A brief Checklist to analyze IT stocks – Part 1

Let me start by spitting out a few facts: According to the Hurun’s report, the IT sector has made 73 billionaires in India and multiple millionaires. And if not by owning an IT company then by just holding some stocks of it, many people have multiplied their wealth. Indeed, Nifty IT index has delivered more than 1800% returns since its inception whereas Sensex has delivered returns of 1100% during the same period.

Not only this but if someone would have invested 10,000 rupees during the inception of Infosys in 1999, the same amount today would have been more than more than a whopping 12 Lakhs rupees. 

Now, I am sure you might hear stories like these every now and then but the key learning is that one should not ponder over the past rather we should look at the future by improvising the present. Even today you can find such companies that can ten fold your investment amounts. This article will help you unveil the checklist needed to analyze the IT stocks.

So, let’s launch like the stocks of IT:   

1. Size of the company:

So most of the IT companies in India are service companies and not product companies. This in simple words means that most of the Indian IT companies do a part of their clients business at a cheaper cost and majority of such companies have not created their own product/software which they can sell to individual clients. Lets understand this with an example:

Microsoft has developed a cloud computing service known as “Azure” which has Azure Bot services as one of its functions and this is used for making chatbots. Now let’s say there is some company in England that wants a Chatbot for their application. This company will contact Infosys for making chatbots and Infosys will provide developers and support employees but you see that the main software (Azure bot services) is not developed by Infosys and hence it has no significant moat over it. If other IT companies like TCS or Wipro provide the same chatbot making services at relatively cheaper cost than Infosys then that England based company will extend their contract to TCS or Wipro. 

Most of the Indian IT companies approach foreign clients and other  Indian companies that want to improvise their services or products with the help of information technology. Later these IT companies propose different solutions to these clients which could include running their human resource department at a lower cost or BPO services like handling their client care services etc. 

Though India ranks 33 in terms of education in the world as per a survey done in 2020 and hence keeping this fact in mind a trivial question arises –

Why do foreign companies want to give contracts to only Indian IT companies?

Tell me, Which professional comes at a very minimal price with no extra pay for overtime and a heck lot of burden?

Boom, that’s an Indian IT employee. So, clients (Foreign companies) opt for providing contracts to IT companies because these companies can provide foreign clients with an acceptable level of service at a lower cost. And one way of increasing your bottom line is by reducing the expenses column in your income statement. This can be done by reducing your employee cost by outsourcing the work. And this process has to be done in all the departments of the company. 

This means that an IT company, which can provide design work, human resource work, client care work, manufacturing work etc. presents a better option to the client than the situation where the client has to find many different companies to do these works. As a result the foreign clients prefer large IT companies, which can provide multiple solutions, than small IT companies, which can provide only a handful of solutions.        

2. Location of the Employees i.e. Onsite-Offsite mix:

Till now we have quite understood that the only way an IT company can win in its space is by providing solutions of acceptable quality at a lower cost. Now, with the advent of the internet one major advantage that the IT companies have is the work which can be done in India and later can be sent to clients sitting in foreign locations. 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 and can provide services/solutions to their clients at the lowest costs.

However, if the client in the USA has to choose between two companies( Both offering the same prices for its services), one which has its employees working from India and the second which has its employees sitting in the USA. In this scenario, the client will choose the latter since the second company would give that client the access to call in its employees to its office to coordinate during office hours. The clients’ preference of dealing with IT companies, which have employees in clients’ countries like the USA makes it necessary for the IT companies to have employees in the 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 centers/sales/marketing offices etc.   

And here comes the dilemma that Indian IT companies face:

1. Having maximum employees in India (off site) lowers the employee expense and hence increases the profitability of the company. However this does not provide a proper coordination opportunity with the client thus resulting in a lost business.
2. However, having a maximum number of employees in foreign locations (On Site) increases the probability of getting new/repetitive orders but in turn increases the employee cost of the company since employees in foreign countries come at a higher cost.

Thus, most IT companies try to achieve a fine balance between their employee strength in India (Offsite) and the employee strength in a foreign country (Onsite). As an investor, you should try to analyze the profits generated by employees working onsite versus the one working offsite. Also, as an investor try to appreciate the companies with most onsite employees as this will help them get new orders and build a solid reputation but before that gaze at the profits generated. 

Lets understand this with an example: Cyient Ltd is an IT company and it witnessed a sharp decline in its Net Profit Margin from 17% in FY2010 to 11% in FY2011.

Upon analyzing deeper, one would realize that employee cost 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. 

3. Productivity: Revenue and profit per employee, attrition levels and utilization level of employees

IT companies do not own any fixed assets like plants or machinery. Rather the biggest asset they have are their employees and hence it makes sense to analyze their productivity. 

The various factors that can be used to measure productivity are:

a. Revenue and Profit per employee

Simply put this as the more the revenue and profit per employee of a company is, the better the company is in terms of productivity. This can be calculated by dividing the Revenue and profit for the period by the total number of employees in the company. Also follow the same metric by comparing the company’s performance from a particular year to the previous one to gauge whether the company is improvising or not. Let’s try to analyze the same for a few companies.  

Clearly by looking at the above table and charts, one can surely state that Mindtree is a way more efficient company than any other large cap IT company since having such a low employee base, it is able to generate an equivalent revenue in comparison to others.  

b. Attrition levels:

Currently the soaring attrition is becoming a major challenge for many IT companies. The departure of any skilled employee might put the client’s project on halt and jeopardy. It may take some time to find the replacement of that employee as well. Moreover, hiring a new employee, training them, and making them serve the probation period involves a lot of time and cost which will hurt the client project in terms of cost and timeliness of completion. 

Therefore it is very essential to analyze the attrition levels of the company in comparison to its previous quarters to gauge better results about the working of the company. The lower the attrition levels, the more suitable it becomes for an investment. 

Though we have covered this topic in great depth. Please click on this link to know more about how the growing attrition has become a major challenge for IT companies. 

c. Utilization levels of employees:

An additional benefit that big IT companies have are the extra employees who are currently not working on any project. These are often called as employees on bench and are available as a readily available resource, which the company can quickly deploy on any project and in turn provide a quick solution to clients. 

Now what if the company does not have any spare employees on bench?

Then in that case, the company might face a situation where it may win a big project but would not be able to commence on time due to lack of readily skilled employees to initiate the project. The company will now have to hire new employees and train them which will again cost time and delay the project completion. This situation also holds true when an existing project suddenly demands more resources or many employees from an existing project leave the company all of a sudden which is currently happening.

Therefore, to provide optimal work speed and project completion deadlines, an IT company needs to have spare employees on the bench. Interestingly the company also has to pay salaries to such employees which are not earning any revenue and hence these are additional costs to the company. Therefore, the IT companies have to maintain a fine balance between the number of employees working on client projects and the number of spare employees on “Bench” so that they may provide the best services to their clients at the lowest cost.

The utilization ratio is one such metric that measures the utilization levels of the employee and can be calculated using the formula: total number of employees/employee hours of the IT Company. The higher the ratio, the better it is for the company but make sure the ratio does not exceed more than 95% as in this scenario the company might not have any spare employees.

Summary for the part:

IT sector is no doubt a gold mine and an evergreen sector that is only going to soar higher in the long run. But before diving into any sector we surely need a checklist to filter the signal from the noise. In the first part we have learnt how size of the company matters while getting orders from the clients and how the company can pitch other services if their company’s size is too big thus multiplying the revenue. We have also learnt how Offshore employees increase the employee cost of the company but helps in getting repeat and new orders from the clients. Further, we have analyzed the Revenue and profit per employee of the company and how attrition and utilization affects the productivity and efficiency of the company.

In the next article, we will gauge others factors that one needs to overlook while making a rational decision in selecting an IT stock.

Click here to read the second part of the research article