Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Should large-cap Indian IT firms look to shift operating bands of per
capita EBIT upwards? Yes, we believe in the long run firms must look to
execute strategies (like non-linearity, higher-value solutions etc.) that actively
improve per capita EBIT as (a) the law of large numbers catches up and (b)
growth tapers off putting the focus on non-linearity. But this cannot come at the
cost of growth (or “g” in the equation) if a trade-off between growth and per
capita metrics exists. This is understood from the equation = EV = EBIT*(1-tax
rate)*(1-g/ROIC)/(Cost of capital – g). Reduced to a per employee basis,
EV/employee = EBIT/employee*(1-tax rate)*(1-g/ROIC)/(Cost of capital – g).
Per capita market cap depends operationally on (a) per capita EBIT, (b)
absolute EBIT growth and (c) sustainable ROIC. Of these three parameters, we
find that per capita market cap is by far the most sensitive to growth.
More than per capita metrics, investors and firms must assess whether
business models offer sustainable growth at comfortable ROIC (>30%).
Theoretically, a 5% improvement in per capita market cap (thus easing the onus
of creating investor returns on employee growth/hiring) is generated by a 5%
improvement in per capita EBIT. But this is very difficult to accomplish in
practice as can be seen from Infosys’ per capita EBIT trend in the last 8-10 years
(virtually in a narrow range; non-linearity has not accomplished much of note).
A much better lever to pull is growth if there is a growth versus per capita
profit trade-off. A 1% extra growth rate over the next 5-6 years accomplishes
the same as a rather difficult (if not impractical) 1-2% improvement in per capita
EBIT per year over the same period. How can one practically view trade-offs
such as these in business? A consulting-dominated proposition invariably
fetches higher per capita profits, but unless it scales (via downstream) for
growth, investor value from consulting-alone is limited from the point of view
of returns. In our view, Accenture understood the trade-off well as evidenced in
its moderating trend in its per capita EBIT over the past 3 years but cranking up
growth and margins in the bargain (through combined, tighter consulting +
outsourcing). This has improved Accenture’s per capita market cap relative
to Infosys. Cognizant’s per capita EBIT is ~30% lower than Infosys, yet it plays
on the “g” of the equation leading to increase of its per capita market cap.
Pay attention to Q factor. For pair comparisons between two companies (Say
Company 1 and company 2), the premium that the market accords to relative
growth is what we call the Q factor (defined as relative ratio of per capita market
cap/Per capita post-tax EBIT). By taking ratios between companies, we
eliminate the impact of P/E dislocation in the sector due to shock events.
Companies’ whose Q scores have improved have done so due to higher change
in growth expectations relative to peers. They have also returned greater
shareholder wealth relative to the chosen index (Infosys). The company that has
increased its Q factor the most over a long-enough secular time frame (3 and 5
years) is Accenture. Change in Q is most sensitive to change in growth
expectations – much less to changes in EBIT/employee. Maximizing per capita
profitability must be subordinate to maximizing growth for investor returns as
long as head-room for growth exists.
Per capita metrics vs. growth…impact of
the trade-off on investor wealth creation
Disaggregation of market cap as market cap/employee (1) x
Number of employees (2) provides interesting insights
Consider the equation market cap = per capita market cap (1) * number of
employees (2)….Indian-IT services companies can increase market cap by:
(a) Increasing both market cap/employee (1) and employee base (2)…increasing both
is the best outcome
(b) Increasing (2) only even if (1) decreases/is broadly constant. This is what they
have done so far.
In our per capita market cap (ex-cash) computations, we take the employee base as
number of employees as of the end of the respective year (year ending March). This
is because per capita market cap is a forward-looking metric.
Pure product/non-linear stories that have track record of great innovation and valueaddition
may depend primarily on (1) rather than (2) for value creation. The
perceived investor risk is that if Indian companies merely add employees (i.e. add in
numbers) without climbing up the value chain, (1) will continue to inexorably
decrease.
The investor's common misgiving over the long term business model of Tier-1 Indian
IT services companies is that increase in (2) (i.e., employees) will not help in
sustainable market cap increase. There is tension/pressure to ensure that increase in
(2) overcomes decrease in (1) to increase market cap. The ideal way to realize market
cap accretion will be to increase both (1) and (2) or at the very least ensure that (1)
does not exhibit a declining trend and is maintained. The question is, can Infosys
and others ensure and sustain (1)? That there will be employee addition is certain;
hence, (2) is ensured but is that enough? Merely (2) will always mean that the
company is perceived to be running the treadmill of commoditization.
The argument is analogous to the stock return principle (Price [P] = P/E x
Earnings [E]). Maximum price appreciation is possible if both P/E and E increase
simultaneously. If firm profitability dips though growth still accrues, E increases but
P/E could suffer. The net impact on P is not always clear. P could increase in the near
term, but soon enough the P/E decline could overpower the role of expanding E and
longer-term sustainability of P would itself be in question.
Can benchmark cost of equity returns (12-13%) be really
sustained over long term without higher per capita metrics?
We believe that the employee base (net) of larger tier-1 players is likely to increase
about 15% p.a. over FY12-15. The law of large numbers will mean that this
percentage change is likely to decrease going forward and perhaps after three years’
time, the employee growth rate could begin to taper down to or below the cost of
equity (12-13%). In such a scenario, benchmark cost of equity stock returns will be
possible only if market cap/employee shows an improving trend.
Thus, beyond the medium-term (three years), it seems that the emphasis will fall
squarely on improving market cap/employee to deliver higher than benchmark cost
of equity (12-13%) returns. The hypothesis is that this will be possible only if tier-
1 companies substantially deliver on their non-linear growth strategies to
deliver at least 20-25% of revenues from such initiatives in 3-4 years. Is this
hypothesis conclusively correct? We investigate in the sections to follow.
Understand per capita market cap for what it truly means in
terms of operating variables
For simplicity we take steady state. In steady state, EV = EBIT * (1- Tax rate)*(1-
g/ROIC)/ (Cost of capital – g)
Converting into per capita terms
EV/employee = EBIT/employee * (1- Tax rate)* (1-g/ROIC)/ (Cost of capital –
g)
Expectedly EV/employee or Market cap per employee ex-cash depends on three
variables:
a) EBIT/employee….(this is the metric that Infosys scores the highest among
its offshore peers, Accenture among all IT services providers)
b) ROIC ……(Accenture leads, while among Indian peers Infosys leads)
c) G (growth) of EBIT….(Cognizant, TCS and Accenture lead on this
dimension).
(The interested reader may see appendix II on page 10 for more details on the
theoretical construct)
Per capita operating profit or EBIT per employee:
Operating profit per employee (or per capita operating profit) is taken as
EBIT/average employee base. This is because, operating profit in a fiscal accrues
over a changing employee base (it is a flow measure), and employees hired during
the fiscal are mostly utilized within six months. The average through the year would
be a better indicator of per capita profits than computing it over the beginning or end
of year employee base.
Also, large-cap Indian IT firms employ sub-contractors to a negligible degree; hence,
we do not run the risk of understating the employee base or overstating per employee
metric.
The three variables are not necessarily independent and interdependence
between them presents trade-offs. For example, a high-end or non-linear
proposition that maximizes per capita EBIT may not sit well with overall growth
objectives if downstream goals are not operationalized (the challenge with consulting
which Accenture has overcome very creditably). Our finding by running sensitivity
of per capita market cap to each of these variables suggests that EV/employee is most
sensitive to growth.
We conclude that if trade-offs between drivers present themselves as they do,
growth is the lever that companies must, first and foremost pull, (at or above a
comfortable ROIC of 30%).
A simple illustration will suffice to explain our point. Currently, Infosys’ current per
capita operational market-cap (ex-cash) is about USD 200,000 while its per capita
EBIT (pre-tax) is about USD 14,500 (FY11). Infosys’ per capita has remained in a
tight band in the last six years
As implied in the current Infosys stock price (Rs.2,533), current expectations build in
about 15% growth for the next 6 years till FY18, before we settle down to 5% growth
to perpetuity after that starting FY19 (6 years of market share gains in the model). If
Infosys raises its game on per capita EBIT by raising it by 1% every year over this
period but in the bargain employee growth were to decline by more than 1% (because
of the trade-off), we estimate the net impact to per capita market cap is negative.
Table 1 highlights the shaded combinations that represent trade-off points between
these two variables (EBIT/employee growth and employee growth). (Note: not all
cells in the table correspond to trade-off points).
Accenture has demonstrated the practical truth of this principle well, in our
view. Despite its per capita EBIT declining by 8-10% since 2008, by stepping up on
growth through outsourcing (lower per capita business line at improved margins) it
has significantly improved its per capita market cap (ex-cash) (see Figure 2). That
when multiplied by employee growth has translated into significant shareholder
returns. Notably, TCS per capita market cap (ex-cash) is broadly on par with Infosys
even though its FY11 per capita EBIT is lower than Infosys by 12%
Conclusion: Almost everything is subordinate to growth at
attractive, sustainable ROIC when there is room to grow
It is intuitive to suggest that companies that consistently manage higher per
capita in employee-intensive sectors such as should track higher per capita
market cap. This is not true. Growth at attractive ROIC is the overriding
factor above all else. If per capita profit goals (such as consulting,
solutions and non-linearity) do conflict with growth at respectable ROIC,
we believe investors must choose companies that give priority to growth
(even if per capita profitability declines while doing so).
Accenture demonstrates the practical truth in our reasoning of which drivers
to focus on in case of trade-offs. Its per capita market cap has moved up
relative to Infosys in the past 3 years even as its per capita EBIT displays a
slightly moderated trend since 2008.
Per capita profitability could be the focus when growth opportunities
get scarce. We do not think that this is yet the case in Indian IT. We foresee
the market offering at least 5-6 years of 15% growth (top-line) for the larger
caps in our universe of coverage.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Should large-cap Indian IT firms look to shift operating bands of per
capita EBIT upwards? Yes, we believe in the long run firms must look to
execute strategies (like non-linearity, higher-value solutions etc.) that actively
improve per capita EBIT as (a) the law of large numbers catches up and (b)
growth tapers off putting the focus on non-linearity. But this cannot come at the
cost of growth (or “g” in the equation) if a trade-off between growth and per
capita metrics exists. This is understood from the equation = EV = EBIT*(1-tax
rate)*(1-g/ROIC)/(Cost of capital – g). Reduced to a per employee basis,
EV/employee = EBIT/employee*(1-tax rate)*(1-g/ROIC)/(Cost of capital – g).
Per capita market cap depends operationally on (a) per capita EBIT, (b)
absolute EBIT growth and (c) sustainable ROIC. Of these three parameters, we
find that per capita market cap is by far the most sensitive to growth.
More than per capita metrics, investors and firms must assess whether
business models offer sustainable growth at comfortable ROIC (>30%).
Theoretically, a 5% improvement in per capita market cap (thus easing the onus
of creating investor returns on employee growth/hiring) is generated by a 5%
improvement in per capita EBIT. But this is very difficult to accomplish in
practice as can be seen from Infosys’ per capita EBIT trend in the last 8-10 years
(virtually in a narrow range; non-linearity has not accomplished much of note).
A much better lever to pull is growth if there is a growth versus per capita
profit trade-off. A 1% extra growth rate over the next 5-6 years accomplishes
the same as a rather difficult (if not impractical) 1-2% improvement in per capita
EBIT per year over the same period. How can one practically view trade-offs
such as these in business? A consulting-dominated proposition invariably
fetches higher per capita profits, but unless it scales (via downstream) for
growth, investor value from consulting-alone is limited from the point of view
of returns. In our view, Accenture understood the trade-off well as evidenced in
its moderating trend in its per capita EBIT over the past 3 years but cranking up
growth and margins in the bargain (through combined, tighter consulting +
outsourcing). This has improved Accenture’s per capita market cap relative
to Infosys. Cognizant’s per capita EBIT is ~30% lower than Infosys, yet it plays
on the “g” of the equation leading to increase of its per capita market cap.
Pay attention to Q factor. For pair comparisons between two companies (Say
Company 1 and company 2), the premium that the market accords to relative
growth is what we call the Q factor (defined as relative ratio of per capita market
cap/Per capita post-tax EBIT). By taking ratios between companies, we
eliminate the impact of P/E dislocation in the sector due to shock events.
Companies’ whose Q scores have improved have done so due to higher change
in growth expectations relative to peers. They have also returned greater
shareholder wealth relative to the chosen index (Infosys). The company that has
increased its Q factor the most over a long-enough secular time frame (3 and 5
years) is Accenture. Change in Q is most sensitive to change in growth
expectations – much less to changes in EBIT/employee. Maximizing per capita
profitability must be subordinate to maximizing growth for investor returns as
long as head-room for growth exists.
Per capita metrics vs. growth…impact of
the trade-off on investor wealth creation
Disaggregation of market cap as market cap/employee (1) x
Number of employees (2) provides interesting insights
Consider the equation market cap = per capita market cap (1) * number of
employees (2)….Indian-IT services companies can increase market cap by:
(a) Increasing both market cap/employee (1) and employee base (2)…increasing both
is the best outcome
(b) Increasing (2) only even if (1) decreases/is broadly constant. This is what they
have done so far.
In our per capita market cap (ex-cash) computations, we take the employee base as
number of employees as of the end of the respective year (year ending March). This
is because per capita market cap is a forward-looking metric.
Pure product/non-linear stories that have track record of great innovation and valueaddition
may depend primarily on (1) rather than (2) for value creation. The
perceived investor risk is that if Indian companies merely add employees (i.e. add in
numbers) without climbing up the value chain, (1) will continue to inexorably
decrease.
The investor's common misgiving over the long term business model of Tier-1 Indian
IT services companies is that increase in (2) (i.e., employees) will not help in
sustainable market cap increase. There is tension/pressure to ensure that increase in
(2) overcomes decrease in (1) to increase market cap. The ideal way to realize market
cap accretion will be to increase both (1) and (2) or at the very least ensure that (1)
does not exhibit a declining trend and is maintained. The question is, can Infosys
and others ensure and sustain (1)? That there will be employee addition is certain;
hence, (2) is ensured but is that enough? Merely (2) will always mean that the
company is perceived to be running the treadmill of commoditization.
The argument is analogous to the stock return principle (Price [P] = P/E x
Earnings [E]). Maximum price appreciation is possible if both P/E and E increase
simultaneously. If firm profitability dips though growth still accrues, E increases but
P/E could suffer. The net impact on P is not always clear. P could increase in the near
term, but soon enough the P/E decline could overpower the role of expanding E and
longer-term sustainability of P would itself be in question.
Can benchmark cost of equity returns (12-13%) be really
sustained over long term without higher per capita metrics?
We believe that the employee base (net) of larger tier-1 players is likely to increase
about 15% p.a. over FY12-15. The law of large numbers will mean that this
percentage change is likely to decrease going forward and perhaps after three years’
time, the employee growth rate could begin to taper down to or below the cost of
equity (12-13%). In such a scenario, benchmark cost of equity stock returns will be
possible only if market cap/employee shows an improving trend.
Thus, beyond the medium-term (three years), it seems that the emphasis will fall
squarely on improving market cap/employee to deliver higher than benchmark cost
of equity (12-13%) returns. The hypothesis is that this will be possible only if tier-
1 companies substantially deliver on their non-linear growth strategies to
deliver at least 20-25% of revenues from such initiatives in 3-4 years. Is this
hypothesis conclusively correct? We investigate in the sections to follow.
Understand per capita market cap for what it truly means in
terms of operating variables
For simplicity we take steady state. In steady state, EV = EBIT * (1- Tax rate)*(1-
g/ROIC)/ (Cost of capital – g)
Converting into per capita terms
EV/employee = EBIT/employee * (1- Tax rate)* (1-g/ROIC)/ (Cost of capital –
g)
Expectedly EV/employee or Market cap per employee ex-cash depends on three
variables:
a) EBIT/employee….(this is the metric that Infosys scores the highest among
its offshore peers, Accenture among all IT services providers)
b) ROIC ……(Accenture leads, while among Indian peers Infosys leads)
c) G (growth) of EBIT….(Cognizant, TCS and Accenture lead on this
dimension).
(The interested reader may see appendix II on page 10 for more details on the
theoretical construct)
Per capita operating profit or EBIT per employee:
Operating profit per employee (or per capita operating profit) is taken as
EBIT/average employee base. This is because, operating profit in a fiscal accrues
over a changing employee base (it is a flow measure), and employees hired during
the fiscal are mostly utilized within six months. The average through the year would
be a better indicator of per capita profits than computing it over the beginning or end
of year employee base.
Also, large-cap Indian IT firms employ sub-contractors to a negligible degree; hence,
we do not run the risk of understating the employee base or overstating per employee
metric.
The three variables are not necessarily independent and interdependence
between them presents trade-offs. For example, a high-end or non-linear
proposition that maximizes per capita EBIT may not sit well with overall growth
objectives if downstream goals are not operationalized (the challenge with consulting
which Accenture has overcome very creditably). Our finding by running sensitivity
of per capita market cap to each of these variables suggests that EV/employee is most
sensitive to growth.
We conclude that if trade-offs between drivers present themselves as they do,
growth is the lever that companies must, first and foremost pull, (at or above a
comfortable ROIC of 30%).
A simple illustration will suffice to explain our point. Currently, Infosys’ current per
capita operational market-cap (ex-cash) is about USD 200,000 while its per capita
EBIT (pre-tax) is about USD 14,500 (FY11). Infosys’ per capita has remained in a
tight band in the last six years
As implied in the current Infosys stock price (Rs.2,533), current expectations build in
about 15% growth for the next 6 years till FY18, before we settle down to 5% growth
to perpetuity after that starting FY19 (6 years of market share gains in the model). If
Infosys raises its game on per capita EBIT by raising it by 1% every year over this
period but in the bargain employee growth were to decline by more than 1% (because
of the trade-off), we estimate the net impact to per capita market cap is negative.
Table 1 highlights the shaded combinations that represent trade-off points between
these two variables (EBIT/employee growth and employee growth). (Note: not all
cells in the table correspond to trade-off points).
Accenture has demonstrated the practical truth of this principle well, in our
view. Despite its per capita EBIT declining by 8-10% since 2008, by stepping up on
growth through outsourcing (lower per capita business line at improved margins) it
has significantly improved its per capita market cap (ex-cash) (see Figure 2). That
when multiplied by employee growth has translated into significant shareholder
returns. Notably, TCS per capita market cap (ex-cash) is broadly on par with Infosys
even though its FY11 per capita EBIT is lower than Infosys by 12%
Conclusion: Almost everything is subordinate to growth at
attractive, sustainable ROIC when there is room to grow
It is intuitive to suggest that companies that consistently manage higher per
capita in employee-intensive sectors such as should track higher per capita
market cap. This is not true. Growth at attractive ROIC is the overriding
factor above all else. If per capita profit goals (such as consulting,
solutions and non-linearity) do conflict with growth at respectable ROIC,
we believe investors must choose companies that give priority to growth
(even if per capita profitability declines while doing so).
Accenture demonstrates the practical truth in our reasoning of which drivers
to focus on in case of trade-offs. Its per capita market cap has moved up
relative to Infosys in the past 3 years even as its per capita EBIT displays a
slightly moderated trend since 2008.
Per capita profitability could be the focus when growth opportunities
get scarce. We do not think that this is yet the case in Indian IT. We foresee
the market offering at least 5-6 years of 15% growth (top-line) for the larger
caps in our universe of coverage.
No comments:
Post a Comment