CategoryIndustry analysis

Warning: A long post on the competitive analysis of IT companies (low in entertainment value 🙂 ). So please get a cup of coffee or tea before you continue further

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

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:

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 :)). 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

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 :)). Most companies pay for this commodity based on what the market prices it.

Buyer power

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

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.
  

Are you still reading? Wow!! ..If I have not put you to sleep, leave me a comment 🙂

I had recently posted on NIIT tech and uploaded the valuation (see here). The way I see it, there seem to be three key risks for the IT industry which I have tried to include in my valuations.

Risk 1 : US slowdown – This is a medium term risk and should not impact the long term economics of the IT industry. On the contrary I think the slow down will not really impact the industry much in terms of overall growth. There could be a bit of a slow down and some pricing pressure. But not much beyond that.

Risk 2 : Rupee appreciation – I think this with cost pressures is the most critical risks as this would impact the margins of the IT companies. In the scenario I have built I am assuming that margins will drop by half in the next 2 years due to the appreciation and cost pressure

Risk 3 : Taxation issues – The tax holiday enjoyed by the industry would be taken out by the government. In response to the slowdown and rupee appreciation the government has extended the tax holiday and there has been a sudden rally due to that. However I think the tax breaks are bound to go, only question is when. However this risk is definable and can easily be worked into the valuation

In my valuation I have assumed the worst case scenario for all the three risks. However as we saw recently if the rupee appreciates, the tax breaks could get extended a bit and that could mitigate the impact. So it is quite likely that the worst may not come to pass. The stock price assumed the worst in march. Since then there has some correction as the market realised that things are not as bad. However it would not take much to change the mood again.

The Auto industry consists of the following products segment and key companies

4 Wheelers (cars, UV etc) – Maruti, Hyundai, Tata motors, Ford etc. This is a fast growing sector of the market with the most action. Rising incomes and easier credit has resulted in growth in the industry. India is also developing into a Hub for exports especially for small and compact cars. This sub-sector is characterised by high competition and aggressive marketing. The key player is maruti with around 51% market share. The last 3-4 years have seen growths in excess of 15-20%. In addition competition is increasing in this segment with aggressive growth plans from Maruti, Tata motors and other foreign majors such as Toyota, GM, Hyundai etc. I have been looking at some of the companies in this sector and there are some good ideas. I will be posting on a few later.

2 wheelers (scooters, Bikes etc) – This has been a growth sector for the last decade. The annual volume is almost 8 Mn units making india one of the largest markets in the world. Bikes account for the majority (around 70 %??) of the demand with the rest taken by scooters and mopeds. The bike segment consists of the entry level bikes which are price sensitive, the mid-segment called the deluxe segment which is dominated by hero honda’s splendour and the top segment. The top segment has high growth currently, lower pricing pressure and shared between bajaj auto and hero honda. This sector has seen slowing down of growth recently and pressure on margins due to increase in raw material costs and increased competition.

Commercial vehicles ( LCV, MCV and HCV) – This sector is dominated by tata motors followed by Ashok leyland. The LCV and HCV sectors are seeing good growth due to development of infrastructure and the transportation model moving towards hub and spoke. The less than 16 ton segment is however seeing its share of the pie shrink. Competition is expected to increase due to foreign players such as Iveco and others. The latest quarter has been weak for the commerical vehicles sector. . The commerical vehicle industry is quite cyclical in nature and the companies in that sector are making an effort to reduce the impact by increasing the service, spares and export component of the business. The two companies in this sector Tata motors and ALL seem to be fairly priced. I will be posting on Ashok leyland soon.

Basic financials of the industry
The industry is characterised by economies of scale. The net margins are low (4-5%) and not likely to increase much due to competition and raw material pressures. The industry has a ROC of 20%+ and moderate compeititive advantages due to Entry barriers from scale, brands and first mover advantage. Rivalrly is not intense as yet, however competition is likely to increase when demand slows and foreign competition intensifies.

A more detailed Analysis of auto industry is updated in the worksheet (Business analysis_working_aug 2007) under ‘AUTO AND ANCILLARIES’

My notes on the power/capital goods and other suppliers

Capital goods suppliers

This sector is dominated by BHEL and ABB followed by several smaller players and Chinese manufacturers. BHEL accounts for almost 65% of capacity and market share. This sector has seen good growth in the last 3-4 years and should see continuing growth for the next couple of years. ABB has a smaller product range mainly for the power sector and industry automation. However it is more profitable company than BHEL and doing extremely well for the past few years.
The companies in this sector are characterized by high return on capital and good competitive advantages. The key competitive advantage is due to Scale, technology and an existing customer base. The companies in this sector are now investing in R&D and also targeting export markets as they increase in size.
This sector should see more competition due to the high demand from Chinese manufacturers, domestic OEM players and foreign players.The market recognizes the bright prospects of this sector and most of the companies in this sector seem to be fairly priced.

Other suppliers (power cable industry)

This industry is characterised by several players. The key ones are
KEI industries
Diamond cables
Nicco
Universal and torrent

The industry was loosing money during the period 2001-2004. Several players had negative networth and the stronger ones such as KEI had very small profits. Since 2004 due to the boom in the power sector, industry, Oil and gas and real estate, demand has soared and this has resulted in a turnaround for all the companies in the sector. Several of them such diamond have wiped out accumulated losses and are now profitable. The stronger and aggressive players such as KEI have invested in additional capacities and are now growing rapidly. There is now a huge demand in the domestic market and some of the export markets. Several companies in this sector are tapping this demand and doing well.

The industry is however cyclical with almost 70% cost due to raw material. The key RM is copper, aluminum and steel the prices for which have increased in the last few years and fluctuate rapidly. The industry has weak competitive advantages and the key strengths come from scale of operation, customer relationship and operational efficiencies. As a result during the cyclical downturn several companies lose money heavily.

KEI industries and Torrent cables are currently the most profitable players with ROC in excess of 30%. At the same time the other companies in the industry have also turned around in performance due to the strong demand. KEI industry is growing rapidly through organic growth via capacity additions, product range extensions and export markets. It is also looking out for acquisitions abroad. Torrent cables is also doing well and has fairly good financials. These two companies seem to be good investment candidates in the sector

The other companies have had a turnaround in the last few years and hence it may not be easy to predict how they will fare during the next downturn.

To get a better understanding of the dynamics of the power cable industry, the AR for KEI industries is a good starting point.

My notes on the power sector below

The power sector can be divided into the following sub-sectors

a. Generation – This sector has companies such as NTPC, REL, tata power and state generation units
b. Transmission and distribution – Mostly owned by SEB except in a few places such as delhi where it has been privatised
c. Capital good suppliers such as BHEL, ABB, L&T etc
d. Other suppliers like power cable companies, fuel suppliers etc.

Detailed analysis of the sector is provided in the business analysis spreadsheet. I have a new version (Business analysis_working_aug 2007) recently.

A brief analysis of each sub-sector follows

Generation

Generation is dominated by companies such as NTPC and State generation utilities. A few private sector players such as REL and Tata power also are important players in the sector.

This sector is characterised by fixed return on capital of around 12-14%. The tariff’s are adjusted in such a way that the company has a fixed return on capital. In addition government companies such as NTPC have had a recievables issue in past due to non-payment of dues by SEB. This was resolved by state government bonds and in the last 2 years this problem seems to be contained. Private sector companies such as reliance do not have a similar issue and have a zero net debt situation

Due to the huge power deficiet in the country, there is current a lot of expansion and new generation capacity being put in place. The XI plan envisages almost 85000 MW of capacity addition. All the generation companies such as NTPC, REL etc have big expansion plans which should result in increase in earnings and good growth. However the sector is characterised by political interference and hence there could be several risks to the expansion plans.

Companies such as REL, NTPC, and Tata power have substantial competitive advantages due to their long term experience in the power sector, financial strength and current backward expansion in fuel sources such as coal, gas exploration and forward integration into transmission, power distribution and power trading.

Most of the companies in this sector sell at around 19-20 times their earnings and seem to be fairly priced. However if government regulation and other obstacles in the power sector are resolved, these companies could see a lot of growth with good return on capital.

Next post : Capital goods suppliers and other suppliers such as power cables

I am currently reading and analysing the capital goods, power and projects industry as a whole. The reason for studying them together is that several companies in the above sectors overlap or are suppliers to the companies in the other sector. For ex: BHEL (capital goods) is a supplier to the Power industry (ex: NTPC).

I will post a detailed analysis later. However a few points stand out

– The capital goods and projects (such as L&T, ABB etc) industry is firing on all cylinders. They are growing a high rates, have high big order books and a high return on capital.
– The market is valuing these companies at 40-50 times earnings. Somehow everyone has forgotten that the above industries are cylical (remember 1999-2002?) and the cycle can turn downwards too. In that event, the stocks can get whacked badly.
– Competition is increasing as india is becoming a major source of demand globally. Increased competition is never good for profits and valuation