Saturday, September 18, 2010

Are IT Industry stocks winning picks now?

The Indian IT Industry has been in the news for both good and bad reasons over the past few years. They put India as a force to reckon with in the IT field a few years back and are still doing it now, but at the same time they were in news for pink slipping employees during the recession. But all said and done, the Indian IT Industry is back on its feet after the long recession and people are speculating on these stocks like never before.

Anyone who has the habit of reading newspapers would have read two kinds of news. One from the Indian media about Indian IT cos riding high on profits and is poised on recruiting thousands of aspiring engineers in the forthcoming year and the other is from the president of the United States Mr. Obama about tighter offshoring norms and higher VISA fees. So as laymen investors many of us are confused about what is going on and are IT cos good bets now from the investment standpoint. The purpose of my article is to throw some light on this confusion.

Please note that – this by no means is a recommendation to buy IT Company stocks. This is purely my personal opinion about how IT cos may perform in the forthcoming years and is not a trading/buying suggestion.

First of all, I would like to apologize for a lengthy article and secondly, I firmly believe in the fact that, DO NOT Invest by hearsay. Get all your facts right before you invest your hard earned money in any company. That is why such a lengthy article. Please read on  ….

IT Cos – The Darlings of the Indian Stock market in the past Decade

The Indian IT Cos have been the darling picks of the Indian stock market over the past decade. Notably Infosys and TCS have been the flag bearers of the Indian IT Industry over the past decade (Of course I am proud to have worked for both these giants for nearly 3 years each) Not only have they grown from a few hundred people to over 1 lac employees, but also their share prices have sky rocketed in the past few years making a lot of millionaires in India. The price of Infosys stock at the time of writing this article is Rs. 2895/- and that of TCS is Rs. 873/-. Considering the fact that the stock market has just started recovering after languishing for months in 4 digit numbers, these numbers are pretty impressive. Even during such lean times, these cos weren’t the worst to be hit by the stock market collapse proving the fact that, these cos have been and most probably will be darling picks of the Indian stock market.

How does an IT company make money?

This is a simple question for a majority of us because we work in this industry but for the rest it’s still a puzzle. Let us take a simpler example which everyone can correlate. All of us hold bank accounts and invariably we would’ve tried the online banking facility. The website you login is an application which is developed by an IT software professional. Similarly there are millions and zillions of customers out there who need IT applications and our IT cos create them to help the customers carry out their business in a better/faster way. In return, the customers pay us for our service and this is how the IT cos make money.

The next question in your mind would be, how come these guys make such staggering profits? Read on for the answer…
IT cos charge its customers in US Dollars on a per hour basis and pays its employees in rupees. Let us take a look at a typical calculation. Lets assume company ABC Infosystems charges its clients USD 30 per hour of effort of its employees, net revenue per employee per month works out to USD 5280 per month (@ 8 hours per day and 22 days a month) This amount if calculated in Indian Rupees is more than 2 lacs.

You might be tempted to think that not all software engineers get paid 2 lacs per month and the cos should be making killer profits. Unfortunately employee salary is not the biggest contributor to the cos expenditures. Buildings, infrastructure, power, water and other logistics for running a company account for the major chunk of a cos budgeted expenditure. Of course salary is a significant contributor but definitely not the biggest.

This is why, even though a cos net revenue runs to a few thousand crores for a financial year, the profit runs to only a few hundred crores.

Why do companies outsource their IT operations?

The reasons are very simple and are as follows:
1. Cheaper workforce - We work for 1/4th or 1/3rd the price at which people from the local town would work for
2. Lack of skilled manpower – Not many countries has skilled manpower to contribute effectively to the IT operations for the cos growth.

The Boons and Banes of Outsourcing!!!

Outsourcing has been a boon for developing nations like India and China where skilled and cheap manpower has drawn thousands of jobs and millions of dollars in revenue but unfortunately it has been both a boon and bane for the country’s from which their local cos outsource jobs.

The Boon Part: A company from USA, by outsourcing 100 jobs to India would boost its profits significantly because the cost of employing 100 people in USA is nearly 4 or 5 times costlier than what it costs from India, plus the chances of getting 100 skilled IT professionals in the nearby locality to finish the job is also not 100% likely.

The Bane Part: 100 locals from USA would have to look somewhere else for their jobs

Can the US clients survive without the IT workforce from India?

The answer is an emphatic NO. (My personal Opinion)

There are thousands and thousands of Indian IT professionals who are working day and night for their customers in the United States. Finding an equal number of people in USA willing to do the same work and more importantly at the same wages is nearly impossible.

Most Importantly – If the US cos have to replace its entire outsourced workforce with locals, they will probably go bankrupt. I don’t think they will have any surplus left after paying employee wages to post any profits.

What are the difficulties IT Cos may face in the US market?

As of today, the United States accounts for 50% or more of the revenue earned by the Indian IT cos. With the economy in USA still struggling and with unemployment rates at new highs, the US government is urging businesses to recruit local talent for their human resource needs and avoid/reduce outsourcing. It is even promising benefits to companies that generate employment to Americans. This could partially motivate large corporations to hire locals in order to gain benefits like tax rebates or access to bailout funds etc. This would significantly affect the growth plans that IT cos would’ve planned for the next few quarters. They would have to aggressively market themselves in order to get new projects and fresh revenue.

Are IT Cos going to be hit by the new legislations/restrictions imposed by the US Government?

This is a very important question which will determine the future of these IT Cos. As of now, the restrictions are not very extensive and proper planning & due diligence on the part of IT cos can help them sail out of this storm. For Ex: IT cos may pass on the extra cost incurred due to higher VISA fees to their customers in order to retain their profit margins.

Considering the bigger picture, the answer is YES. IT Cos in India will be affected by newer legislations laid down by the US government in its attempt to reduce unemployment. But, it will not ruin the Indian IT cos.

IMHO, Dealing with the negative hype created by the news media would be much more of a challenge to the IT cos than dealing with such challenging business situation. The sales people for the leading IT cos have enough talent and skills to hunt for new business opportunities. This would be much easier than trying to minimize the damage that negative media hype can cause.

How will all this affect the Share Prices of IT Companies?

The stock market at times reacts in an impulse. If you see news that reads like below:

US President Obama, bans offshoring of jobs. Mandates companies to hire only locals

What would your instant reaction be if you hold stocks of IT cos? You’ll think, Oh my god, let me sell off my holdings at whatever profit I can make today. I don’t want to lose money. A classic example of “Panic Selling”

Am not blaming any of my dear Indian investors, I would’ve done the exact same thing if such a news had come up in my initial years of stock market investing. The problem is, we are all scared that we will lose our hard earned money and there is nothing wrong in thinking like that.

News like these, if they come up, they can badly affect the price of the IT cos stocks. But it will be short lived. The moment you see another news like below

IT Major Infosys signs multi billion dollar deal with ABC Ltd USA

Investors will start buying the stock and the price will rise again.

What will IT Cos do to handle the situation?

The IT giants in India have already weathered the recession and have proved that we are much more than what the world thinks we are. The upcoming few months are going to be difficult but not as bad as the recession. So below is what I feel will happen.
1. Cos will try to reduce their exposure to the US markets. As of now more than 50% of the revenues of Indian IT Cos is from the US markets. I even read an article on Infosys planning to reduce exposure to US markets to 40% from the present 65% over the next few years.
2. Cos will not hire every week. They will hire on a need basis maintaining a good bench strength to ensure that they do not run short of resources in case of huge deals coming through
3. Sales persons will be set stringent targets. They are the face and the voice of the IT Cos to their customers and a bulk or all of the load of gathering new business will be on their shoulders
4. Billing rates for workforce maybe reduced in order to boost customer chances of outsourcing because of cost benefits
5. Luxurious benefits to top managers may be cut in order to maintain cost effectiveness and profit margins
6. Exorbitant salary hikes to people while switching jobs may be reduced to an industry standard hike level
7. etc…

In short, IT Cos will try harder than ever to boost their revenue and reduce costs in order to grow their profit margins – which in turn would invite more investors to buy their shares.

In my personal opinion, this is not the end of the world for the Indian IT cos. They are backed by thousands of talented individuals and a strong management that has propelled them from a hundred employees to more than hundred thousand of them. We Indians are known to thrive under unforgiving situations and I am sure that our IT cos will come out as shining stars and two years down the lane, they’ll still be the market leaders as they are now.

Happy Investing!!!!

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