Indian IT is facing its biggest challenge in years

September 29, 2011, 7:09 PM UTC

By Vishesh Kumar, contributor

FORTUNE — Y2K wasn’t all bad. The millennial hysteria surrounding the dreaded glitch pushed the Indian IT industry onto the world stage, its armies of low-cost technical labor ideally suited to checking endless lines of potentially bad code. Giants Infosys, Wipro and Cognizant took the boost and, over the next decade, cemented their positions as go-to service providers for companies around the world. The industry saw export revenue climb roughly tenfold to an expected $68 billion in the coming year. Infosys even sparked Thomas Friedman’s influential “flat world” argument.

But now, the industry finds itself fast approaching another crucial juncture, possibly its most significant in more than a decade. Indian wage inflation is the highest in Asia; salaries have posted double-digit gains over much of the last decade. Increasing competition from low-wage countries like the Philippines, Eastern Europe and Latin America is putting more pressure on pricing. At the same time, expensive and complex software deployments are quickly losing ground to lighter, far less lucrative models. Setting up (CRM), for example, doesn’t bring in what a Siebel implementation from Oracle (ORCL) would. Simply put, the industry faces changes similar to the ones it helped launch a decade ago.

The current services-based model is likely to keep losing appeal as margins crumble and logistics become increasingly complex. Infosys (INFY), for example, would have to quintuple recruiting to 100,000 new employees a year within five years to sustain current growth rates, according to William Blair & Co. analyst Bhavan Suri. “Recruiting, training and managing this many people is an incredibly hard and almost unmanageable task,” Suri says.

In order to evade the coming crunch, the industry is pinning its hopes on being able to tack from services to products. The jump will be difficult and there are few results to show so far. As far as products are concerned, it has two options: build them or buy them.

Developing traditional products that allow companies to grow revenue without bringing in and renting out new headcount is quickly becoming the goal for the industry. Getting to this “non-linearity” of revenue would be akin to the fountain of youth, according to Nabil Elsheshai, an analyst at Pacific Securities. That companies with services cultures will flourish in creating products is questionable, though. Infosys’ banking application Finacle is one standout.
There have been some niche applications too, like a Wipro (WIT) wireless device that can be used to monitor patients remotely even over older networks, an example of a product created in conjunction with an existing client. Aside from these, however, examples are few and far between.

Buying could trump building from scratch. A vast stockpile of cash helps; Infosys, Wipro and Cognizant (CTSH) have amassed $8.6 billion between them. What’s more, cash accounts for about 12% of the total market cap for all three, rivaling the proportion of US internet companies like Yahoo (YHOO) and eBay (EBAY). Indian companies have signaled a willingness to buy overseas before. But the appetite for bigger deals may be on the rise.

Last week, the CEO of Tata Consulting Services said the company was looking to make purchases around the world. But it’s the increased aggressiveness on the part of Infosys that could prove more noteworthy. Seen as gun-shy for having lost deals to more aggressive competitors before, the company’s recently appointed chairman previously ran India’s biggest private bank — a good background for deal-making. Indeed, reports swirled earlier in the month that Infosys was close to buying the healthcare arm of Thomson Reuters (TRI) for as much as $750 million. On Friday, the company was also cited as a potential acquirer for business analytics company Core Logic.

What’s missing? Concrete action. The Indian IT industry has been facing fundamental changes for years. Now, rumors and speculation are swirling more than usual, as the industry’s cash hoard puts it in a position to make bold bets. So far, few such bets have been placed. A wave of big acquisitions could indeed mark the turning point, much the way Y2K did many years ago.