Warning: A long post on the competitive analysis of IT companies (low in entertainment value J ). 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 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

 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 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 J

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Now that I have managed to irritate some of you, by rejecting stocks which you hold, let me push it still further J

Torrent cables: Erratic performance in the past. Loss in the current year and some years in the past.

TRF ltd: Negative cash flow. High accounts recievables being funded by supplier debt

Bharat bijlee: Poor cash flow. Rough estimate is 20% of net profit, hence the valuation is double the current PE. Fairly valued.

Allied digital services ltd: Raised new capital, majority of which has been used in accounts receivables

Ganesh housing: Fully valued or overvalued. Constantly raising capital for growth

Supreme industries: very low free cash flow and low margins.

UB engineering: Negative networth. Business turned around in the last 2-3 years.

Some quarterly results

Some of the companies, I hold currently have declared their quarterly results. A quick review and some thoughts

VST industries: The company reported a 40% increase in topline and 50% improvement in bottom line. Volume growth seems to be driving the top and bottom line in case of this company. I do not have access to the reasons behind it and hence it is difficult to evaluate the sustainability of the performance. I need to analyze if the growth is being driven by some new products as it is unlikely that the existing products would suddenly do so well.

Asian paints: The company is now firing on all cylinders. The company has reported a 100%+ growth in net profits. This has been a long term holding for me and as I have written in the past, I am also an ex-employee of the company. I am not surprised with the performance of the company. The company has a long history of good performance and has increased its market share and competitive advantage substantially in the last few years. The valuations of course reflect the strength of the company

NIIT tech: The company reported a 12% decline in topline and similar decline in the bottom line. The key reason behind it are the hedging losses. The company has been able to improve its operating margin during this period. There is nothing much to get excited in the current quarter results and with rupee appreciation, it is likely that the negative impact of the hedges will be reduced. I do not expect much in terms of the performance, which has clearly been a disappointment for me. I have marked down the intrinsic value of the company accordingly.

Maruti Suzuki: The company reported a 45% increase in topline and 90%+ improvement in net profits. The topline has been driven by domestic growth and major increase in exports. The bottom line has been driven by moderation of various commodity prices. The performance has been as expected in view the good monthly sales numbers and the stock price has already factored in this performance. As I have written earlier, I have started exiting this position.

I will be posting on the results of the other companies in the coming weeks as they are published and I am able to complete my review of the numbers.

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The period from Oct 2008 – Mar 2008 was a no brainer period – as long you could suppress the sinking feeling of watching your holdings drop everyday. As I had gone through a similar phase (though longer, but equally mind numbing) in 2001-2003, I was better prepared emotionally to deal with it. I had promised myself in 2003, that I will ignore the doomsday predictions and invest a meaningful amount of money when and if the crash came.

As they say, be careful what you wish for. I got my wish in 2008 and more. So during this period it was a matter of picking a decent company and investing in it. The valuations did not matter much as almost everything was dirt cheap, as long as one could be sure that the company would survive the likely recession and prosper in the future. This period did not last too long and we have been on an upswing since April 2009.

The situation is now completely different. I have never seen a market where almost every company, especially mid-caps and microcaps are doing well too. During the previous bull market in 2007, there were pockets of undervaluation as the markets were focused on the hot sectors – realty and infrastructure at that time. So one could find undervalued IT or midcap companies easily.

Sudden corrections

That situation has now changed completely. The correction in undervaluation for several companies is startling. I have seen companies like Hawkins cooker, VST and countless more correctly suddenly by 40-50% or more in a matter of days. This is more pronounced in case of companies which have reported good results in the previous quarter.

The upside is that most of us are sitting on pretty decent gains for the year, far more than we expected at the beginning of the year. The downside is that the number of attractive opportunities are shrinking by the day.

Modified approach

I have been running filters and have done an initial analysis on some 200 odd companies and can hardly find anything which would send my pulse racing. There are a few decent opportunities out there and one could invest a moderate amount of capital in it, but nothing in which I could commit something meaningful and be confident about it. One option could be to do nothing and wait till something really attractive comes up. The other alternative, which I may end up following, is to buy the entire set of moderately attractive ideas in equal proportions. The end result would that each one of these ideas may not do well, but the group as a whole should give me above average returns.

I plan to publish a few of these ideas in the coming weeks, provided they do not run up in the meantime. However, as I promised in my previous post, the top 1-2 ideas are reserved for those who have already contributed or plan to do so in the near future.

A Happy Diwali

Finally a happy Diwali to all the Indian readers and may all of us have a prosperous year ahead.

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About
Sulzer india is a 200 Cr company in the business of mass transfer technology (mixers, separation column etc) for industries such as refineries, chemicals, gas processing etc. The company is a subsidiary of Sulzer chemtech AG. The parent also has a fully owned subsidiary – sulzer pumps.

Sulzer india has received technology support from its parent, which holds 80% of the equity in the company

Financials
The company has maintained an ROE in excess of 25%, with the number increasing to around 40%+ in the last 2 years. The company’s total asset base is almost same as the cash balance, so net of cash the invested capital is a very low amount. In addition the company also has a source of additional capital – customer advance which reduce the net capital requirement in the business.

The sales have tripled and net profits gone up by more than four times in the last 4years. The company is debt free and now operates with negative working capital

Positives
The company operates in a knowledge and technology intensive industry. It is supported by the parent in terms of technology and technical transfer. The company also has a strong balance sheet with excess cash and has demonstrated a decent growth record in the last 5 years.

Finally the company has maintained a decent dividend payout ratio in the last few years

Risks
The key risk in my mind is the lack of in depth information available on the company. The annual report is fairly sketchy. The parent holds 80% of the company and has attempted to delist the subsidiary in the past. As a result, I personally don’t expect them to care too much about their Indian shareholders. The tone and disclosure in the annual report seems to reflect the lack of interest on part of the management for the minority shareholder.

The core business of the company is fairly healthy and the company should continue to do well in the future. The risk is how much the minority shareholder will benefit directly from the value creation.

Management quality checklist
-        Management compensation : The management compensation is not excessive and appears to be on the lower side
-        Capital allocation record (dividend, ROE, excess cash, acquisitions etc) : seems decent with reasonable payouts in the form of dividends
-        Shareholder communication: sketchy and poor.
-        Accounting practise: appears conservative
-        Conflict of interest: Though strictly not conflict of interest, the company pays 2% of sales as royalty to the parent. There is no explicit conflict of interest.
-        Performance track record: The business performance has been good even during the downturn.

Conclusion
The company sells at around 11 time current earnings with cash levels in excess of 10% of the market cap. In view the fundamental performance, the company could easily be valued at 20 times current earnings. However fundamental performance is not always the sole determinant of value. In cases such as sulzer, which are MNC subsidiary companies the business performance does not always translate into shareholder returns as long as the management does not take specific measure to improve shareholder returns.

Sulzer has tried to delist the company in the past and current holds 80% of the stock. I will have to stretch my imagination on the point, that the company will suddenly start looking at improving the returns for the minority shareholder. In such a scenario, it is quite difficult to put an appropriate number on the intrinsic or fair value of the company.

Disclosure : I do not currently hold the stock. I may or may not buy the stock in the future and may not declare my holdings. Please read my disclaimer at the end of this blog.

Additional message
Let me take a break from our regular broadcast. I am currently looking for two things and would appreciate if any reader can help me on it
-        I am looking at someone with the requisite technical skills, who can help me make changes to my blog layout and design. I can workout an appropriate payment either in cash or kind (you redesign my blog and I provide advisory service for your portfolio).  If you know someone or can do it yourself – please write to me on rohitc99@indiatimes.com or leave a comment.
-        I am looking at developing an automated spreadsheet for filtering stock based on various preset criterias by pulling data automatically from a public websites. I am not sure if this can be done and would appreciate any feedback on the feasibility of this requirement.

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I managed to achieve perfect timing this time. It managed to sell exactly before the fundamental performance of VST and India nippon turned around. I wrote the following post on the two companies and my key reason for exiting the two stocks was stagnation of their fundamental performance for the last 2-3 years.

VST reported a 126% increase in their net profit, driven by a 100% increase in topline. This increase is not really a one time increase as the other companies in the industry like Godfrey Philips have reported similar results driven by the topline growth. I have yet to investigate the sudden turnaround in the industry and whether it is sustainable.

Indian nippon reported a 100% growth in profits, driven by a 20% increase in topline. The reason for the profit growth in excess of the topline is due to the operating leverage enjoyed by the company. I need to analyze how sustainable is the performance for India nippon.

My confidence levels in terms of fundamental performance is still higher for VST than India nippon (irrespective of the stock price). The reason is that VST sells a consumer product with pricing strength, whereas India nippon is an auto component supplier which could be benefitting from the upturn in the auto business. The company however, does not enjoy as much pricing power and hence may not derive as much benefit from the upturn in business.

So where did I goof up?
The first thing i do when something turns out different from my expectations is to analyze if I could have analyzed it differently. My reason for the exit was stagnant fundamental performance (irrespective of the stock price).

At the time of the sale, after I had analyzed the two companies, I could not foresee a turnaround in the business. In case of VST an economic downturn will not hurt the businesses and hence when the economy turned, I did not expect the business to turn as much.

In case of India nippon, It can be argued that the auto industry is turning around and hence it just a matter of time that the auto component industry would benefit too. However, it was difficult to reach such a conclusion in case of India nippon as the company has performed poorly in the last 3 years when the auto industry was still doing well.

The other drawback with these companies is the lack of transparency on the part of the management. The Annual reports are very brief or cryptic and there are no management calls which an investor like me can read to get an idea of the likely direction of the business. A professional investor having access to the management would be able to avoid this problem.

The final point is how long should one hold onto a stock before the fundamental performance turns around. I typically hold a stock for 2-3 years and even longer if the fundamental performance is satisfactory. However if the fundamental performance is deteorating, I tend to exit the stock. As someone has said – Hope is not an investment strategy.

Indentifying turnaround in business performance is difficult for me and I tend to get the exact timing more wrong than right.  Ofcourse this is not new for me – I have sold L&T in 2003 after holding it for 5 years, right before the company took off

It does not disturb me
The above occurrence does not disturb me. It does not mean that I am proud of missing such turnaround and will not analyze my thought process further to see how I can improve on it in the future.

I have said in the past that if I can get a 70% success rate in my picks, I will do fairly well. What is the logic of this number ..did I pull it out of my hat?. There is a logic to it. I typically invest in a stock with a 2:1 to 3:1 odds. What that means is that if the stock is priced at 100 / share, then the possible upside is between 70-80 and the possible loss is between 20-30. The expected gain (gain * probability of gain + loss* probability of loss) is around 35-40 ( .7*70+.3*30) or 30-40% which provides me a margin of safety too.

My actual success rate has been around 70-80% in the past with the gain/ loss ratio around the same level. As a result, I have been able to meet my return targets in the past. In addition, an additional lever in managing the performance is managing the allocation percentage to a specific idea. One should allocate a higher percentage to the ideas where one has higher confidence.

Follow me – in reverse
Considering my almost perfect record in selling (around 0%), I think it would make sense to hold or buy when I decide to sell

When I suggest, that you should do your own research and not buy based on my recommendation, I am dead serious about it. A 70% success rate has worked out well for me. The impact of the 30% failure has been further reduced as i have not allocated too much of my funds to those ideas as I did not have as much confidence in them. If you decide to have a higher allocation than me, your results could be worse.

An additional point: I tend to change my mind suddenly, if the current facts invalidate my expectations. So I may end up buying something which I recently sold or sell something which I bought and realized that my thesis is wrong.

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I started the analysis of P&G (US) in my previous post. The balance of the analysis follows

Competitive analysis
The company faces a host of competitors ranging from local to store brands to companies like unilever. Most of the local and store brands compete on price.

P&G has rightfully realized the need for innovating in all the categories to stay ahead of the competition and thus maintain a price premium. In addition the company has a wide portfolio of brands and an extensive marketing and distribution infrastructure. These competitive strengths allows the company to fight price based competition.

The company has been investing almost 10% in marketing and sales and 3% in R&D. These investments are key to maintaining the competitive edge of the company.

Management quality checklist
-        Management compensation: The chairman received a total compensation and bonus of around 57 Mn usd, which does not appear excessive. The company has an options program which would result in a rough dilution of around 10% or less.
-        Capital allocation record: The management has a very good capital allocation record. They have maintained an ROE in excess of 20% for the 7-8 yrs. In addition the company has maintained a dividend payout in excess of 40%. The excess cash has been utilized to fund acquisitions and buyback stock. I would give the management high grade on capital allocation.
-        Shareholder communication: The company has communicated its strategy and focus on innovation. In addition the company has is also transparent in communicating the long term goals such as organic growth, free cash flow target etc and the achievement against the goals. The company has also discussed in detail the performance of each division with clear details of the organic volume growth to enable the investor to understand the source of the topline growth. The company has been consistent in communicating good as well as bad performance.
-        Accounting practice: appears conservative and I could not find any red flags. The company seems to have made conservative pension assumptions, has minimal derivative exposures and other off balance sheet liabilities. My only concern is the benefit assumptions. Although the actual returns are negative, the company is using positive expected returns on assets (allowed by GAAP). If the returns do not turn positive, we could see higher pension expense in the future. 

Valuation
The company has a free cash flow which is almost equal to net profits. The company has an ROE in excess of 20% and an average growth in excess of 8%. If we assume a CAP period of around 10 years, a net profit growth of 8%, the intrinsic value comes to around 72-75 usd per share. If one reverse engineers the current price, the implied growth seems to be around 2-3% for the next 10 years.        

The company thus appears to be undervalued by around 20-25% at current prices.

Conclusion
The company has been able to show a low single digit growth inspite of the global recession. The topline however has shown a low single digit drop. The company is in the process of disposing non core businesses such as coffee and the medical division. This should provide the company extra capital to invest in the core business, retire debt or continue with the buyback program.

The company has maintained its focus on innovation and new products and has been investing heavily in brand building and R&D, even through the recession. This should help the company when growth returns. The company has enormous competitive advantages in the form of strong brands, deep distribution network and a innovation oriented culture. Although the company is not undervalued by a wide margin, it should give moderate returns in excess of the index returns over the next few years. In summary it is moderate return, low risk opportunity.

I have created a pdf version of the analysis. Please feel free to download and share with others

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