Indian IT powers face big growth challenges

Size matters when it comes to Indian IT services companies.

Sales and profits of both smaller tier two Indian IT players — those with less than $500 million in annual revenue — and tier one giants like Tata Consultancy Services (TCS) and Wipro — are both way up over the past 18 months. But, the valuations of tier two companies were off sharply compared to the big guys, according to new research from Martin Wolf M&A Advisors, a company that consults with tech companies about their merger and acquisition options.

For the period from January 1, 2011 till August 1, 2012, the valuation for the big Indian IT providers fell 15.6 percent compared to a 24.9 percent fall-off in valuations for the tier two companies, according to the MW IT Index India Edition which looks at 36 Indian IT service providers — which make money  implementing technology for businesses — in both camps. For that same period, sales for tier one players rose 33.5 percent compared to 38.4 percent for the tier two players. Profit for the top-tier IT providers was up a healthy 43.4 percent compared to a healthier 78 percent for their tier two counterparts.

For Indian IT players, safety in size

Those sales and profit numbers, recounted in a Times of India story last week, are deceiving, said consultancy founder Martin Wolf.  In his view, the tier two players have their work cut out for them if they want to stay relevant in a tough economy because the slower-growing-but-bigger tier one providers are better positioned. They have deeper management, bigger IP portfolios and sport more expertise across vertical industries, he said.

Martin Wolf, founder of Martin Wolf M&A Advisors

Martin Wolf, founder of Martin Wolf M&A Advisors

The smaller players are running out of runway for easy growth — it’s easier to grow off a small base. They will be increasingly challenged by the slowing Indian economy while the bigger players work more outside India. TCS, for example, got 53 percent of its revenue from the U.S. compared to 7.1 percent from India for its first quarter. The smaller players are more focused and dependent on the flagging domestic market, Wolf said.

In Wolf’s opinion — and remember he’s in the M&A business —  is that the Indian IT giants will have to do dramatic deals — along the lines of IBM’s(s ibm) $3.5 billion buyout of PwC Consulting a decade ago,  in order to keep competitive with companies like, well like IBM Global Services.

The big get bigger, as the small struggle to do the same

These “big buys” will be necessary for the tier one companies to boost their skills further in vertical markets and to accumulate important intellectual property. An example of a smart tier 1 buyout Wipro’s buyout of U.S.-based InfoCrossing and its managed IT and hosted infrastructure expertise for about $600 million five years ago.

Another factor to consider is that smaller companies are not necessarily more vertically focused. “The assumption is that because the tier two companies are smaller, they have more niche-y vertical domain experience, but that is not the case,” Wolf said. For these companies it will be a major challenge to grow enough to stay relevant, Wolf said.

Wolf cited iGATE’s $291 million purchase of Patni Computer Systems early last year as a smart tier two acquisition. According to the MW India IT Index:

This is a synergistic combination: Patni was a high-growth innovator while iGATE was bigger yet slower moving. Together, they broke the US billion dollar revenue mark, giving the new company clout in a market where size matters.

The growing acceptance of cloud computing poses a another problem for IT services companies across the board. “These companies can help clients move to the cloud, but in most cases, that’s a one-time engagement,” Wolf said.

Still, tier one players have an advantage over smaller competitors due not only to their size, but their expertise across domains, geographic coverage and management strength.

“We think the larger guys will make it they’re very well run companies run by very tough guys who focus on the client. You should expect much larger, higher-end acquisitions and see these companies buying up meaningful IP,” Wolf said.

As for tier two, watch for consolidation to ramp up.

Feature photo courtesy of Flickr user fraboof