I recently posted the following comment on twitter
Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term
This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)
I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,
The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows
- Switching cost due to customer relationships
- Economies of scale
- Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
- Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.
Let’s look at where we stand on these factors
a. Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.
b. Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further
c. Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)
d. Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.
Weak and strong moats
Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.
A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.
My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.
Let’s look at the ROIC numbers for some IT companies (Indian and global)
IBM – 15-20 % (based on invested capital including debt)
Infosys – 50% (based on invested capital, excluding cash)
NIIT tech – 25%+ (based on invested capital, excluding cash)
The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.
What explains this big difference?
Eliminating some factors
I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors
Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage
Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)
Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.
I will take a guess now (which is as good as yours). I think the return on capital (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.
This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.