, where is MphasiS and others of its ilk, such as Polaris, Hexaware, Subex, Sasken, iGate, Patni and Mastek headed? With revenues ranging between $200 million and $500 million (Rs 880 crore and Rs 2,200 crore), how many of them will make it to IT's billion-dollar league and how soon, and what happens to those that aren't growing fast enough?

Making The Leap

Talk to analysts on Dalal Street, and you'll hear mixed opinions on the prospects of such companies. There is, however, unanimity on two issues. One, that they'll need a well-defined and differentiated positioning against tier-I players and, two, they'll need diversification and a stronger focus on product development. "As business pitches get crowded with top (five or six) IT vendors (who, according to Nasscom, account for almost half of the industry revenues) also competing for the space that mid-sized IT companies operate in, the latter will have to review their survival tactics," says Partha Iyengar, Vice President (Research) at IT consulting and research firm, Gartner. Adds Sudha Kumar, CEO of Bangalore-based Prayag Consulting: "Mid-sized companies must keenly look at creating a strong verticalised value proposition. This will help them ward off competition from tier-I players, because, despite their vertical structures and stated goals, tier-I companies are still in the process of offering industry-specific solutions."

Some of the players in question have, in fact, got the hint. Sasken Technologies, for instance, has identified wireless telecom solutions as its niche area. Why? Wireless subscribers worldwide (estimated at around 1.8 billion at present and growing by 300 million every year) are demanding new and exciting communication media. This requires operators to come up with compelling content that could be the differentiator. Says CFO Neeta Revankar: "There is huge opportunity here, and not much competition either." According to estimates, the total size of the wireless multimedia R&D industry stands at around $1 billion (Rs 4,400 crore) and Sasken's chief marketing officer Swami Krishnan says that the company "intend(s) to capture as much of it as possible."

Another route, analysts say, that companies need to explore is that of newer markets. Today, the US contributes 50 per cent to 70 per cent of the total revenues of most Indian IT vendors. Although the market itself is far from saturated-only 10-15 per cent of it has been tapped by Indian companies-it is getting crowded and extremely competitive. "Non-conventional markets in Europe, Middle East, Asia-Pacific and Africa present huge opportunities. Clients in these markets may have smaller budgets, but they have growing needs. Moreover, their requirements are quite targeted, which mid-sized IT companies are most suited to fulfil," says Ajith Sankar, Analyst, IDC India. In fact, players like Subex, KPIT Cummins and Polaris have diversified into markets like Italy, Romania, Sweden, Ireland, Cyprus, Algeria and Senegal.

Subex Systems CEO Subash Menon: He is successfully tapping into non-US markets

Product development is another area that, most experts feel, has been long neglected by Indian vendors. Mid-sized companies, they suggest, should shed their me-too approach and invest in building some world-class products. But the problem is product development needs bigger investments, longer gestation periods and a bigger appetite for risk. Such a strategy may not be conducive to companies having a quarter-to-quarter earnings approach. "But a consistent investment in products can help companies generate spectacular returns over a period of time," says Sankar.

It's true that when it comes to Indian IT products, there is not much brand recall beyond i-flex's Flexicube and Infosys' Finnacle, whereas some of the biggest global IT companies such as hp and IBM are quite strong in their product lineup. While there are companies like Subex and Sasken who have invested in developing products, they have another problem to grapple with-a lack of credibility. Says Subash Menon, CEO, Subex Systems, a telecom software product company: "Mid-sized Indian product companies suffer from an identity crisis in the us." He, again, thinks that besides focussing more on branding and marketing, vendors should explore "non-conventional markets, which seem positive towards Indian products". Interestingly enough, Subex drew around 60 per cent of its product earnings from markets other than the US last year.

Meanwhile, companies are waking up to the need for better focus on brand communication. "Mid-sized companies have given branding and marketing a complete miss and, hence, they lose out in competition with the big boys," says Kumar of Prayag. IT selling, traditionally, has been a b2b proposition. Hence, the CFOs have not been quite convinced about the benefits of brand promotion in traditional terms. But now with the ever-increasing competition, they have started appreciating the fact that a good share of voice helps in closing deals, too. Says Govind Singhal, Executive Director of the Chennai-based Polaris Software Lab: "Higher and sharper investments on marketing and branding are the need of the hour. It can help vendors build a differentiated market presence."

The other way to accelerate growth, say experts, could be market consolidation, "which Indian vendors have so far have shied away from", notes Gartner's Iyengar. There are three ways in which Indian market could consolidate. "First, the $1-billion-and-above group may look at acquiring those at the lowest level (below $100 million or Rs 440 crore)," says Jayant Sinha, Partner, McKinsey & Co. Agrees Ravi Ramu, former CFO of MphasiS: "This will do away with mid-sized classification as there will only be big and small-sized companies, and while bigger companies will provide more holistic and end-to-end solutions, the smaller ones can focus on their niches."

iGate CEO Phaneesh Murthy: Looking at M&As with tier-II companies abroad to establish a foothold there

The second route is for tier-II companies to merge or acquire players of their own sizes with different but complementary capabilities. "With it business being people-intensive and conducive to economies of scale, such alliances will boost organic growth as well as add new domains and verticals, which, in turn, will ensure better growth," says Sinha. Similarly, alliances with tier-II companies in markets abroad can help players gain a foothold in new markets. In fact, there are some successful instances of such mergers and alliances. Patni's acquisition of Cymbal in 2004 (for $68 million or Rs 299 crore), iGate's merger with Quintant in 2004 ($19 million or Rs 84 crore), hardware manufacturing major Flextronics' purchase of Hughes Software in 2004 ($226 million or Rs 994 crore), and Subex's acquisition of fraud management business from Alcatel ($3 million or Rs 13 crore) in July this year are good cases in point.

The third option, according to McKinsey's Sinha, is for the $100-$200 million (Rs 440-880 crore) companies to merge with each other to gain critical mass. Big global mncs acquiring mid-sized companies, like the i-flex-Oracle deal, is another option. The only downside, some analysts say, is that the smaller company tends to lose its identity and focus in such deals. "Oracle may say that i-flex will continue to operate like an independent entity, but it's a foregone conclusion that eventually, the latter's capabilities will be spent on furthering Oracle's own agenda. That will set back i-flex's own plans of pushing its services business," says an analyst.

In their pursuit of growth, the tier-II companies will try out an assortment of strategies, including aligning themselves with global players such as Sun, Microsoft or IBM to get a preferred partner status and offer some niche services to these giants. It is reasonable to expect that a handful of them will also manage to make it to the big league. We can't predict which these companies will be, but we can tell you of what sort they will be: Single-mindedly focussed on growth, open to all options to achieve it, and their promoters will not be wedded to control.

So the next time you churn your IT stock portfolio, put your tier-II favourites through this simple test.