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Analysis Framework for IT Services Companies

Modified on August 5, 2019

Recently, we analysed an information technology services company for providing our inputs to the analysis submitted by a reader. While analysing this IT Company, we attempted to understand this sector, along with the key parameters, which can act as an actionable framework for making investing decisions. The current article contains our learning of the key parameters to focus on while analysing an information technology services company from an investment perspective.

Regular readers of our website would remember that we have a process to learn more about companies in the industries that are new to us. The process involves reading the rating methodology used by different credit rating agencies in their analysis of companies in a sector. These rating methodology documents provide a conceptual and theoretical perceptive of a sector to an investor, which she can build upon to improve her understanding of the sector and its companies.

We have used the credit rating methodology documents of CRISIL and ICRA to understand information technology services sector and in turn, understand identify the key parameters that an investor should analyse while studying an IT company.

These parameters can act as a guide to investors for making an opinion about the companies in the Information Technology sector. However, please note that these parameters provide inputs on the business aspect of IT services companies. In order to complete her analysis of IT companies, an investor would have to study other standard aspects of any company analysis like financial analysis, business analysis, management analysis, valuation analysis, and margin of safety assessment etc.

Let us now study the key parameters, which differentiate information technology companies from each other and in turn may help investors to make good investment decisions about IT industry services companies.

 

Key Parameters for Analysis of IT Services Companies

 

1) Size of the company:

Most of the IT companies in India are service companies and not product companies. This means that most Indian IT companies help their customers by doing a part of the customers’ business for them at a cheaper cost. Majority of India IT companies have not created their own software products, which they can sell to business or individual consumers.

While thinking of an IT product, an investor may think of Microsoft Windows or Android as operating systems. These are software products, which Microsoft and Google make and sell to different computer and mobile manufacturers. In India, there are very few IT companies, which have created such IT products.

Most of the IT companies in India approach other foreign as well as other Indian companies (customers) that want to use information technology in their business to improve their products/ increase profits etc. Then the India IT companies propose different solutions to these customers. These solutions may include BPO solutions like running customers’ entire departments at a lower cost like product design department, human resource department, or customer care department etc. at a lower cost. Otherwise, the solutions may include contributing only in a part of customers’ large business operation like designing a wing/tail for an aircraft manufacturer.

Customers opt for collaborating with IT companies providing such services because Indian IT companies can provide them with an acceptable level of service at a lower cost. Taking forward the example of designing parts of an aircraft, if the customer puts her 20 employees in the USA to design it, then the cost of those employees would be higher compared to the scenario when an Indian IT company employs 20 employees in India to design that part. An investor needs to appreciate that the employees in India are as capable as employees in the USA are in terms of knowledge, efficiency, and calibre. In addition, the customers of IT companies do a rigorous assessment of these companies to satisfy themselves about their ability to do work of good quality.

An investor would appreciate that if an aircraft manufacturer wishes to lower down its cost in each of the design department/company function, then it would have to outsource a lot of work to other IT companies like the ones from India. In such a situation, if the customer has to select a different IT company to outsource each of its work, then it becomes a very cumbersome work to deal and manage multiple IT companies. As a result, most of the customers like to deal with only a few but large IT companies, which can make things easy for the customer by taking over a lot of their work in one contract.

This means that an IT company, which can provide design work, human resource work, customer care work, manufacturing work etc. presents a better option to the customer than the situation where the customer has to find many different companies to do these works.

As a result, customers prefer large IT companies, which can provide multiple solutions to small IT companies, which can provide only a handful of solutions.

An argument may say that a small IT company may provide a unique solution, which a large IT company may not have in its skills and as a result, the small IT Company will stand a good chance of getting many orders in its niche area. This is true. However, an investor should also keep in mind that the large IT companies keep on looking for such gaps in their services, which these small IT companies try to exploit. Whenever a large IT company finds such a gap in its services, then the large IT Company plugs it by either developing this new skill in house by either research & development or by hiring trained employees from outside or many times by buying out the small IT companies that have this new skill.

It is due to this continued effort of large IT companies to provide the maximum amount of solutions to their customers that the large IT companies keep on acquiring small IT companies providing unique skills/solutions. As a result, the information technology (IT) sector witnesses a large number of mergers & acquisitions.

Moreover, a large IT company can afford to keep many spare employees who can be quickly assigned to new orders/projects and in turn provide quick solutions to customers than small IT companies, which may not be able to afford a large number of spare employees all the time. The small IT companies may have to hire new employees when they win many/large contracts and this may increase the time taken by them to finish the projects.

Therefore, an investor would appreciate that a large IT company stands a higher chance of getting more business from its existing customers as well as winning new customers.

 

2) Location of employees of the IT Company i.e. Onsite-Offshore mix:

From the above discussion, an investor would appreciate that the key business proposition offered by Indian IT companies to their customers is to provide solutions of acceptable quality at a lower cost. This is because, if the price of the services quoted by the IT companies is the same what the customer gets by doing the project on its own, then the customers may not give the work to other IT company. Therefore, an investor would appreciate that the IT Company, which can provide the acceptable quality work at the lowest cost stands the best chance to win orders.

In today’s internet-connected world, it is possible to do a lot of work in India and then after completion, send it to the customers in foreign locations over the internet. This provides the biggest advantage that the IT companies can hire good employees at a comparatively lower cost in India who can provide good quality skills at a lower cost than the employees in foreign countries like the USA can. Therefore, IT companies, which can get the maximum work done in India, can provide services/solutions to their customers at the lowest costs.

However, if a customer in the USA has to choose between two companies (offering the same price for services), one of which has its employees sitting far in India (a different time zone) and the second company, which has its employees in the USA, then the customer would prefer the second company. This is because; the customers can get access to the IT Company’s employees during its own office hours and call them to its office to co-ordinate etc. The customers’ preference of dealing with IT companies, which have employees in customers’ country like the USA makes it necessary for the IT companies to have employees in USA etc. because it improves their chances of winning orders/repeat business. The offices of IT companies in foreign countries are under the name of delivery centres/sales/marketing offices etc.

From the above discussion, an investor will appreciate that dilemma faced by IT companies in terms of the countries in which they should hire their employees.

  • Having maximum employees in India (Offsite location) lowers the costs and in turn, improves the profitability of IT companies. However, it does not provide the best coordination opportunity with the client.
  • On the contrary, having maximum employees in a foreign country (Onsite location) provides good interactions with the client and in turn, increases chances for winning new/repeat orders. However, it increases the cost of IT companies because the employees in foreign countries come at a higher cost. This, in turn, lowers the profitability of the IT Company.

Therefore, most of the IT companies try to achieve a fine balance between their employee strength in India (Offsite) and the employee strength in a foreign country (Onsite).

However, an investor would appreciate that an IT company having most of the employees in India (Offsite) will have higher profitability than the IT company having most of its employees in a foreign country (Onsite). However, the investor would also appreciate that the company with most of the employees “Onsite (like the USA)” will have higher growth opportunities that the IT company with maximum employees “Offsite (in India)” as the company will higher onsite presence will have higher chances of winning new/repeat orders.

Let’s look at the below example of an Indian IT company, Cyient Ltd, which witnessed a steep decline in its profit margins in FY2011 when its net profit margin (NPM) declined from 17% in FY2010 to 11% in FY2011. (FY2011 annual report, page 103):

Cyient Ltd Decrease In Profits In FY2011

While analysing the reasons for the decline in the profits, an investor notices that employee costs of Cyient Ltd had increased sharply in FY2011 to 61% of its total revenue from 54% in FY2010. Upon further analysis of the FY2011 annual report, an investor notices that in FY2011, the company had a sharp jump in its onsite work (employees based in a foreign country).

FY2011 annual report, page 31:

Cyient Ltd Onsite Offshore Mix 2010 2011

Looking at the above table, an investor would appreciate that in FY2011, the share of onsite work (i.e. employees working in foreign location) increased sharply to 51% from 44% in FY2010. As discussed above, an investor understands that a higher number of employees in a foreign country (onsite location) means higher employee costs and lower profit margins.

Therefore, an investor would appreciate that the IT companies with a higher number of employees in India (offshore location) will have higher profits but lower growth opportunities whereas the companies with more employees in foreign countries (onsite location) will have lower profits but higher growth opportunities.

You may read the complete analysis of Cyient Ltd here: Analyiss: Cyient Ltd

 

3) Nature of Business Contracts: Time & material contracts vs. Fixed price contracts:

In the IT sector, companies usually get their order in one of the two forms.

a) Time & material contract:

In these contracts, the customer pays the IT Company based on the amount of time taken to complete the project and the amount of material (number of employees) used to complete the project. It means that the IT Company charges the customer based on the number of employee hours consumed to complete the project.

An investor would appreciate that in Time & material contract, the IT Company will always charge the customers a premium over what it costs to hire & train the employees and make them work on the customer’s project. There is very little possibility of the IT Company making a loss in time & material contracts.

 

b) Fixed price contract:

In a fixed-price contract, the customer assigns a value to the work to be done by the IT Company as a project. After giving the order to the IT Company, the customer is not concerned about how many employees the IT Company has employed to complete the work. In fixed price contracts, the customer is concerned with the quality of the work and the timeline for completion of the work.

In case of a fixed-price contract, the IT Company can manage resources at its end to get more work done by employing efficient workers and other cost-cutting measures to complete the work at the lowest cost and in turn, make maximum profit from the contract. However, if due to any reason, the IT Company is not able to complete the work in a given time or the most efficient employees leave the company, then it may have to bear a loss as well. This is because the customer may not pay the IT Company for failure to give acceptable quality work within the promised time.

Looking at the above discussion of time & material contracts and fixed price contracts, an investor would appreciate that the time & material contracts are low risk, safe contracts. As a result, the customers also negotiate hard on the pricing of time & material contracts and the IT companies that primarily rely on time & material contracts usually have lower profitability.

On the contrary, in fixed-price contracts, the IT companies have the scope of lowering their costs by improving efficiency and in turn, enjoy higher profits. However, such higher profits come with a risk of making losses as well in the case; the IT Company is not able to deliver acceptable quality of work within the promised time.

The IT companies provide a breakup of the nature of their business contracts in terms of time & material contracts and fixed-price contracts in their annual report. E.g. Cyient Ltd has provided this breakup in its FY2019 annual report, page 214:

Cyient Ltd Time And Material And Fixed Price Contract Breakup 2019

 

4) Mergers and Acquisitions:

From the above discussion on the scale of the IT companies, an investor would remember that the large IT companies enjoy an advantage over smaller IT companies in winning new/repeat orders because a large IT Company can provide solutions of multiple business problems to the customer.

In order to strengthen their advantage further, the IT companies are continuously on a lookout for skills, which can further improve their value addition to customers. Whenever, IT companies come across a small IT company, which has mastered a unique technology/skill, which the large IT companies can provide as an added solution to their clients, then many times, the large IT companies acquire the small IT company with unique skill/technology. This addition of new skill helps the large IT Company in providing new/better solutions to its existing clients as well as win new orders. IT companies also acquire other companies to gain access to the customers of these companies.

Therefore, an investor would appreciate that established IT companies keep on acquiring new small companies on a continuous basis. Many times, large IT companies may acquire many small companies within one year.

However, an investor would also appreciate that along with the advantage of better business opportunities, a high merger & acquisition activity opens the door for malpractices like syphoning of money by marking up the price of acquisition or accounting juggleries where accounting frauds go undetected for many years under the cover of complex merger accounting.

In the recent times, an investor would remember the case of one such acquisition by a large IT company when Infosys Ltd acquired a small Israeli IT company, Panaya for ₹200 million in 2015 (Source: Infosys).

  • At that time, Vishal Sikka, CEO of Infosys said:

“The acquisition of Panaya is a key step in renewing and differentiating our service lines. This will help amplify the potential of our people, freeing us from the drudgery of many repetitive tasks, so we may focus more on the important, strategic challenges faced by our clients. At the same time, Panaya’s proven technology helps dramatically simplify the costs and complexities faced by businesses in managing their enterprise application landscapes.”

Therefore, while analysing companies in the information technology (IT) sector, an investor should be prepared to witness a lot of mergers & acquisitions, which may prove valuable to the business in terms of new skills and customers. However, these mergers & acquisitions also bring with them the possibility of misdeeds by management by syphoning off the money by the overvaluation of acquisition as well as covering up accounting frauds in complex merger accounting.

Further advised reading: 7 Signs to tell whether a Company is cooking its Books: “Financial Shenanigans”

 

5) Productivity: Revenue and profit per employee, utilization level of employees, attrition levels:

An investor would appreciate that business of IT companies is very people-centric and is not based on the amount of fixed assets (plant & machinery) owned by these companies. The employees are the main sources of productivity and therefore, efficient management of employees is one of the most essential activities for any IT Company.

In the case of IT companies, the following parameters take significance:

  1. Revenue and profit per employee
  2. Utilization level of employees
  3. Attrition level of employees

Companies disclose these parameters in different public disclosures like annual reports, investor presentations etc. Let us take an example of Cyient Ltd.

 

a) Revenue and profit per employee:

FY2010 annual report, page 30:

Cyient Ltd Revenue And Profit Per Employee 2006 2010

 

b) Utilization level of employees:

At any point in time, an IT Company has employees who are involved in project work for the customers as well as those employees who are currently not working for any customer project. The employees who are currently not working on any customer project form the “Bench” strength. These employees are available as a readily available resource, which the company can quickly deploy on any project and in turn provide a quick solution to customers.

If an IT Company does not have spare employees on bench, then it may face a situation that the company has won a new project but it is not able to commence it on time, as it does not have ready skilled employees to initiate the project. The company may have to hire new employees and train them for a specific project, which will take time and delay the project completion. This situation also holds true in cases where an existing project suddenly demands more resources or many employees from an existing project leave the company.

Therefore, to provide optimal work speed to the customer, an IT Company needs to have spare employees on “bench”.

However, an investor would also appreciate that spare employees who are not working on any customer project are a cost to the company, which is currently not earning any revenue. This is because the IT Company has to pay salaries to these spare employees irrespective of the fact that they are currently not working on any customer project.

Therefore, all IT companies attempt to reduce the number of spare employees on “bench” so that it may save on costs whereas having sufficient spare employees so that they do not run the risk of timely completion of existing projects and quick initiation of new projects.

Therefore, the IT companies have to maintain a fine balance between the number of employees working on customer projects and the number of spare employees on “Bench” so that they may provide best services to their customers at the lowest cost.

The utilization ratio is the total number of employees/employee hours of the IT Company, which worked on customer projects during any period. IT companies disclose this information in their public disclosures. E.g. Cyient Ltd, investor’s presentation dated April 25, 2019, page 42:

Cyient Ltd Utilization Level FY2019

 

c) Attrition level of employees:

An investor would appreciate that an IT Company is highly dependent on its employees as a departure of any key resource/skilled employee may put a customer project in jeopardy and it may take some time for the company to find a replacement for the key employee. Moreover, hiring a new employee and training her to meet expected skill levels may involve additional cost and time, which will hurt the customer project in terms of cost and timeliness of completion.

Therefore, it is essential that an IT Company keep its attrition level at a low level. IT companies provide the attrition levels of their employees in their public disclosures. E.g. Cyient Ltd, investor’s presentation dated April 25, 2019, page 43:

Cyient Ltd Employee Attrition Level FY2019

Monitoring employee productivity in terms of revenue & profits per employee as well as utilization and attrition levels is essential in cases of IT Companies because any disruption at employee level can cause a delay in completion of customer projects, which apart from monetary loss also hurts the reputation of the company. It also has an impact on the chances of winning new/repeat business for IT companies.

We may see an example of Cyient Ltd, which lost revenue opportunities in FY2019 primarily due to attrition and inability to find required talent in its remaining employees. Cyient Ltd, April 25, 2019 conference call, page 10-11:

Cyient Ltd Revenue Lost Due To Attrition In FY2019

Therefore, an investor would appreciate that employee management is one of the most critical aspects of an IT Company.

 

6) Percentage of repeat revenue:

The business model of IT companies is to provide acceptable levels of business solutions to the customers at a low cost. Therefore, a customer usually sticks to an IT Company until the time the solution/service provided by the IT Company is at an acceptable cost and quality.

Due to the highly competitive nature of the information technology services industry, the customer will continuously get a business proposal from other competing IT companies. If the price charged by an IT Company to its existing customers turns out to be higher than the market price, and the customer finds value in the new proposals after factoring in the switching costs from IT Company to another IT Company, then the customer will shift to the new IT Company to save on costs.

In the light of intense competition, if an IT Company is able to get repeat orders from its existing customers, then it indicates that the services provided by the IT Company to its customers are of acceptable quality and at an acceptable price. Moreover, for the IT Company, it is easier and cost effective to get repeat orders/new projects from existing customers than finding new customers.

Therefore, the IT companies, which have high repeat revenues from existing customers, usually have a strength in their business model and a competitive advantage over their peers.

IT companies disclose the amount of repeat revenue i.e. revenue from existing customers in various public disclosures. E.g. Cyient Ltd, FY2012 annual report, page 13:

Cyient Ltd Repeat Revenue FY2012

 

7) Foreign exchange risk management:

Indian IT companies earn most of their revenue from customers located outside India. They earn this revenue in currencies like the US Dollar, the Euro etc. In such cases, the impact of the movement of Indian Rupee against foreign currencies may play a major factor in increasing or decreasing the earnings of the IT Company in Indian Rupees even if the IT Company has earned same revenue in US Dollars or Euro.

Let us take an example of Cyient Ltd, which grew its revenues by about 18% in FY2014. However, when an investor does a deeper analysis, then she realises that out of 18% growth, about 12% is only due to Rupee depreciation. Cyient Ltd, FY2014 annual report, page 82:

Cyient Ltd Rupee Depreciation Revenue Growth FY2014

Looking at the above table, an investor may feel happy that the company has benefited a lot due to rupee depreciation against foreign currencies. However, an investor will appreciate that if an IT Company does not have a good and effective foreign exchange hedging policy, then it can easily lose significant money in case of rupee appreciation against foreign currencies.

 

8) Geographical and business segment diversification:

Like any other industry, diversification of revenue in terms of different countries/markets as well as different customer industries helps an IT Company to survive a downturn in any particular geography/country or industry.

After the above discussion, an investor would appreciate that the following parameters form a key aspect of analysing the business of an IT services company:

  1. Size of the company
  2. Onsite-offshore mix of employees
  3. Nature of business contracts: time & material vs. fixed price contracts
  4. Mergers & acquisitions
  5. Productivity parameters like revenue & profits per employee, utilization level of employees and attrition levels
  6. Percentage of repeat revenue
  7. Foreign exchange risk management
  8. Geographical and business diversification

If your wish to learn further by reading analysis of some of the IT companies, then you may read the following articles:

An investor has to note that the above parameters provide a glimpse into the strength of the business model of an IT services company. To complete the analysis of the IT Company, an investor to analyse additional parameters like:

Once an investor has done her analysis on all these above parameters, then she would be able to make a reasonably good investment decision about an IT services company.

Further advised reading: Selecting Best Shares to Buy for Beginners and Retail Investors

 

Your Turn:

Please share your experience of analysing and investing in information technology (IT) companies. What are the parameters that you look for in an IT Company? Do you have a different opinion on the parameters mentioned above? You may share your opinion and inputs in the comments section below.

 

P.S.

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above

 

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