I recently received a comment from madhav
The question I have on outsourcing kind of IT companies like NIIT, Infosys, TCS etc is, “where is the moat?”.
Every company seems to be into everything that happened yesterday, today or will happen in the future. All companies are generally present in all geographies, across all industry sectors etc. To top up the challenge, the “asset” of such IT companies are their people, but the employees keep hopping between the competitors and there is hardly anything preventing them from doing so. So where is the moat or where is the long term advantage? This also leads to the question - how do you value such a company?
This is an interesting question and there are several ways to answer it. I will try to answer it, by first doing a porter’s five factor model analysis on IT companies (for more on this model you will have read this book). I will then use the conclusions from this analysis to answer madhav’s question and see if we can value these companies.
The porter’s five factor model has the following five factors, on which the moat of a company can be analyzed (by the way, I do this analysis for every investment I do)
- Entry barrier : Level of entry barriers in the industry to a new entrant
- Level of rivalry : Level of competition within the existing companies
- Supplier power : bargaining power of suppliers
- Buyer power : bargaining power of buyers
- Substitute product : presence of substitute products
I have a spreadsheet uploaded in Google groups, wherein I had done a similar analysis some time back for multiple industries. It is dry reading, but I think a useful document (for me). I am reproducing some parts below for this post, for the IT industry with appropriate updates.
Entry barriers: This factor can be analyzed in detail based on multiple sub-factors. I have listed the analysis in the table below. The summary of the analysis is in the first row
| ENTRY BARRIER - No. 1 Factor deciding industry profitability |
- - Moderate to high switching costs
- - Barriers due to economies of scale especially in the volume business
- - Some barriers due to vertical based competency (BCM / Insurance )
|
| Asset specificity |
Low. Mainly buildings and facilities. |
| Economies of Scale |
Economies of scale important in recruitment, training and staffing, especially for outsourcing |
| Proprietary Product difference |
None - IPR / knowledge base for vertical is the only differentiator |
| Brand Identity |
To a small extent for specific verticals. However not too critical |
| Switching cost |
High |
| Capital Requirement |
High now, especially for the mid-size and large deals |
| Distribution strength |
NA |
| Cost Advantage |
High - but available to all. Scale adds to this advantage |
| Government Policy |
NA |
| Expected Retaliation |
High |
| Production scale |
NA |
| Anticipated payoff for new entrant |
Moderate at the low end |
| Precommitted contracts |
High |
| Learning curve barriers |
Moderate |
| Network effect advantages of incumbents |
None |
| No. of competitors - Monopoly / oligopoly or intense competition (concentration ratio ) |
Intense competition |
The above analysis clearly shows 2-3 main sources of competitive advantage. Scale is critical in this business as the larger companies tend of have cost advantages due to economies of scale and can also provide the requisite resources for large engagements. In addition, these companies can afford to spend higher amounts on marketing and sales. The second source of advantage is customer relationships (long term contracts). This advantage is not set in stone, but it a very critical asset. For ex: After the scandal, the key value in satyam, was existing client relationships and Mahindra paid for that. Ofcourse this asset does not have as much life as fixed assets and can be lost much more easily.
Level of rivalry
| RIVALRY DETERMINANT |
Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past |
| Industry growth |
moderate |
| Fixed cost / value added |
Low |
| Intermittent overcapacity |
Low |
| Product difference |
Low |
| Informational complexity |
Medium to Low |
| Exit Barrier |
Low |
| Demand variability |
Low |
The above analysis shows that the level of rivalry has been high, but not destructive till date. Most companies in the sector earn high return on capital and are fairly profitable. This has been mainly due to high growth in the industry and low fixed costs (they can cut our salary and bonus when the demand drops J). Due to multiple companies in the industry, the long term returns in the industry are bound to trend lower (read that as profit margins).
Supplier power
| SUPPLIER POWER |
None - Input is manpower |
| Differentiation of input |
None |
| Switching cost of supplier |
None |
| Presence of substitute |
None |
| Supplier Concentration |
None |
| Imp of volume to supplier |
None |
| Cost relative to total purchase |
None |
| Threat of forward v/s Backward integration |
None |
If you work in the IT industry, you are the supplier. Supplier power - zip, nothing..doesn’t exist. Yes, companies say employees are their asset etc etc. We all know the reality. Employees are the raw material for the industry like steel and copper (sorry if I hurt your feeling by comparing you to a commodity J ). Most companies pay for this commodity based on what the market prices it.
Buyer power
| BUYER POWER |
% Sales contributed by Top 5 account. High for smaller companies |
| Buyer conc. v/s firm concentration |
Varies for companies. Tier II companies have higher Buyer conc. |
| Buyer volume |
High for Tier II companies |
| Buyer switching cost |
High for buyers |
| Buyer information |
High |
| Ability to integrate backward |
Low. The reverse is happening |
Buyer power is clearly a bigger issue for smaller companies. The large IT companies have consciously tried to diversify their revenue to reduce dependence on any specific client. This is a key variable for a company. If the buyer concentration is high, the vendor can get squeezed and will not be able to make high returns.
Substitute product
| Substitute product |
Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable |
| Price sensitivity |
High for low end work |
| Price / Total Purchase |
High |
| Product difference |
Low |
| Switching cost |
Medium |
| Buyer propensity to Substitute |
Medium to high |
Substitution of one vendor with another is a key competitive threat for each company. Clients typically have multiple vendors to ensure that they can maintain competition and keep the prices low. Till date, the competition has not been destructive and most companies have made decent returns in the past.
Conclusion
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.
Inverting the question
Let’s assume for argument sake that the industry does not have a competitive advantage and is similar to the steel or cement industry (which by the way has some competitive advantage). In such as case, the industry would be characterized by intense competition and low returns on capital (low ROE). This has not been the case for the last 15 odd years and most companies especially the larger ones have maintained fairly high returns on capital. This variable alone shows that the industry has some level of competitive advantage - especially the larger ones.
Valuation
The above analysis is clearly a backward looking exercise. Valuation on the contrary requires a forward looking estimate. Can we arrive at any conclusion from the above analysis?
It is difficult to arrive at how each company will evolve over the next 5-10 yrs (the typical duration required for a valuation). However we can arrive at some general conclusions
- 1. As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
- 2. The industry could split in two levels - the large SI (system integrators) such as Infosys, Accenture, Wipro, IBM etc and the niche players. Both these type of players should enjoy a decent level of profitability.
- 3. The industry is likely to diversify and expand into new geographies, but the future growth is unlikely to be as high for the big players.
The above conclusions are my educated guess and are as valid as anyone else’s. However based on these conclusions I would propose the following
- - The large SI like Infosys, WIPRO etc should continue to do well. However, these companies would see only moderate growth in profit. As a result I would be hesitant in giving a PE of more than 25 to these companies.
- - The attractive returns in this sector are to be made with the small niche players. These companies, if they can be indentified early enough, are likely to have high growth and profit. However this is a specialized form of investing, requiring deep skills in the specific sub-segments.
This article was written by Rohit Chauhan
. He also writes at his own blog
Value investor india.
