The IT industry has been a cornerstone of India’s economic growth, contributing 7.4% to the country’s GDP. However, the Q4 results of major companies like Infosys have caused investors to question the short-term prospects of the sector. While the concerns are valid, it's important to look beyond just the bottom line. In this article, we'll explore the key metrics that investors should focus on to analyse IT stocks so that they can make informed investment decisions.
What’s the business model of IT companies?
Indian IT companies primarily provide services to foreign clients, who outsource their IT needs to Indian firms for high-quality services at a lower cost. For instance, TCS provides software to streamline operations and customer support for airlines. While Indian IT firms typically do not create and sell software like Microsoft or Google, they are known for their expertise in software services, IT consulting, and business process outsourcing.
The top five parameters to analyse IT service companies
IT companies have two forms of revenue contracts: Time & Material and Fixed Price.
In Time and Material contracts, clients are charged based on employee hours, whereas in Fixed Price contracts, a set value for the project is determined by the client.
Time and Material contracts are low-risk but have lower profitability, while Fixed Price contracts offer higher profits but come with the risk of making losses if the work isn't completed in time or is of lower quality. A healthy mix of both is ideal for revenue diversification.
For instance, in FY22, Oracle Financial Software Services had 56% Fixed Price contracts and 44% Time and Material contracts which indicated a healthy balance.
Mergers and acquisitions
In the IT sector, established companies frequently acquire smaller ones to add more clients, enhance capabilities, and expand their presence in different sectors. Assessing the impact of an acquisition can help investors understand the company’s future growth potential.
For instance, LTI acquired Mindtree, which caters to different industries with minimal client overlap, enabling LTI to add new clients. In contrast, Infosys acquired Panaya, which was marred by corporate governance issues, leading to the acquired company being put up for sale.
Utilisation (% of employees assigned to a project) and attrition (% exiting firm) are crucial for IT companies as employees are their biggest asset and cost. High utilisation and low attrition rates are ideal. For instance, Infosys Q4 2023 Report reveals an employee attrition rate of 20.9%, a significant improvement from the previous quarter’s 24%.
Segment and regional diversification
IT firms have to diversify across countries and industries to survive regional or industry downturns. For example, TCS's Annual Report 2022 highlights it generates 52% of its revenue from the Americas region and 32.2% of its revenue comes from the BFSI sector (banking, financial services and insurance). Since it has exposure to US financial sector, the recent banking crisis could impact the company’s revenue. However, this will be <1% because TCS is well-diversified.
IT companies' revenue in rupee terms is negatively affected by the appreciation of the rupee against major foreign currencies, especially if they have a poor foreign exchange hedging policy. A 1% change in USD/INR rate could impact IT companies’ Earnings Before Interest/Tax (EBIT) by 20-30 basis points.
Besides the above, IT companies are impacted by the global macro environment as their revenue is mainly generated outside India. For instance, global events like COVID-19 can disrupt client businesses, causing a reduction in overall spending, including IT spends. In the current context, many IT companies that are heavily reliant on the US market are suffering as the US economy is experiencing a slowdown.
In a nutshell
In conclusion, while the Q4 results of major IT companies have caused concerns about the short-term prospects of the sector, it's important to consider the bigger picture. The Indian IT industry has been a key contributor to the country’s economic growth for several decades, and its importance is unlikely to wane anytime soon. The long-term outlook for the Indian IT industry remains positive, and with the right approach, investors can benefit from the opportunities it presents.
Naveen KR is smallcase manager, Senior Director - Investment Products, Windmill Capital.
Disclaimer: The content in this article is purely the author’s personal opinion and is for informational and educational purposes only. It should not be construed as professional financial advice and nor be construed as an offer to buy/sell or the solicitation of an offer to buy / sell any security or financial products.
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