June 15, 2012

Moat or no Moat – Indian IT

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.
Some numbers
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.
The future
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.

25 comments:

Prabhakar Kudva said...

I has once mentioned the following on twitter (https://twitter.com/GSR_80/statuses/84611214226886656): “It seems to me that our big 3 tech companies will turn into dividend paying tech utility stocks over time and trade at 15x from 25x today”. The reasons being more or less the same that you’ve listed out. I agree that there is not much of a moat to speak about in this sector. As a matter of fact there never was. Right from 95 to the first half of the decade this was a business where the market itself was expanding and every IT company was growing without getting into market share battles.

I think what really has happened now is that the market is more or less saturated. Every big firm that needs the IT services already has it. Now everyone is fighting out for what is left to sustain the past growth rates. This seems futile. Some like Infosys are betting on newer strategies for growth which as you mentioned mostly looks like fluff but we don’t know.

It is beyond doubt that Indian IT is set to get de-rated unless they really are able to monetize the “product” and/or “value added niche services” areas that they keep talking about. We all know betting on such things is mere speculation and one could be wrong as easily as one could be right.

I would stay away from this sector. The only way these guys can sustain the valuations is if they increase payouts substantially.

As far are foreign IT is concerned I am not sure if the numbers are exactly comparable because these guys have additional expense items like R&D expenses etc which Indian IT doesn’t account for. So it might be possible that their return on capital if considered in the services business alone is comparable to Indian IT although it definitely could be lower. I haven’t seen the numbers really in detail so can’t comment. However if your thesis and numbers are accurate foreign IT should do better than Indian IT going forward because there is scope for ROE expansion.

Overall this isn’t a great sector to be in because growth which I believe is the engine of every missing seems to be eluding.

Abhishek said...

Interesting post. I follow the IT industry very closely and have been doing it for a reasonably long time (over a decade). I think there is a need to distinguish between services and product companies. Services ones, specially the lower-end of the spectrum ones, which cater to ADM (Application Development and Maintenance) are becoming a commodity. Unfortunately, that is the bread and butter of most of the large listed IT companies in India. Also, some companies, in order to expand market share and revenues have started under-cutting the others in rates. This is bound to bring down the overall profitability in the longer run. But that is expected in any emerging industry over time.
Another aspect is that all companies are becoming global. The MNC's have a large India presence and are building skills and capabilities in newer emerging markets like Africa. The large transformation projects, consulting projects are still areas where the Indian companies are way behind their gobal peers.
From this perspective the moat is shrinking on the existing business.

However, if you look at the newer developments that some of the companies are taking - getting into end-to-end transformation (TCS in Indian passport project), getting into newer geographies (Africa, Latin America) and moving to more of packaged solutions, asset based development, cloud implementation and others, the moat is going to grow for some of them.

So, in the longer run, it is those companies that has a good and visionary management that will maintain and widen their moats.

Abhishek
http://valueinvstr.blogspot.com

Kiran said...

Great points!

I also work within the IT industry and speak to a few senior folks on a regular basis. Here are some of the takeaways that I've had in the last year or two.

The focus currently is on large deals (> $100mn) in all of the big Indian IT companies.

I am also not seeing much of investment happening till they have a client's need in place (as in, assured business). So, packaged solutions/cloud etc., can come to fruition only if they invest. Whatever I have seen and talked to some senior guys in the IT industry, it's not happening unless you guarantee a 3x return in 3 years (thumb-rule).

In fact, in one firm (not mine), I have heard that the sales guy as well as the solution-proposer would be held responsible for the investment which is leading to some perverse incentives (such as, not proposing anything at all).

The only angle that we missed was the SEZ/STP angle which has unfairly pushed up the NPMs quite a bit for these Indian IT companies. If that policy expires (and it has expired for quite a few locations already and hence you see lesser expansion in Bangalore and more explansion in Chennai since the duration of exemption is till 2020 there), then we would have quite a bit of an issue.

Rohit Chauhan said...

Hi prabhakar
I have worked in the industry for 10+ years now and though we cannot generalize from my experience, i can tell you one thing - none of the top IT majors in india do meaningful research or work on developing IP

sure they have those pretty ppt and marketing collateral, but scratch under the surface and there is no substance

ofcourse this is for services companies only..i dont claim the same for product companies and cannot comment on them. but i am sure that if some of them are focussed on specific areas, they may be doing good work

that brings me to the point, the you can either have niche and focussed high IP type companies which could be good investment if you can analyse them. the IT service companies look more like commodity companies

if you agree with my point (and you may not), how do you value a commodity company with declining ROC ?

rgds
rohit

Rohit Chauhan said...

Hi abhishek
completely agree with your initial points ...namely that we now have convergence happening in the industry between players ...which happens in commodity companies

as far as the expansion in new geographies like africa or LA ...is that not just new revenue sources ? that is not any competitive edge isnt it ? almost every other company can enter these market ?

i diverge with your view on the point that good management will maintain the moat ...i think good management will run the business well and execute well. these companies may not have much moat, but they will be run efficiently and will be good businesses


rgds
rohit

Rohit Chauhan said...

Hi kiran
you described my ex-firm and a lot of other IT companies.

At the risk of sounding harsh and unfair, the top management at many companies think that it is their god given right to earn 60%+ return on capital. anything less than a 30% margin is not good !!

i have seen this for the last 12+ years. now till 2008 this was fine as there was this huge offshoring wave which everyone rode and there was a lot of low hanging fruit to be picked

now all the easy money is gone.

when i say lower ROC ...it would be from a combination of reducing margins, higher investments in R&D and IP (with possible failure)

finally the point around SEZ and tax holidays ...i think over time that is again not a sustainable advanatge as every one has access to it and there is a limit to it too

rgds
rohit

Achin Jain said...

ADM is the main thing that is making money on consistent basis for Indian IT companies. I havent seen Accenture trying to get pie in ADM business for its clients. They are big in consulting (which is now called high end business)

Major reason of the revenue growth with same client I think is because of the relationship btw vendor and client folks majorly.

Thing that we have missed I think is their financial models - T&M and FP. I think major ADM work happens in FP which is the main reason for NPM spikes.

On STP/SEZ, I think the % breakup of the revenue can give us the visibility of the impact on NPM. I dont think that is major now as IT companies are doing away from STP work.

I kind of agree with Rohit's comment that hardly any Indian IT companies are spending majorly on research or basic or something new from scratch. Latest patent fillings from Indian IT companies can give us knowledge on that front (Infosys is leading this). But then patents / royalty revenue is hardly any % as of today.

Earlier client were looking for more offshoring but now new working models have come to the market like Agile which is doing reverse (more onshoring) and shorting project timescales drastically.

PS: I am in IT space

Prabhakar Kudva said...

Hi Rohit,

I think our conclusions are the same: this business is only going to get more competitive and since there is no apparent moat the magin/ROC is going to go down.

Personally i would stay away from this sector. In my opinion if anyone wants exposure to this sector then the best bet right now is Infosys, because of the valuation. I don't think there is much downside in Infosys but none of us can be sure from where the upside will come.

Anonymous said...

Is dividend reinvestment available in India ?
Regards,
Gian

wideningthemoat said...

Hi Rohit


Wonderful analysis; the way you have described the Indian IT sector, the moat is weak and is declining. The Indian IT companies can be seen as more of commodity plays rather than having any durable competitive advantage. Suppose this conclusion is true, then I should value the Indian IT companies based on the reproduction cost of their assets (including everything from tangibles to intangibles) and not based on their earning power. Because whatever they are earning today, they won’t be able to sustain it in the future.


Besides anyone can set up the same business, buy the similar assets, hire the same talent, build customer relationships and start delivering. Easier said than done, all this will take time and money; but we are talking about a long term here and the business model can be replicated by others. The reproduction cost has to take care of all these considerations. That’s the theory part of it, how to go about and calculate that reproduction cost is anyone’s guess :)

Anonymous said...

Whether this IT companies are good for investment for bad I don't know but one thing is sure that we are simply coolies and this fact is getting noticed by many people.

Salil

Ninad Kunder said...

Hi Rohit

We have discussed this in the past and broadly been negative on the sector for the past few years.

I just want to add an additional perspective to the discussions. One of the things that I have begun to notice is that gradually the bargaining power is shifting from the employees to the employers. So wage inflation in my opinion is going to start going down both in terms of lower wage increases and replacement of high cost resources with low cost ones.

It is not going to be a great time as a employee to be in this industry.

Cheers

Ninad

Rohit Chauhan said...

Hi achin
same here ...i have been in IT space too and have worked in the industry for 10+ years. i am now looking at it as an investor.

The support / ADM work is bread and butter. but the problem is that it is a commodity and we may see margin pressures in time ...wage increases, more onshoring, new technologies such as SAAS etc.

my concern as an investor is that valuations dont reflect the changes in the underlying model

rgds
rohit

Rohit Chauhan said...

Hi prabhakar
i agree ..our view point on the industry is same. but i differ on infosys. the company has the highest margins in the industry ..25% NPM versus 12-15% for others

i have worked in infosys for a long time and i did not see anything which differentiated them from all other vendors. now if something has changed dramatically in the last 3-4 yrs ...then its a different issue

rgds
rohit

Rohit Chauhan said...

hi gian
in terms of investment in the stock again ?

rgds
rohit

Rohit Chauhan said...

Hi wideningthemoat

agree ..there is still some moat. not anyone can build an infosys in a day. but still look at the indsutry structure gloably ..it is very fragmented. so long term the returns are bound to come down

rgds
rohit

Rohit Chauhan said...

Hi salil

LOL :)

i understand the pain ...i am myself one of the coolies :)

rgds
rohit

Rohit Chauhan said...

Hi ninad
dude yes we have discussed that and as they say ...dukhti rag pe haath rakh diya :)

i guess you are telling me that i should start looking for a new profession :) and as salil mentioned the coolies are going to get paid lesser over time

kind of expected ...the margins and salaries are bound to get squeezed in the usual ADM work

In the US , the young crowd is into mobile space and social media ...nobody wants to get into ADM work

rgds
rohit

Anonymous said...

Is ROIC applicable to "our" IT industry? What is its invested capital anyway?

I can understand if you use ROIC to value companies like IBM which has a large R&D and a long history of providing "complete IT solution"

Why TCS is missing in your discussion?

Rohit Chauhan said...

Hi anon
why is ROIC not applicable to IT industry ?

it is applicable to every industry. some industries need more capital such as cement or steel and some less

IT needs lesser capital and usually expenses it , rather than capitalize it (like R&D or SGA to build relationship)

I have used infosys only as an example. It holds true for TCS or WIPRO or any other IT company. These companies differ in terms of execution capability of the management, but fundamentally have similar competitive advantages

Rohit Chauhan said...

Hi anon
maybe i am missing something ..but how is TCS different from other IT companies ?

rgds
rohit

Anonymous said...

Rohit,
Yes, I mean automatic dividend reinvestment by companies.
Gian

MSK said...

Hi Rohit,

I was reading the post "Special opportunity framework" published on 9th Feb 2010. Could you please tell me how to download the arbitrage delisting template?

Regards,
MSK

Anonymous said...

hi rohit how do you get time to analyse companies in detail when you have a day job? i am struggling! any tips pl?

Rohit Chauhan said...

hi anon
weekends and nights is when i work on this ...yes it is tough ..but then unless you do it full time which has its own challenges if you have family, i dont see an easier way

rgds
rohit