A brief Checklist to analyze IT stocks – Part 2

After covering a few factors in the previous blog, we now move forward in analyzing the other factors that an investor should look upon while selecting an IT stock to invest in. These factors would serve as a checklist to an investor. But before moving forward please read the first part to get a better insight about the reasearch.

Please click on the link to read the first part

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

So in IT sector, the companies get contracts in two forms:

a. Time and Material contract:

Now, in these types of contracts, the client pays the IT company based on the amount of time taken and resources consumed (number of employees) in order to complete the project. In this scenario, the IT Company charges the client based on the number of employee hours consumed to complete the project.   

In such contracts, the IT company charges a premium over what it costs to hire & train the employees and make them work on the client’s project. There is very minimal possibility of the IT Company making a loss in time & material contracts.   

b. Fixed price contract:

In a fixed price contract, the client pays a fixed amount for the completion of the project. It is not concerned about how many employees the IT Company has employed to complete the work but only worried about the quality of the work and timeline for the completion of the project. 

Now the company can do a lot of cost cutting in this contract by assigning such a project to highly efficient and skilled employees and make a maximum profit of it. However, if due to any reason, the IT company is not able to deliver the project in given time or the most efficient employees leave the company then it might even bear the loss as the client will not make the payment due to failure of timely delivery of project. 

So, it makes sense for an investor to look for companies having a mix of both types of contracts. Doing time & material contracts as these are low risk safe contracts but the clients also negotiate hard on the pricing of such contracts and the IT companies that primarily rely on time & material contracts usually have lower profitability. While fixed price contracts have higher risk of failure, IT companies have the scope of lowering their costs by improving efficiency and in turn, enjoy higher profits.  

The above table represents the segregation of fixed and time & material contracts of HCL Technologies. One can witness that the company is highly focused more on Fixed price contracts and as a result of which the Revenue per employee metric is quite higher for this company compared to others.  

5. Percentage of Repeat Revenue:

A client usually sticks to the IT company until the services provided by the company are at an acceptable cost than the market and of premium quality. You see, IT industry is a highly competitive sector and a certain client will continuously get business proposals from other competing IT companies at a lower cost and if the price charged by the current IT Company to its existing clients turns out to be higher than the market price, and the client finds value in the new proposals after factoring in the switching costs from IT Company to another IT Company, then the client will shift to the new IT Company to save on costs. 

Thus if in such a competitive environment, a certain IT company is able to get its repeat revenue from its existing clients then that means the services provided by the company are of acceptable quality, cost effective and usually such companies hold a certain competitive advantage over other companies due to their strong business model. Moreover, for the IT Company, it is easier and cost-effective to get repeat orders/new projects from existing customers than to find new customers.   

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:

6. Other factors:

a. Forex movement  change:

As Indian IT companies are heavily reliant on foreign countries for their business and thus they earn in dollars, euros, etc. In such cases, the impact of the movement of the 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 the same revenue in US Dollars or Euro.  

However, 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. This happened a lot after the pandemic was over and the world economy was stabilizing while India was battling with the second wave of COVID. So, as an investor do look out for the hedging policy of the company.

b. Industry focus:

Major IT companies have their clients from specific industries which becomes their strength and niche in some time. Often to gauge whether the IT company would multiply your wealth, you must check the growth in the end industry where the major clients are. For example: From the past few decades, HCL has had its major clients in the life sciences and healthcare industry. In fact, ten of the top twenty pharmaceutical companies and seven leading medical devices firms are their clients and this is the reason why the stock of HCL rallied more than 200% from the dip in COVID (April 2020) to Sept 2021.

Similarly, Mindtree attains 43% of its revenues from Communication, media and Technology followed by 24% from Retail and manufacturing. TCS has developed a core banking software suit by the name of Bancs which is used by major banks like Goldman Sachs, UBS, JP Morgan and others. This is why you would realize their major revenues coming from the banking sector (39.2%) followed by Communication, Media and Technology (16.6%).

c. CFO to Net income:

Maybe, just like other kids you might know how to become an astronaut but if you are a student of finance then you surely know the importance of Cash flow from Operations. Well, the CFO is critical in meeting the cash outflows in the day-to-day activities of a firm. A firm should have a positive figure for the CFO to get the attention of the investors. Now, this ratio is otherwise known as the quality of earnings ratio and is computed by dividing CFO by Profit After Tax (PAT or Net Income) of a firm. If the ratio is less than one it’s a Red flag, which usually means working capital needs are on the rise or all the profit the company is making is being used to meet rising working capital needs. As a result, again the higher the ratio, the better it gets for the company. Ideally, this ratio should be greater than 0.8. Let’s analyze the metric for some companies:

Conclusion:

If COVID has taught has one thing about capital market then its surely the timely entry and exit in the market and some sectors will always make money, no matter what the scenario is. Banking and FMCG are counted among the defensive sectors which will never stop because people will never stop buying essential items and surely are not gonna keep money in cash. But these sectors wont yield you out of the box returns though IT is one such sector that will never disappoint you in the long run. After witnessing the learnings from previous part, we moved forward in gauging other factors and found that companies with fixed price contract can make a lot of money by effective cost cutting and what repeat revenue tells about the robustness of the business model of a certain company. We further gauged an insight how and why hedging against the forex movement is necessary and how CFO to net income can tell you a lot about an IT company. Though one should look at other metrics as well that includes ROE & ROCE growth over the years with Revenue and net profit growth.

Hope you enjoyed the analysis and are on the road to select your next multibagger in the IT sector !!