IT Services majors are struggling for growth after a brief COVID-induced surge in digitalization during 2021-22. There has been an unprecedented drop in the employee headcount for most Tier 1 companies for many quarters. These companies were synonymous with high double-digit growth for almost 3 decades. So, what ails them and what is the recourse?
The last couple of years have belonged to the Gen AI. It has become fashionable to attribute every success and failure to AI. There was a similar trend in the latter half of the last decade to blame everything on Automation (loosely called RPA), and Digitalization. Geo-political and macroeconomic factors have contributed handsomely to the current industry scenario, but sometimes the commentary gets buried under the noisy pitch of AI and Gen AI. Analyst reports and leadership interviews predict AI as the slayer, and also the savior.
A closer look indicates that Tier 1 has been struggling for close to a decade now, barring a few years in between. Organic growth is subdued; rather there is a de-growth. Big organizations have used the cash reserves to acquire small niche companies almost every quarter. Most of these acquisitions are intended to show a better P&L to the street than, what they portray as, strategic acquisitions. Even if there is geo-political stability, wars stop and major economies start doing better, it is difficult to regain the old mojo. It is doubtful that an easing macro-economic scenario and thus the related growth in IT spending is likely to bring the old rate of growth for the biggies. Many factors will keep pulling the growth down.
- The rise of the Global Capability Center (GCC) appears unstoppable. From a mere 500 odd GCCs in India during the early 2000s, it has grown to over 1500 currently and each GCC has multiplied the headcount over the years. According to one estimate, the GCC count will surpass 2000 very soon. GCCs will grow 10-12% in the foreseeable future. This has a direct impact on the IT vendors. A lot of work has been shifted to the GCCs, who invariably keep the high-end work for themselves and outsource the remaining. GCCs are involved in contract discussions with the IT providers. This has led to substantial opportunity and margin erosion for the IT service providers.
- Low-code no-code platforms, automation platforms, domain-based SaaS, COTS products, and of course, Gen AI will keep challenging the growth of IT providers. AI is massively disruptive and is far from achieving its peak. No one knows if this will turn the tide. With the improvement in platform-driven productivity, it takes less human effort to finish the same work, translating into lower revenue for the providers.
- There has been sustained pressure on the Run The Business (RTB) spending over the years, which will continue for obvious reasons. Vendors have no choice but to provide YoY cost savings on RTB by optimizing IT operations through automation and other means. Typically, these savings are in double-digit percentages YoY. Change The Business (CTB) spending being a function of the economic cycle, which is getting shorter by the years, will face a greater degree of uncertainty.
- With the commoditization of IT service offerings, competition is stiff in a highly crowded market. Vendors resort to predatory pricing in a multi-vendor scenario. The market is tilted heavily in favor of the customer.
- COVID-19 showed how the work can continue remotely, busting the myth of onsite presence. Generally, the onsite rates are higher. This has a direct bearing on the TCV (Total Contract Value) and the top line of the IT service suppliers.
So, where is the hope apart from the magic of Gen AI, and business transformation opportunities through digitalization? A new trend has emerged of late. Several top IT service providers are building capabilities and offerings in the engineering services space. While Accenture and Cognizant have spent more than a billion dollars each in acquiring engineering IT firms recently; many others like Infosys, HCL Tech, Tech Mahindra and Cap Gemini have spent millions in new acquisitions of the engineering firms. Even the smaller IT services companies like Happiest Minds and Xorient have jumped into the fray. In a contrarian approach, KPIT demerged its IT services business and carved out engineering services, but it was way back in 2019. A couple of large business houses like Tata and L&T manage their IT services and engineering services businesses separately. I guess, their business models play well at the moment. We at WEISS, took a reverse route, where WEISS with a strong engineering services capability acquired an IT services firm Ecotech IT Solutions. WEISS GmbH is headquartered in Baden-Württemberg state of Germany, the Engineering hub of the world; and Ecotech is based out of India, the IT hub of the world.
For starters, the scope of engineering services includes engineering software, such as CAD, PLM, PDM, and QMS. Integration of ERP, AI, AR, VR, and embedded SW/IOT comes into play. One can include 3D modelling, MES, SCADA and other factory automation software to help users accomplish enterprise-wide tasks across various industries for smart design and smart manufacturing.
Why is engineering service a vehicle of future growth for the services behemoths?
Companies, so far, have been keen to keep ER&D in-house. Per analyst reports, less than 20% of the total engineering spend is outsourced. This is expected to grow 3x in the next decade. Engineering services seem to be now at a place where IT services used to be a couple of decades ago. Analysts greatly differ on the market size, but most researchers estimate the global engineering services market size at USD 2 to 3 trillion in 2024 and is expected to grow at a high single-digit CAGR till 2030. Some prominent analysts who quote a smaller market size (in billions) are considering a narrow scope of engineering services, in my view. The market is experiencing significant growth driven by technological advancements, increasing infrastructure development, and the need for sustainable solutions. The rise of Industry 4.0 (now x.0) and smart manufacturing are expanding market opportunities. With the shortage of skilled talent in the developed markets, and increasing price competition, the ER&D sourcing (in-house or 3rd party) is expected to grow rapidly in the coming years. Companies are under pressure to bring in new products to the market faster while managing costs. These factors are forcing them to shift towards an asset-light model.
The key to success for the IT players will be to manage the post-acquisition synergies well through proper organization change management. Most of the acquisitions in the IT space have notoriously failed to achieve its strategic objectives. Engineering services have to be a consulting-led business. Staying invested with specialized talents who possess deep domain and consulting expertise will be vital – IT services companies have traditionally failed to keep different operational yardsticks for the acquired entities for long. COOs would have to carve out separate measures of resource level contribution margin and other operational parameters for the two services. Potential customers typically keep different departments – IT services under the CIO, and ER&D under CTO. There would be a need to educate and equip client partners to address the two client stakeholders and harness x-selling.