Non-linear revenues have emerged as a new focus area and talking point with large Indian IT vendors. Non-linear revenues account for only ~8% of revenues currently for large IT companies. Over the next 5-7 years, though, large IT companies expect them to account for as much as 30-35% of revenues. Infosys appears most convinced about the road ahead for new engagement models (NEMs). Wipro and TCS have them on their radar, but smaller vendors are dismissive. Our sense is that Infosys has invested over two-three years of senior management effort in developing NEMs and has the most concrete road map in this area.

What is meant by non-linearity? Non-linearity implies that revenues from products, platforms and solutions are linked to usage/savings by clients rather than the efforts deployed to provide these services. Indian IT-BPO companies earn non-linear revenues primarily from products (for TCS and Infosys), platform-based BPO services (WNS, Genpact), and infrastructure services (HCLT, Wipro). These services account for 15-20% of total revenues for IT companies as of now but only a fraction of the above services currently use non-linear models.

Implications for financials

Non-linear pricing models result in higher revenue productivity per employee and improved margins for companies. For example, Infosys? revenue per employee for its products business in FY09 is ~70% higher than the company average. We believe that for a 5% shift to non-linear revenues, the EBIT margin gain could be 90-110 bps, assuming companies make a 45-50% EBIT margin on their non-linear part of revenues in a steady state.

Models (NEMs) have emerged as the new focus area for Indian IT companies. Traditionally Indian IT companies have been pricing services based on time and material (T&M) and fixed price (FP). However, the non-linear pricing models are now being used to price services based on the value delivered from them to the users rather than headcount deployed.

A case for delinking

Under the traditional pricing models, revenues for Indian IT companies have so far grown with corresponding growth in employee strength. Over the years, this has effectively led to IT vendors selling more headcount to clients in order to increase revenues. We believe the effort-based pricing model offers little incentive for IT vendors either to lower resource usage or to improve productivity of their employees.

Non-linear revenue models aim to link clients? expenses to their business outcomes, making it a variable cost for them. At the same time, these models help lower the dependence of IT companies on increasing headcount in line with the expected revenue growth. The shift in focus to non-linear models appears to be a ?win-win?, as they create an incentive for higher productivity and more efficient use of resources.

Outlook

Large IT companies believe that non-linear revenues could account for as much as 30-35% of their total revenues over the next five-seven years. Currently, non-linear revenues account for ~8% of revenues for large IT companies. Managements of Infosys and Wipro aim to scale it up to 33% and 15%, respectively over the coming years. We believe this proportion could increase to 15-20% of revenues over the next three years for large IT companies. The margin benefit from non-linear revenues for large vendors could be ~90-110 bps.

We believe a mere 5% shift of overall revenues to non-linear revenues that have higher EBIT margins of ~50% vs company average of 24-30% can add 90-110 bps to the overall company margins. In our analysis, for similar improvement in non-linear revenues and margins, Wipro appears to have the least impact on its overall business as IT services form only ~70% of total revenues. On the other hand, TCS appears to have the highest percentage impact on margins.

Broadly, all companies have a margin gain of ~1% for every 5% move to non-linear revenues, assuming they are able to generate ~50% EBIT margins on the non-linear revenues. Wipro seeks to achieve ~15% of revenues from non-linear pricing modes in 12-18 months while Infosys targets 33% over the next five-seven years.