The Choking of Innovation: India’s much-vaunted IT Industry has to dramatically

change if it to maintain its leadership role in the next 10 years.

A fundamental re-think of the business has to occur with innovation on the front-burner if it has to continue
to grasp the world’s attention. A look at the industry today by Sanjay Anandaram, Managing Director of
JumpStartUp Fund Advisors. The views expressed here are his own.
________________________________________________________________________

“On January 6, 2005, the prime minister spoke about his intention to set up a Knowledge Commission to
look into the issue of building quality human capital.

The government believes that investments in institutions of higher education and R and D organisations are
as important as investments in physical capital and physical infrastructure. What we need are world class
universities and we must make a beginning with one institution.

We must have a university that will be ranked alongside Oxford and Cambridge or Harvard and Stanford.
I am happy to inform the House that we have selected the IISc, Bangalore, which enjoys a high reputation as
a centre of excellence in R and D. We shall work to make IISc, in a few years, a world class university. I
propose to provide an additional sum of Rs.100 crore as a grant for this purpose”, Finance Minister P.
Chidambaram in his 2005 budget speech

Perhaps for the first time, an Indian Finance Minister had actually acknowledged and acted
upon the need for developing R&D excellence as a policy measure for achieving national
goals. It is an acknowledgment also of the fact that for India to find its place in the sun in
the years to come, R&D based excellence – or, innovation based solutions – is mandatory.
That if India’s destiny lay in just being a low cost supplier of the world’s goods and services,
then the tryst with that destiny would be short-lived. But if India’s destiny lies in being an
international leader in the supply of goods and services then it has no choice but to embrace
innovation and R&D based excellence.

Over the past 57 years, India’s share in world trade has shrunk from over 2% to about 0.6%
today. Of India’s top items of merchandise export are in traditional commodity items like
textiles, gems and jewelry, leather, chemicals, engineering goods, minerals, and agro-
products. The value-added by India in the commodity items is minimal and hence prone to
significant international price pressures. Due to the lack of investments and innovation along
the entire value-chain, from design to marketing to technology to the business model itself,
these industries capture just a tiny share of their global markets. These industries have grown
in large part due to the natural advantages enjoyed by India of which an abundant supply of
low cost labour is a significant part. In the world of tomorrow, innovation has to take
centre-stage if these industries are to have positions of dominance on the world stage.

Non-traditional businesses like IT services and pharmaceuticals have grown significantly in

the last decade and are now recognized as having “arrived” on the global stage. Both these
businesses are knowledge driven and employ a significantly different profile of employees
than the traditional businesses. It is therefore imperative tha t with their arrival on the global
stage, with their access to world class talent and capital, cost & quality led advantages, and
with high global demand, they do not become complacent and lose their leading positions
much like the traditional businesses have done.
With over 300,000 engineers graduating each year, India is sitting on a human capital
goldmine that most countries can only dream about. However, the issue of global leadership
isn’t one that’s only about numbers. After all, with only 7000 engineers graduating each year,
Israel with 6.5m people has over 100 innovative companies listed on Nasdaq! And India
with over 250m head of cattle – the world’s largest – is not even a player in the global dairy
business!

Indian pharmaceutical companies have already realized that in the post WTO world, they
need to compete with multinationals in India and in global markets. “In this new patent era”,
says Ajit Dangi, director general of the Organization of Pharmaceutical Producers of India,
“unless Indian companies can rapidly change their business model from imitation to innovation, by 2010
there will be just 500 to 1000 companies.” (from the current 10,000 plus companies). Indian
pharmaceutical companies spend about 8% of revenues on R&D today; In the fiscal year
ended March 2004, a total of 855 drug patents were filed by Indian companies, up from
virtually zero 10 years ago.1

However, no such resolve or action is seen from the Indian IT services companies. The
industry that has put brought India into the collective consciousness of the economic world
- terms such as outsourcing and offshoring were even raised in the US Presidential elections
- is growing by leaps and bounds. Why should they be worried? After all, the industry is
growing at 25+% and the prospects look very good for the foreseeable future. Or do they?
For one, the next 10 years for the industry will not be anything like the first 10 years.
Increased globalization, increased choices for employees and customers, and increased
competition will force huge changes. While the industry has grown admirably over the past
decade and a half from an almost standing start to reach its current size, it has also attracted
the attention of the rest of the world. That means Indian IT services now have to contend
with really brutal global competition and market demands.

If we believe, however, that the next 10 years will play out as the previous 10 years have then
we have nothing to fear and the industry and its stakeholders can all sleep well at night. This
article will also then be quite irrelevant. However, if the next 10 years are not replicas of the
previous 10, then we have a lot to worry about. For then, India would have lost an
opportunity to achieve true global leadership in IT. We would have once again snatched
defeat from the jaws of victory. But I believe that the next 10 years will be different. I believe
that there are serious issues that need addressing if the Indian IT (as opposed to MNCs
leveraging India through captive units) industry is to continue to create value 10 years from
now.

The Serious Issues

a) Structure of the industry

According to data published by Nasscom in its Strategic Review 2005, the top 20 companies
(of these, 5 are quasi-captive companies of overseas companies e.g. Digital Globalsoft - now HP - which
derive a significant chunk of their revenues from their financial and other relationships with their overseas
sponsors/parent companies) accounted for nearly 63% of the industry’s exports in 2003-04.

1 quoted in Business Week, April 18 2005

Which means that approximately 3200 companies in India (out of the universe of about
3200) delivered 37% of the industry’s exports or about US$ 3.4 billion. Put another way, the
average size of these 3000-odd companies is just US$1.13 million or Rs 49 million! And, a
vast majority of these companies is over 7 years old. If this situation were to be put in a
social context, it is as if we had a society composed of the few extremely wealthy and a vast
number of poor buttressed by a negligible sliver of the middle-class – an unhealthy state for
any economy let alone one that’s ostensibly a knowledge driven one.

b) The Paradigm

The paradigm of the Indian software services industry most closely resembles that of
“made-to-order” contract manufacturing (CM).

Dimensions Contract Manufacturing Indian Software Services

Input Raw Materials Engineers
Focus • Flexible Manufacturing • Flexible Delivery (Global, Onsite,
• Quality Offshore)
• Low cost • Quality
• Volume Led • Low cost
• Yield Mgt • Volume Led
• Yield Mgt ($/seat)
Quality Metric • Six Sigma • Six Sigma
• TQM • CMM
• Deming
Efficiency Reduced Manufacturing cycletime Improved Utilisation (Reduced benchtime)
Metric (e.g. Finished Good to Shipment)
Costs • Sourcing • Sourcing (Hiring)
• Conversion • Training
• Carrying costs • Bench costs
R&D Negligible Negligible
Capex • Plant • Real Estate
• Machinery • Workstations
Marketing Low; Low Brand Premium Low; Low Brand Premium

Worldwide, CM companies under

margin and revenue growth pressures High
have been morphing into OEMs
(original equipment manufacturers) to
ODM (Original Design and S&M
ODM
Brand
Revenue
Manufacturing). Today, the entire OEM
design, development, sourcing,
manufacturing, testing, packaging, CM
shipping is undertaken by the larger
Low
ODMs leaving their customer, say Low High
R&D
Cisco, to manage the customer, Revenue
channel and marketing relationships. Some ODMs are venturing into launching their own
brands (e.g. Haier, BenQ) in carefully chosen markets. Complex technological products from
PDAs to PCs to Digital Cameras to Phones to Networking gear are being increasingly
supplied by ODMs from Taiwan and China. More importantly, these companies are
investing heavily in innovation in technology, marketing and business models!

Indian IT services need to see the writing on the wall and start investing in innovation now
when they have the luxury of enviable margins and revenue growth. Investments in R&D,
Sales & Marketing, and business development activities have to dramatically increase. Such
investments take time to fructify and will stand the Indian companies in good stead when
growth starts tapering off over the next few years as it inevitably will. The past 10 years has
seen the Indian IT services industry successfully perfect the equivalent of the CM business
model but will the next 10 see them perfect the equivalent of the ODM model? After all,
pay-offs from investments in soft infrastructure like R&D, culture, and mindsets take a lot
longer than investments in hard infrastructure like land and buildings.

c) Maturing of the Industry

The results of the top Indian IT services companies (TCS, Wipro, Infosys) for the year
ending March 2005 brings another aspect to light. That their growth is being largely driven
by volumes (increased deployment of headcounts) as opposed to increases in prices. It is no
surprise then that the Nasscom Strategic Review 2005 goes on to say that the industry is
maturing. The ability of the large companies to continue to hire and deploy large pools of
manpower appears to be the only constraint to growth at this point. However rising costs,
attrition rates due to increased choices for employees, increased awareness of customers
about India and other geographies, competition from other countries, and concerns about
availability of skilled and trained talent will start to make an impact on these impressive
growth rates.

As in any services industry, the industry is clearly quite skewed in favour of the large
companies since the drivers of value are scale (armies of programmers are required since
revenues are proportional to headcount) and scope (a wide suite of services is offered to
customers – different services across different industry verticals). The small companies do
not offer any differentiated services and are more often than not, hamstrung by lack of
capital and lack of management talent. Mergers and Acquisitions are the way out for many of
the smaller companies that offer any set of differentiated capabilities. The others continue to
struggle against market forces to remain afloat.

That the industry has matured is evidenced also by the fact that no IT services startup has
been financed by VCs in the last 3 years. On the other hand, capital is however available for
purposes of consolidating holdings and undertaking M&As.
d) Impact of MNCs

Global companies are becoming “Indian” faster than Indian companies are becoming
“Global”.

IBM, Accenture and HP alone employ over 50,000 people in India today as part of their
global services operations. They also have operations in many low cost countries around the
globe to which they are rapidly moving low end, price sensitive activities to face the threat
from Indian IT services. As their headcounts in India (& in other lower costs locations)
increase as a proportion of their global headcounts, their ability to effectively compete on
price against vendors from India (& other low cost countries) will only increase.

Indian companies, on the other hand, have their centres of gravity and the locus of
operations in India: they are yet to make serious investments in building capacity,
competence, and relationships globally. In the coming years, notwithstanding their “global
delivery model”, Indian services companies will need to aggressively step out of their India
centric delivery models and invest in global workforces, global relationships and partnerships
with customers, partners, and vendors. Meanwhile, here’s what Claudia Van Munce,
Managing Director of IBM’s Venture Capital Group has to say in a March 23rd 2005
interview with Always-On “….IBM used to be known as the company that only played with the large
corporations. But then if you look at NASDAQ, 70 percent of the NASDAQ 100 was at one time a
venture-funded startup. So, we're obviously casting our net in areas where these companies can be very
successful and become critical partners of IBM”.

In addition, companies like IBM and Accenture invest in research in different industries,
subjects, and technologies to gather insight into how they can impact their customers. For
example, Accenture has its Institute for High Performance Business that does research in
areas like strategy, innovation, CRM, Supply Chains, and business models. IBM works with
academia and key technologies on a global basis to devise next generation innovative
solutions for its customers.

Lets take an example: India’s top three IT services companies together employ over 10,000
people in their BFSI (banking, financial services and insurance) groups and generate over a
$1billion in revenues. Most of the top banks in the world are their customers. Yet, can these
10,000 generate an original technology vision and thought leadership for say, the global
insurance industry, without regurgitating analyst reports from various analysts? Generating
thought leaders is a critical element of innovation and requires investments.

As the Indian market grows, MNCs will start aggressively going after “local” business.
Already, the signs are ominous. For example, the 10 year deal between Accenture and Dabur
for management of Dabur’s IT needs, the Bank of India-HP deal for branch office
computertisation, $750m Bharti-IBM deal and the mega Reliance Infocomm telecom
network & Reliance retail petrol pump projects with IBM are clear indicators of what can
happen in the Indian landscape. A look at the Indian domestic IT market amply illustrates
this – once owned by Indian brands, it is dominated by MNCs brands today. MNC
consulting companies generate higher revenues per employees from Indian customers than
Indian consulting companies. Brand value, domain knowledge and experience are clearly the
major differentiators.
e) Lack of eco-system development

The Indian industry has grown in an ad-hoc manner where supply side advantages (cost,
quality, availability, English language skills, project management) in India meshed with global
demand for capacity (Y2K & e-Commerce being among big drivers). As a rising tide lifts all
boats, so too did the entire Indian software industry get lifted by these drivers.
Unfortunately, the effect of the rising tide was such that it forced the all too ready Indian
industry to further focus only on the supply side of the equation since demand generation
became essentially a passive activity.

This, unfortunately, in turn forced companies into vigorous competition for talent rather
than co-operation. Therefore what could or perhaps should have resulted in companies
forging alliances and partnerships amongst themselves for accessing resources relating to
technology, markets, vertical domains, best practices did not quite materialize; Linkages with
academia or industry too did not take place: IT services companies did not see it worthwhile
to partner with domain or technology experts or with companies in specific verticals like
telecom, automotives, FMCG, and hospitality. In other countries, one sees linkages and
meshes (formal and informal) between smaller and larger companies that benefit all players
e.g. Taiwanese hardware industry, Japan’s automotive industry, intense co-operation &
competition amongst Silicon Valley companies. Here companies operate in isolation and in
a vacuum. Domain knowledge, intellectual property, best practices and the like are not
shared. There are no programmes with large companies to work with smaller, innovative or
differentiated companies.

Industry bodies which had performed yeoman service championing the cause of the
fledgling IT industry in its early days appear to be currently satisfied with maintaining the
status quo with regard to taxation policy, visas to the US and UK and the token event or
conference. Development of a conducive eco-system say, by becoming the facilitator for
capital, mentoring, technological tie-ups, managerial inputs, partnerships and alliances for the
benefit of the 3000 smaller companies does not appear to be a priority.

The approach of MNCs in India like Texas Instruments, Analog Devices, and IBM is
illuminating. They work closely with several small companies providing marketing and
technological support and with academia in developing or testing hypotheses. They also
work with venture capitalists to get share insights about market & technology trends; small
companies are tracked for potential partnering purposes, for possible M & A transactions,
and for getting an understanding of the local market and technological capabilities.

f) “BPOisation” of industry

The BPO business (incl call centres) from India is over $5billion in size today from an
almost standing start in 1999. The business was fuelled in large part by private equity and
venture capital funds who invested an estimated $200m in this sector in the period 1999-
2001. Today, the business is dominated by the large (quasi)-captive units of MNCs like GE,
HSBC, Citigroup, Dell and AOL or by large 3rd party players like Convergys. Large Indian
companies entered the arena through the M&A route (Wipro-Spectramind) or organically by
raising many millions of dollars from investors (Progeon-Citi, Satyam-Olympus-Intel). The
business has rapidly matured in just 5 years and is displaying all the characteristics of the
more mature IT services industry; namely, the concentration of business in the hands of the
few large players and the squeezing out of the smaller players due to reasons of size, lack of
differentiation, capital, management talent a nd the like.

While the employment generation outlook for this sector is undeniable, the rush to BPO
everything (from insurance claims to sales orders to filing legal drafts to reading X-rays to
even preparing tax forms for clients overseas) is seeing mundane tasks being done by over-
qualified Indian employees. We have accountants doing ledger entry, statisticians running
SAS/SPSS packages, and engineers doing low end engineering drawing. Since the focus on
innovation is low (with process compliance, quality, and maintenance of service levels being
of predominant interest) and the lure of BPO so high, the possibility of more and more
Indian companies hiring away under-paid and under-appreciated engineers, doctors, and
scientists to BPO work is very real.

Or is it? Do we need to really worry that the knowledge workers of the Indian economy are
being transformed into robots? Is this fear alarmist, irrational and over the top?

Contrast this with the following comments by John Chambers, Cisco’s CEO:

“When he looks at China and India, Chambers sees two countries—each with more than a billion people—
that are methodically focusing their efforts on improving the math and science skills of their top students. For
every new engineering graduate in the U.S., which has a much smaller population to begin with, there are five
in China, he says. “In China and India, they clearly understand that if they get the engineers, then they get
the managers, then they get the companies, then they get the innovation." 2

This is from a top person of a top company from the top country in the world today! This
article and others talk of how top technology business leaders like John Chambers, Jeff
Immelt of GE, and Craig Barrett of Intel are paranoid about the US losing its competitive
edge due to a shortage of engineers and scientists. How many of our top leaders worry about
losing their competitive edge of innovation due to the country’s scientists and engineers
migrating to performing outsourced tasks?

The very nature of a BPO business with its relentless focus on volumes, high
standardization, low variance, managing costs, process compliance, managing service levels
agreements, managing hiring and attrition issues, simply cannot be conducive for the
emergence of innovation from Indian companies.

g) Mindsets

This is the single most important aspect for innovation to happen. I recall sitting in, a couple
of years ago, on a meeting to discuss innovation in a top Indian services company. This
company had set up an innovation council and appeared to be serious about engendering

2
from Fortune’s David Kirkpatrick’s March 30th 2005 column “Cisco CEO on US education – We’re losing the
battle”
innovation in-house. The meeting lasted about 2 hours and for most of the time the
discussion centered around the processes to be followed by the company to ensure that the
process of innovation discovery was compliant with various internal standards and practices
that the corporate quality group had laid out!

In another case, the group was set up to pursue “innovation”. This group had developed
interesting technology building blocks and was wondering about the next steps. There was
no plan for any cash investment for travel to meet customers, to do some market and
customer validations, to hire experts. The only resource made available was some engineers.
Losing patience with the group, the company decided to quickly convert these engineers into
“billable resources” and when I last checked, one of the experts was an account manager for
a top customer!

Now see how Jeff Immelt, CEO of GE a $152 billion company and one of the largest
companies in the world is “turning GE’s culture upside down, and demanding far more risk and
innovation”:

“….Jeff Immelt admits to two fears: that General Electric Co. will become boring, and that his top people
might act like cowards. That’s right: cowards. He worries that GE’s famous obsession with bottom-line
results – and tendency to get rid of those who don’t meet them – will make some execs shy away from taking
risks that could revolutionize the company..”3

The article goes on to say how CEO Immelt is trying to shift the GE mindset:

Pay: Link bonuses to new ideas, customer satisfaction, sales growth with less emphasis on bottom line results
Risk: Spend billions to fund “imagination breakthrough” projects that extend the boundaries of GE
Experts: Rotate executives less often and bring in more outsiders to create industry experts instead of
professional managers

Indian IT services companies are prisoners of their own success. Enjoying unprecedented
market capitalizations thanks to their terrific earnings growth, they find it hard to make the
investments with unsure time horizons and unsure pay-offs. Investments will dent their
earnings and affect stock prices. Investments in exploring new business models, in
partnerships, in undertaking M&A transactions of any significance, in hiring globally, in
research, and in creating organizational change are sure to impact near term earnings. But
what of the serious possibility of a bigger impact on the business in a few years by not
making these investments now?

Instead of investing their cash surpluses in making long term investments of the types
mentioned above, Indian companies tend to reward their shareholders with hefty tax-free
dividend payouts (thereby enjoying shareholder loyalty) and perform treasury management
functions by investing the money in safe mutual funds. Clearly, these companies are
signalling that they have no other productive or imaginative use for this capital (e.g. investing
in long term competence and capability development) than paying dividends. The
conservativeness of management is reinforced by the pressure of maintaining quarterly
earnings.

3 Business Week, March 28th 2005

It is disheartening from an industry standpoint to see hundreds of millions of dollars simply
lying on the balance sheet and not being invested in creating innovative competitive
advantages for the future. It is disheartening to see companies lacking confidence in taking
big, bold steps even after 20 successful years in the global arena. The ability to dream big on
a global level and then take the required confident steps to realize these dreams is what will
distinguish the true global players from the also-rans in the next ten years.

Mindsets need to change dramatically especially amongst the leadership levels. From
managing status-quos to managing risks, from managing people to managing businesses and
leveraging opportunities, from managing Indians to managing a diverse global workforce,
from a “span of control” to a “span of competencies”, all need to happen. Career paths for
R&D technologists and industry experts for example need to be made as attractive as jobs
that are oriented to regular people-management routines. An entrepreneurial environment
and mindset has to be put in place.

A Presumptuous Prescription

Let me be presumptuously prescriptive. Why cannot the large companies look at developing
their own “global eco-systems” much like the MNCs have done:

Tech & Market Business Models

. VCs . Think Tanks

. Tech. Startup . Customers
. Customers . Analysts Possible
. Academic . Academic Engagement Models
Institutions Institutions • JV
• M&A
• Strategic Investments
Size Cash • Partnerships Programs
Rich • “Vendor” development
Technical Project • Spin outs & Spin-Ins
Capabilities IT Mgt
Services
Low Co.
Quality
Cost
Service Customers Competencies
Delivery • Global M&A
• Investments
• Risk evaluation
• Managing diverse
workforces
Domain Knowledge Market Access • Partner Management
• Research
. Industry Experts . Startups
. Analysts . VCs
. Consultants . Partners (Service
. Academic Companies)
. Consultants
. Press
Activities along each spoke have to be driven by qualified entrepreneurial business managers
with clear goals and objectives; Access to organizational resources must be made available –
this availability will only be guaranteed if executive management sponsorship at the hub of
the activities is real and visible. Initial failure must not force the company to immediately
withdraw and get into a “I told you so” mindset. For all of this to happen, companies will
need to acquire & develop new competencies and capabilities. And as always, the change has
to be driven from the top. And again, the mindset change has to be driven by a recognition
of the impending reality of the next 10 years.

Some of the larger companies are thinking of such things and have taken their first hesitant
steps. But is it displaying the confident strides of a 20+ year old industry with a global
footprint, global recognition, enviable top and bottom line growth, and access to large
amounts of cash? The answer cannot be “Yes”.

I, for one, as a well-wisher of Indian IT am keeping my fingers firmly crossed!

Is the picture so disquieting that innovation is unlikely? The answer, as always, is that
innovative people always find a way and, as everywhere else people in small companies are ar
the forefront of this effort. There’s a quiet but rapidly developing wave of innovation taking
place in Indian companies.