While we do not normally recommend banking and IT stocks, due to their close correlation with global variables, which sometimes render them aloof to India growth story, it is this very nature which can present frequent opportunities in times of tumult.
With a short term perspective, as distinct from our routine investment perspective, we analyze IT stocks to identify the potential investment opportunities that can fructify under certain triggers.
IT Companies have a fairly simple business model. They staff their employees on lucrative client assignments. The average sales per employee (a key valuation driver) is determined by the utilization rate and average billing rate. The utilization rate of larger IT firms hover around 70%-75%. Smaller firms tend to focus on better utilization, which at times means need-based hiring and premature firing resulting in higher staffing costs, which more than undo the better utilization.
On the cost side, IT firms pay their employees salaries and incur an overhead per employees (in terms of office rent, support services and others).
Employees salaries will typically be about 50% of the sales or 60-65% of the total cost. IT Companies' net margins range from 10%-25%.
The table above shows major listed IT companies arranged in order of decreasing number of employees. Since an employee is the smallest possible business unit in an IT services company, we have considered their valuation on a per employees basis. TCS and Infosys command better valuation (Rs 1.25cr+ per employee) primarily due to better margins earned, largely on account of their ability to attract better talent at similar salary levels to their competitors. Cognizant is better placed than Wipro largely due to the higher growth trajectory of the company (Note: Wipro also has a debt of Rs7lacs per employee). HCL seems cheaper in comparison, but its higher debt of Rs 10lacs per employee and lower margins (largely due to higher overheads) put it at par.
The next two companies in line present unique challenges. iGate has acquired Patni, and Tech Mahindra acquired Satyam (on which there is still lack of clarity about the financials). Any value judgment on these stocks has to be a based on a thorougher due diligence that is beyond the scope of our analysis. Polaris (with focus on BFSI vertical) and KPIT Cummins (specialized in Manufacturing domain) have been the darlings of FIIs lately, however there low sales per employee figure, coupled with lower than industry average margins, put them at a none too attractive pedestal. Polaris is a better value stock, but has a highly uncertain growth trajectory.
Glodyne Technoserve caters mostly to domestic clients in IT infrastructure management, that explains its low sales per employee. But it has been able to maintain good margins along with higher growth (expected due to its domestic focus). But with a debt of Rs 6lacs per employee, Glodyne at firm valuation of Rs 26lacs per employees is not exactly cheap considering its size. Yet we sense a strong opportunity in case of a 30%+ fall in stock price due to a Sensex crash.
Persistent Systems is a product development outsourcing firm having low sales per employee along with an un-scalable model (difficult to repatriate employees across projects seamlessly). Mindtree is suffering from a mid-life crisis, even its founder deserted it after seeing the writing on the wall.
Vakrangee operates on top of a distinct business model, it implements eGovernance solutions and primarily trades software packages (hence higher sales per employees). Their largest cost component is not the salaries (less than 10% of sales), but cost of traded software packages. The space offers good growth potential but the profitability of the model is uncertain and hence a call on Vakrangee is fraught with uncertainty.
Zensar provides a good opportunity to own a pie of an IT services stock at a good value. It may have an uncertain growth trajectory in the face of relentless pursuit of additional accounts from IT biggies, yet its valuation is attractive.
Zylog Systems and Take Solutions are product development firms focusing on telecom (Zylog) and life sciences and supply chain management respectively. Product Development firms spend lesser amount on salaries (roughly 40% of sales) despite higher salaries on an average due to better sales realization per employee. Despite better margins and historical growth, Zylog is available at half the value of Take. Even accounting for Rs14 lacs per employee debt in Zylog, it is still available at a discount to Take's price. A 20-25% fall in stock price can provide a very good entry point for an investment in Zylog.
