Reversion to Mean

The law of "Reversion to Mean" is finally getting applied to leading India-based service providers. (For those who many have forgotten, it's the statistical phenomenon stating that the greater the deviation of a random variant from its mean, the greater the probability that the next measured variant will deviate less. In other words, an extreme event is likely to be followed by a less extreme event.) Much ink and newsprint has been consumed during the last six months on speculations about the future top-line and bottom-line growth rates of these providers. We have to look further than the headwinds of the weak U.S. dollar, potential tax implications after 2009, and offshore wage pressures, to examine the future performance of these providers. The performance some of these providers have enjoyed so far is rather exceptional (and not reflective of normal business scenarios). A bunch of factors drove it: smaller scales relative to large multinational providers, highly under-penetrated market in primary service segments such as application development and maintenance, favorable tax regime in the country of operation (India), and business model affordability of growth over 35-40 percent annually with U.S.-centric demand and India-centric delivery.

All that is set to change and had to change at some point since it wasn't a sustainable level of performance. It's the "Reversion to Mean" coming into play.

It's true that the rise of the rupee, increasing wage pressures, and scheduled, or in view of lobbying, "potential" expiry of Software Technology Parks of India (STPI) tax exemptions have taken their toll on providers' market capitalization during the last 12 months. But more fundamentally, I argue that their business model must change, and this change will result in their financial performance reverting to more normal levels.

The current headwinds can be managed to a degree and will be weaker than predicated. For instance, I can't imagine the rupee strengthening more than 12 percent every year. Wage pressures didn't surface for the first time in 2007 either - we have been hearing that since 2003. Tax exemptions have been a long-time factor, which can be, at least partially, offset through the new Special Economic Zones (SEZ) scheme, while extension of the STPI scheme can't be ruled out just yet.

From the business model perspective, however, these providers are facing certain imperatives to compete for large transactions in the marketplace. It's through these they'll grow and sustain business performance as leading global providers of outsourced services. Here are some imperatives breathing down their necks:

• Spread of geographic presence for both sales and delivery
• Hire of foreign (non-Indian) nationals in greater proportion
• Compete for large deals
• Operate and have strong credentials in all service segments (Testing, Infra management, KPO, BPO, etc.)
• Invest in R&D (develop new market offerings, deliver innovation to clients)
• Delegate greater authority down the line
• Assume more risks in contracting processes
• Lose India-centricity (although they can still remain headquartered in India)

To what extent will the above impact business performance? Your guess is as good as mine. But it isn't a gloom or doom scenario. I believe these providers will continue to grow and be highly profitable relative to the industry average. They have the potential to continue to outsmart their multinational peer group simply because they are starting from the other side of the mountain to embrace the world.

Message to shareholders: Past performance is truly not indicative of the future.