IT firms need to focus on execution skills to drive margins

Indian software firms need to focus on their execution capabilities to drive margins as clients are increasingly opting for fixed-price contracts instead of time-and-material projects.

The fixed-price mechanism enables clients to fix their costs well in advance and any over-runs will have to be borne by the vendors. The share of fixed-price projects in the revenues of most top tier technology companies like Tata Consultancy Services (TCS), Infosys, Wipro and HCL Technologies has climbed up over the past few years.

"We believe individual reported metrics such as billing rates and utilisation will slowly become irrelevant and execution will be the key factor...Execution capabilities will start mattering more as the proportion of fixed-price revenue increases. Execution of such projects will drive margins," Anantha Narayan and Sagar Rastogi, analysts with Credit Suisse, wrote in a note to clients.

The nature of deals is also changing with software outsourcers now getting involved in far more complex projects than plain vanilla application development and maintenance work. Their clients are also becoming more savvy outsourcers. Hence the pricing is often getting linked to outcomes rather than the number of resources used to complete the project.

According to Credit Suisse parameters like unbilled revenues, pricing, utilisation, offshore mix and gross margins will offer clues on the execution abilities of a software firm.

For instance, a consistently high proportion of revenue delivered offshore may indicate that a software firm has strong execution capabilities while a low utilisation rate may highlight the weak execution skills.

"In this context, we remain comfortable with our two preferred large-cap picks in the sector – HCL Technologies and TCS. We think TCS is demonstrating the best execution among the offshore information technology services companies and HCL Technologies' execution seems steady," the analysts said.

TCS is the only large Indian technology services company to have improved its gross margins over the past five years and anecdotally, it appears best in fixed price execution, they said. The company also has relatively low unbilled revenue as a proportion of overall revenue and stable realised pricing.

The analysts noted that HCL Technologies has little room for error due to its low margins and aggressive pricing for increasingly complex projects, its execution capabilities appears to be strong so far.