Understanding The Nuances Of The IT Industry

Information Technology Industry, popularly known as IT industry among the investors is one such industry in India that generates the majority of its revenue from International Markets (majorly from the United States and Europe, while other markets like EMEA are still small and growing).

As exporters of services across the globe, the IT industry becomes a fierce market where established players, growing players, and incumbents compete to survive and thrive.  

Historically, Indian IT players have given tough competition to their global counterparts and some have even gained market share from the long-established international players. Companies like TCS, and Infosys have gained market share over the years while international companies like IBM, and Fujitsu on the other hand have lost market share.

It is important to note that not every Indian IT has gained market share or has survived in this fierce market. There has been only a handful of companies that were able to survive and thrive.

So, now the question arises, what makes companies like Infosys, TCS, etc different from the herd and how can an investor identify one such company?

Well to begin with, every industry has some specific nuances which must be understood and tracked well to know what is happening in the industry and to identify a company out of the industry. 

Our Indian IT Industry also has such nuances, which will be the focus of today’s blog. 

Before diving right into the metrics, one thing the investors should keep in mind is that, unlike manufacturing companies where the biggest cost is “Cost of goods sold”, IT company’s biggest cost is employee cost as it is a service-based business where the work is done by employees of the company. Hence, the employees are also the biggest asset of the companies, and therefore, efficient management of employees is one of the most essential activities for any IT Company.

Now with that let us head down to the metrics:

Headcount (No. of Employees): 

Headcount acts as a leading indicator for projecting the future demand of the company and hence should be kept in the investor’s checklist. Focusing on the addition & subtraction of employees can give some idea about the future demand. Employee cost is sticky in nature (impossible to reverse a salary hike and quite difficult to fire employees) and the biggest expense for an IT company, so they will increase headcount when they have demand visibility.

Headcount in top companies in IT industry

Covid came as a blessing in disguise for IT companies because Covid increased the pace of technology adaptation across the globe, leading to flourishing demand, due to which most of the companies went on a hiring spree to cater to the high demand scenario. However due to the recent headwinds that the industry is going through, companies have slowed down employee hiring and are focusing more on using the existing bench strength to cater to existing demand.

Attrition Levels:

There are two types of attrition: Voluntary attrition and Involuntary attrition. Voluntary attrition indicates how many employees have resigned from the company while involuntary attrition indicates how many employees’ companies have fired.

Voluntary attrition is an important number to be tracked as when the employee gets hired, they go into training for a few months before getting assigned to a project and generating revenue for the company. If the voluntary attrition is too high that means the company is not able to retain existing employees and will have to continuously hire new employees even at a higher salary, train them and wait for them to become billable while bearing the cost (salary). This long process can lead to loss of deals for the company and may even hurt the reputation of the company, which in turn can hurt in getting new deals & repeat business. 

Hence, the lower the attrition number, the better it is. It would be fair to say that the lower attrition number will also signify that employees are fairly satisfied with their company and hence attrition can also be used to get some idea about the culture of the company.

For Example: Cyient Ltd an IT & ERD company faced headwinds not because of less opportunity (demand) but because of supply-side issues (attrition).

Utilization: 

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 on any customer project. The employees who are currently not working on any customer project form the “Bench” strength. These employees are available as an available resource that the company can deploy on any project and in turn provide a quick solution to customers of the company.

However, the employees who are currently “Benched” are not earning anything for the company as they are not assigned to any project, while they are incurring costs as the company will have to pay them a salary.

Hence theoretically speaking, the higher the utilization number, the better it is as more employees are earning for the company.

But, in reality, one will never see this number reaching 100% or even 95% because companies tend to keep some employees on the bench by choice so that if any important project comes up, they can immediately start working on it and provide a quick solution to the customer and thus, reducing the chances of losing the deal.

Hence, the historical average utilization number and in what range the company is comfortable in operating matters more than the common rule of thumb “higher the number the better”.

Utilisation level of IT companies
Note: – TCS and HCL Technologies do not disclose utilization numbers.

Generally, companies provide utilization in two ways (including trainees and excluding trainees).

Above chart represents the Utilization level excluding trainees i.e., employees who are already trained and can be readily deployed is taken. Employees recently hired and who have gone in the training are excluded. As I mentioned the levels are not even crossing 90% and are staying in the range of 80-90%.

Effort Mix (Onsite & Offshore):  

Indian IT companies can provide the same level of service at a lower cost compared to their global peers. For example:  If the customer puts his 50 employees in the US to design a business, then the cost of those employees would be higher compared to the scenario when an Indian IT company employs 50 employees in India to design the same business. Assuming that the skill set is the same among the Indian employee and a US-based employee.

Offshore signifies that the employee is working from the home country, while Onsite means that the employee is working from any other country than the home country.

For Example: Infosys is based in India, so the employees working from India will be categorized as Offshore employees, while the employees based in any other country than India will be categorized as Onsite employees.

Offshore provides cost benefits as the same skill level employee in India vs Other developed countries like the US will be cheaper and hence will be good from the profitability perspective. 

However, having Onsite employees has its own benefits as the employees might be closer to clients, and hence it would be easier to develop a relationship with clients. It can be beneficial from a long-term perspective as it will help in creating stickiness, cross-selling opportunities, and wallet share gain.

Just like Utilization, “higher the number the better it is” doesn’t work here as well.  One can argue that higher offshore is better as it can become a margin lever and is good from the profitability perspective, however, such margin expansion can even come at the cost of growth.

Hence, when it comes to Effort mix, having a balanced mix is more important from a longer-term perspective than “higher the number the better it is”.

Effort mix of IT companies in India
Note: TCS and HCL Tech do not disclose the effort mix.

Now shifting from the metrics related to employees, we will focus on the metrics which revolve around revenue

Nature of the contract (Fixed Price and Time & Material Contracts):

Time & Material Contracts:  In these contracts, the customer pays the company based on the amount of time taken to complete the project and the number of employees used to complete the project. It means that the Company charges the customer based on the number of employee hours consumed to complete the project.

Fixed Price Contracts: 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 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 the completion of the work.

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

Hence, Time & Material are low-risk contracts. The customers also negotiate on the pricing of T&M contracts and the IT companies that primarily rely on T&M contracts might have lower profitability compare to the company that has more fixed-price customers as fixed prices are risky contracts. In Fixed price contracts, the company has the scope of lowering their costs and enjoying higher margins from the contract. However, such a high margin also comes with a risk of making losses in the case; the company is not able to deliver acceptable quality of work within the promised timeline.

Percentage of Repeat Business

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

Due to fierce competition in the IT industry, the customer will continuously get a business proposals from other peers of the company. If the price charged by an IT Company to its existing customers turns out to be higher than what others are providing, and the customer finds value in the new proposals after factoring in other costs like switching costs i.e., from one company to another company, then the customer will shift to the new IT Company to save on costs.

Hence in this industry where the competition is always high, if a company is able to get repeat orders from its existing customers, then it indicates that the services provided by the company to its customers are of acceptable quality and at an acceptable price.

And, for the IT Company, it is easier and cost-effective to get repeat orders/new projects from existing customers than to find new customers as they will not have to hunt for new customers and go through the whole process of getting selected out of all the peers who have bid for the project.

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

Total Contract Value (TCV) & Annual Contract Value (ACV):

In simpler terms, TCV and ACV are nothing but the Order book of an IT Company. TCV is the total order book of the company whereas ACV is the order executable in the next 12 months. Growing TCV and ACV will increase revenue visibility for the company and will also indicate that the company is able to win contracts against its peers indicating the strength of the company. Hence TCV and ACV should be on the investor’s checklist.

Total Contract Value of IT industry

In conclusion, when looking at the Indian IT companies, the metrics discussed above should ideally be a part of the investor’s checklist, however, the decision should not be solely based on just these metrics as there are other factors to be considered like corporate governance, other fundamentals factors, etc. However, keeping track of these metrics can provide more clarity while tracking an IT company.

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