Classroom | What to look for when analysing the IT sector (Equity: Part 21)

Part 21 of the Moneycontrol Classroom deals with key parameters to look at when considering investing in the IT sector.

Volumes: In the IT services sector, volumes represent the number of people billed and is measured by man-months billed. This is what companies bill to their clients. Until IT services followed a linear model, volumes were important as they were proportional to revenues. That's no longer the case and in a non-linear world where digital revenues are being chased, the volume parameter is losing significance.

Revenue growth: Revenue growth is a combination of volume in man-months billed and realizations which are decided by the pricing of the service provided. A healthy uptrend in revenue growth is what you would like to see. Do adjust for the effect of acquisitions, both of companies and business units being bought out. Revenue growth in reported currency (INR for Indian companies) gets affected by cross currency movements. Hence constant currency growth is a better gauge. Constant currency refers to a fixed exchange rate that eliminates fluctuations when calculating financial performance figures. When companies provide a growth guidance, it's better to look at the constant currency guidance.

Operating profit and operating margin are important indicators of profitability and efficiency. A host of factors have a bearing on it.

Selling expense is one key ratio to keep an eye on. As as a percentage of revenue (SG&A, selling general & administrative expenses), it shows how much of the revenue is taken away by the cost of client acquisition and general overhead expenses. The lower the better and if it's following a decreasing trend, then it augurs well.

Utilisation rate pertains to how effectively the bench strength or people on payroll are deployed to projects that are generating revenue, and it is a key margin lever. A high utilisation rate implies that the bench strength is falling, so revenue cannot grow without adding resources. A low utilisation rate implies that the firm is not utilising resources optimally.

The onsite-offshore mix is important. Since costs in India are lower, productivity is higher compared to resources deployed on the client's site overseas. This proportion plays a part in determining profit margins.

A key margin lever is, of course, the movement in the currency. The depreciation of the rupee is a boon to Indian IT companies although most companies hedge their currency risk.

An analysis of the geographical mix of an IT company's business is important. If a lion’s share of its revenue comes from a particular region, the business becomes more vulnerable to that region. The Indian IT sector, for instance, has excessive dependence on US markets.

Performance of different verticals (the end-user industry being catered to such as healthcare or retail) and service lines (like application services, infrastructure services, business process services etc.) are important data points to monitor, especially the share of digital business which is turning out to be a key driver of margin and profitability.

Deal wins are relevant to gauge future business outlook both in terms of the number of deals and the ticket size of individual deals.

The Net addition of employees is a reflection of demand outlook, as companies tend to hire when there's more work at hand. This and the attrition rate should be tracked since the industry is facing a talent shortage. Increasing protectionism in the developed world (like visa restrictions in the US), as well as a dearth of the right skills, are adding to sub-contracting costs of IT companies and affecting margins. A high attrition rate can make matters worse by forcing a company to pay generously to retain talent.

The Client matrix gives an idea of how well a firm is doing in terms of client addition and size of its new clients. Client concentration is also revealed. Typically, a high concentration is perceived as risky because over dependence on one or two clients means that a problem with even one client can adversely affect business.

P/E ratio or the price to earnings ratio is the most commonly used valuation tool for IT companies.