As IT firms prepare for their potentially worst financial quarter in almost a decade, the controversies that Infosys, TCS and Cognizant are undergoing also emphasise the difficulties in turning around legacy business models.

New Delhi: Software services firm Cognizant, along with most of its peers in the broader Indian IT industry, hasn’t had a particularly great business year.

The New Jersey-based firm — which has four out of every five of its employees deployed in India — has downgraded its revenue forecast two times since January, starting from “between 10% and 14%” to “at-best 13%” and finally “around 8.5-9.5%”.

The company’s 2016 revenue forecast is not only sharply down from its growth last year (when it clocked a cool 15%), but is also its slowest pace of growth since 1997; which is when Cognizant as we know it today officially came into existence.

Adding to this is a potential scandal in the making. Two weeks ago, in an early morning Nasdaq notification, Cognizant announced that it had commenced an internal probe into whether “certain payments relating to facilities in India were made improperly and in possible violation of the US Foreign Corrupt Practices Act”.

The market’s reaction was swift: Cognizant’s shares closed down a little over 13% on the day of the stock exchange notification, wiping out nearly $4.5 billion off the company’s market value. Shareholder reaction was equally swift and similarly punishing, with a class-action lawsuit being filed against the company last week.

Cognizant, however, isn’t alone. Rivals Infosys and TCS have their own controversies they are grappling with — one stemming from a massive lawsuit over possible trade secret and IP violations and the other from a crisis of leadership.

Both Infosys and TCS have also slashed their own growth projections for this year. TCS in particular ended up backpedalling after announcing at first that there was nothing to worry, but then later expressing concern over demand from the BFSI sector, a massive vertical for most Indian IT companies.

“The stage is now set for what could be the worst second quarter performance in almost a decade. Revenues of the top five large cap companies are expected to grow by around 1.5% quarter on quarter. Consequently, Nasscom is likely to cut its 10-12% constant currency industry growth target as well, which it has been holding onto stubbornly,” the head of a large Mumbai-based brokerage, who declined to be identified, told The Wire.

What’s going wrong?

When financial headwinds have hit the IT industry in the past, CEOs trot out the usual suspects. Softening sectoral specific-demand, US elections, global protectionism, a particularly nasty dollar-rupee exchange rate and often whatever is the latest geo-economic event that could threaten business.

This time around, some of these factors are in play, although most of them haven’t had significant impact. BFSI (banking, financial services and insurance) sector clients are indeed pulling back on discretionary spending. The run-up to the US election has had Congress focusing (mostly unsuccessfully) on plugging H1B visa loopholes. Brexit is turning out be a minor spoilsport.

“Cyclical and seasonal factors like that are always taken into account at the CFO level and are seen as something that passes eventually. More fundamentally though, what is happening right now is that IT firms are being hit at both ends by the general reducing of their traditional bread-and-butter business and an inability to capture meaningful digital business,” a senior executive of blue-chip IT firm, who declined to be identified, told The Wire.

Digital business growth

Multiple analysts and executives across the IT industry The Wire spoke to offered up numerous examples of this two-punch blow.

Two months ago, a top Indian IT firm ran into an increasingly common situation with a 10-year old European client. The client, a healthcare retailer, originally had a 20 million euro contract with the IT firm, which was due for renewal. Past business had included setting up a modified ERP and some typical maintenance work over a five-year period.

“Very little of that past business was obviously up for renewal. Essentially, no more 20 million euro contracts. Some legacy work was there, but the digital business that the IT firm was able to win was a contract worth less and had to be executed within a much shorter time-frame,” a person with direct knowledge of the matter said.

What the Indian IT firm was able to salvage from that client was a 18-month contract for low-end data analytics, shifting some applications onto the cloud and making a number of applications mobile-ready — but only for around 4 million euros. On one hand, therefore, traditional business is reduced and on the other hand the fancy new ‘digital’ or ‘SMAC’ (social media, analytics, cloud) business that Indian IT firms usually end up getting aren’t enough to offset the loss in traditional business.

New digital business, however, isn’t low-margin by any means. Indian IT companies are just struggling to win the kind of high-margin digital business that a company like Accenture normally would win and execute. While Infosys, TCS and Cognizant can easily win smaller contracts and low-end digital work, selling their own technology platforms are proving to be a much more difficult task.

As one analysis of the issue put it, while the average revenue per employee in TCS’ digital business stood at $48,780 in FY’15, which was on part with the revenue per employee from the firm’s traditional business verticals, the revenue per employee in Accenture Digital (the firm’s digital business vertical) was $214,286.

Quite simply, India’s IT firms are still working their way up the value chain even as they increasingly lose out on business (traditional and digital) from their top clients. For example, while Wipro’s quarterly revenue has increased by 6% over the last two years, the firm’s top clients have done less business with the company.

Controversies and Scandals – Cognizant

What doesn’t help are the various controversies the top three IT firms are going through. Ironically, all three of these embarrassingly public issues highlight the various aspects of Indian IT’s old business models and the difficulties in orienting towards the future.

Take Cognizant. The fall-out of its internal bribery probe has been particularly nasty. A day before it was officially announced, company president Gordon Coburn stepped down, although there has been no confirmation (official or otherwise) as to whether his resignation has anything to do with the probe.

According to multiple people with direct knowledge of the matter, teams of lawyers have arrived at Cognizant’s Chennai offices over the last month and are investigating the various land deals that company officials struck in order to open its massive outsourcing centres across Tamil Nadu. These development centres have over the last decade supported the company’s headcount-driven business strategy; a strategy that will almost certainly no longer hold true for Cognizant and the broader IT industry the coming decade.

“In the days after the notification was given, we have been instructed not to provide any information to the media or members of the investment community regarding the probe into improper payments. Basically it’s a gag order,” a senior Cognizant employee told The Wire, on condition of anonymity.

A Times of India report points to allegations made in the past that the firm bribed various political parties to get the land needed for its outsourcing centres, although this could not be independently confirmed.

Putting aside the legal, financial and ethical issues associated with this alleged scandal, it is more than a little amusing that Cognizant is grappling with a crisis that is no longer wholly aligned with its future business model. The search for higher-margin digital business, cloud computing and automation platforms are all putting a wet blanket over the large-scale hiring that IT firms are best known for.

In the next five-to-ten years, the quest to secure more and more land to build new outsourcing centres in tax-free zones will likely be seen as a relic of the past.

TCS intellectual property lawsuit

If Cognizant is struggling with its past, the latest controversy to hit TCS has everything to do with its future. As The Wire reported and analysed, earlier this year, the IT firm lost a Rs. 6,000 crore lawsuit over allegations of intellectual property infringement and potential violations of data confidentiality.

Unlike other high-tech corporate espionage cases, the TCS-Kaiser incident mostly revolved around simple aspects of IP and data confidentiality: the company suing TCS alleged that Internet access wasn’t restricted in client-specific development centres, creative workarounds were constructed to ignore intellectual property agreements, and trivial issues that are nearly almost taken for granted (such as ensuring proper user authorisation) were ignored.

As market analyst Deepak Shenoy noted at the time, TCS’ defense primarily boiled down to “okay we downloaded documents, but we didn’t misuse them, so don’t fine us much”. “This isn’t defensible — the reason those documents were confidential were that TCS shouldn’t have access to them even to read them and get ideas about their competitive projects,” Shenoy wrote.

The lesson to be drawn from this, however, is that if TCS and other Indian IT firms want to transform themselves and chase high-margin digital business, they need to adopt stricter standards for themselves.

“Breaking confidentiality and IP agreements can’t be seen simply as a cost of doing business or a means of creating higher internal capabilities, the way many Indian firms currently are doing. If they want to move up the chain, and as they create their own technology platforms, they need to shed earlier business practices that might have worked for them,” said a senior IT analyst, who had discussions with TCS over the possible ramifications of the lawsuit.

Infosys leadership crisis?

Infosys’ demons, like Cognizant and TCS, are internal. Vishal Sikka, the first outside CEO to be appointed, has struggled with the wishes and desires of the company’s founders. The company’s senior leadership has seen much churning over the last eighteen months, and Sikka has publicly stated that he is unhappy with company’s execution and inability to quickly shift towards an innovation-led business strategy.

In remarks to a group of Pune-based market analysts earlier this year, Sikka pointed out that the conversations that Infosys had been having with clients were still not “strategic, not very high level”. “We, by and large, are an industry of procurement. IT-oriented kinds of conversations are largely RFP-driven (request for proposal), cost-driven and so on,” Sikka was reported to have said.

Other incidents have also distracted: the lingering influence of Narayana Murthy and other company founders, the curious severance package paid to previous CFO Rajiv Bansal and the question of whether Infosys’ promoters thought Sikka’s compensation was too high.

The company’s digital business contributes around 8-10% of its overall business, at last count. It has however refused to provide analysts or the stock market with how much if makes from specific areas such as cloud or data analytics.

Orienting towards digital future

None of these controversies, however, get to the crux of the matter: India’s IT Industry is struggling to bring about a digital business transformation and this year’s projected high one-digit growth reflects that.

It is unlikely that this transformation — as companies double down on automation and creating and marketing their own intellectual property — will be bloodless. Large-scale hiring will be a thing of the past and poorly performing middle-managers that might have earlier skated by will be replaced by automated bots.

On the other hand, the transformation will also create opportunities for India’s start-up ecosystem, who larger IT firms will look to for partnerships. Generally high-skilled talent, PhDs included, will also be in far more demand. If the last two years have shown how difficult it has been for the Indian IT industry shed its legacy business model, the next two years will determine how long it will be for IT sector’s icons to return to high double-digit growth.