About
Tata sponge ltd is a 676 cr sponge iron manufacturer with an annual capacity of 3.42 Lac MT. The company uses iron ore and coal as the raw material, which is used to produce sponge iron. Sponge iron is an important raw material for the manufacture of steel and the price for sponge iron in turn depends on steel demand and pricing.
The company is a part of the Tata group, which holds a 40% stake in the company through Tata steel. Tata steel also supports the company, by supplying iron ore. In addition the company has purchased and is developing coal mines for captive use and to control input costs.
Financials
The company has revenue of 676 crs and has recorded an average growth of 15%+ in the last 10 years. The bottom line is around 105 Crs with a growth of 20%+ in the last 5 years. The key point to note in the performance is that quite a bit of growth in the topline and bottomline has happened in the last 5 years.
The net margin of the company is currently at 17%. However the net margin has fluctuated between 4% and 17% in the last 10 years. These fluctuation are closely linked to the steel demand and pricing and has generally fallen when the overall economy has slowed down.
The company has now become a debt free company and has a cash holding of around 115 crs on its balance sheet.
Positives
The company has a strong balance sheet with excess cash which can be used to fund additional capacity without taking on debt. In addition the company is a part of the Tata group which is known for good corporate governance.
The company also has access to ore supplied by Tata steel which provides some stability to raw material costs. In addition the company has acquired a coal mine and is in process of developing it. This would help the company to control its key inputs costs which is iron ore and coal.
The company has demonstrated good topline and bottom line performance and has a high ROE (15% or higher) at low to moderate levels of debt. Finally the company has always operated at a low or negative working capital.
Risks
The key risk for the company is the nature of the industry in which it operates. The industry is cyclical, with low barriers to entry. In addition, the product is a commodity and hence the profitability of the company is tied to steel prices and the demand supply situation of the same.
The industry and the company are also characterized by large swings in performance depending on the demand and pricing for its product.
Competitive analysis
The industry is characterized by low entry barriers and the only competitive edge a company can have in this industry would be from economies of scale. Companies do not have much control on raw material (coal and iron ore mainly) pricing and the pricing of the final product (sponge iron) is also driven by steel prices. Scrap steel is a substitute for sponge iron and hence the price and availability of scrap steel also has an impact on the price of sponge iron.
Finally the industry faces price based competition, atleast at the local level and most of the companies are price takers. I don’t think any company can demand a premium for their sponge iron.
Management quality checklist
- Management compensation: Management compensation is fairly low with the MD drawing a compensation in the region of 50-60 lacs
- Capital allocation record: The management has demonstrated a good capital allocation record. The company has maintained an ROE in excess of 15% even during downturns. The company has also demonstrated an ROE of around 25% on the incremental capital invested in the last 5 years. The only negative has been the low level of dividend payout. The low dividend payout is however understandable due to the lower levels of free cash flows (atleast 20-30% of the earnings is required as maintenance capex).
- Shareholder communication – Shareholder communication has been good and the management has been transparent about the performance.
- Accounting practice – looks conservative
- Conflict of interest - none
- Performance track record – good in comparison to the industry economics
Valuation
The intrinsic value of the company can be taken between 350-400 for a net profit margin of around 11-13% over a business cycle and for a topline growth of around 13-15%. The current margins of around 17% cannot be taken as a base line as the margins have fluctuated between 4 to 24% with an average of 11% for the last 10 yrs. The topline assumption is a bit conservative, but a higher rate of growth will not increase the intrinsic value as much, as a higher growth would require a higher level of re-investment and result in a lower free cash flow.
Scenario analysis
The current price discounts a net margin of 11% and topline growth of 9%. A topline growth of 15% would give an intrinsic value of around 360-400.
Conclusion
The company seems to be undervalued by around 30-35% at best. The company may look undervalued based on the PE, but the correct approach to value a company is to compute its intrinsic value based on a DCF (discounted cash flow) formulae using the free cash flow generated by the company.
A company such as Tata sponge is in a commodity business which requires a higher level of maintenance capex (for understanding maintenance capex, see here). As a result the earnings of such a business consistently overstates the free cash flow. In case of tata sponge, the free cash is around 70-80% of the earnings. Based on the above free cash flow, margin and growth estimates, I would conservatively put the intrinsic value between 350-400.
Finally, the industry and the company is in a commodity industry with low to non-existent competitive advantages. As a result, it would be sensible to take the intrinsic value on the conservative side
Disclosure: I don’t hold the stock as it is not cheap enough for me. However I may not disclose it on my blog, when I decide to initiate a position in the stock. As always, please read the disclaimer
Friday, November 27, 2009
Thursday, November 19, 2009
What’s on my mind – Nov 09
I am planning to start a new monthly post with the topic – what's on my mind. It's more likely to be a brain dump of my thoughts – more for myself – to check back in future as to what I was thinking (or smoking J ) at a particular point of time. This should help me cross-reference some of the investing decision I took at the time.
It's a natural tendency to look at decision after they play out with a fair amount of hindsight bias. Like others, I too have a tendency to forget the key factors which played into my decision and color the history based on present information. Anyway, more on this bias in a later post.
Dollar depreciation
The US is now running a deficit of almost 1.4 trillion (that's 1000 billion and 1 billion = 100 crores). That's a lot of zeroes. The deficit is almost 10% of GDP and projected to continue for some time. A deficit of this proportion would land (and it did in 91) a country like India in serious trouble very quickly. If we had to borrow as much to fund our deficit, we would have a crisis (as we did in 1991).
Now the US dollar is a reserve currency and they get to print it and hence can monetize their debt. In addition, it's a rich country, so other countries are ready to lend to the US. However there is finally a limit to everything and something which cannot go on forever will stop some way or other. In the usual case, a country incurring such a deficit could see its currency depreciate, cost of debt and inflation shoot up and contraction of its economy if it went too far. The US has been able to avoid all this as it is still the largest economy and other countries do not really have too much of an alternative.
That said, it is appear likely (atleast in the long run), that the currency will keep depreciating. That does not mean, that we will not have episodes (as in 2008), where the currency strengthened. However in the long run a country with a large deficit and growing debt can fix it in 3 ways – inflate, raise taxes and cut expenses. Inflation (via currency depreciation) is easier politically and hence looks more likely to happen.
All of the above is a conjecture, but still a probable scenario. Now, you may ask, how does it impact us? A few points come to my mind
- Our currency is still a managed currency and everytime the dollar has depreciated, RBI attempts to control the appreciation of the rupee. This has in general resulted in high liquidity in the domestic markets which results in asset bubbles – spike in real estate and Stock markets etc.
- Higher inflation due to higher commodity prices as most of commodities are priced in dollar
- Reduction in margins for IT and export oriented companies due to stronger rupee and weaker growth in export market such as US
The problem with macroeconomics is that you may be right in the long run, but in the short run be completely off the mark. In addition, it is easy to guess, but difficult to arrive at specific investment decisions based on these macro-economic mumbo jumbo.
All said and done, I am worried about the implied (based on current valuations) bottom line growth for IT companies and the head winds faced by them.
Automotive sector
The growth for the current quarter is likely to be high due to the base effect (dec 2008 was bad) and hence the market may still react positively. However in view of the valuations, I have already started reducing my position in maruti. Need to make up my mind on Ashok Leyland, which has appreciated quite a bit
Overall market levels
I am not sure if the market are overvalued at 22 times earnings, but at the same time I have started reducing my Index ETF positions. I do not look at chart and any other technical indicators. As I have said in the past, when the market has fallen below 12 times earnings, it has generally been a good time to buy the index and a market level of 23 and above a decent time to sell. Its not a precise approach, but makes decent sense from a valuation perspective.
Fixed income investing
I would prefer to buy short dated debt (short term deposits) or floating rate funds. I think that inflation is likely to go up and hence it would better to buy floating rate funds than fixed rate ones. Again, no specific analysis as to why I think that inflation will go up – only reason is that the government has a stimulus package and low rates. Once the inflation starts creeping up, RBI may have to raise rates again.
New ideas
Not many attractive ones. So I am currently just studying some companies such as Tata sponge and others from a learning perspective. This should help me pull the trigger when the valuations are right. I need to avoid trying to be too clever for my own good.
Friday, November 13, 2009
Comments and reply to my options post
Aniruddha brought up a very good point in the comments and as a result, I decided to add it to the post as it captures the issue for a long term investor. My response follows the comment
Hi Rohit,
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it's waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.
hi anirudha
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.
If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.
Options work well as disaster protection too...end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
--------------------------------------------------------------------------------
I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post
The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)
In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.
In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.
Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.
Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period
Imperfect hedge
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.
Educational experience
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.
I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.
The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.
Hi Rohit,
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it's waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.
hi anirudha
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.
If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.
Options work well as disaster protection too...end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
--------------------------------------------------------------------------------
I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post
The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)
In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.
In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.
Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.
Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period
Imperfect hedge
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.
Educational experience
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.
I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.
The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.
Tuesday, November 10, 2009
Moving to the dark side – bought options
Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post
I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.
I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.
There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.
If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.
The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.
So how does a derivative – a put or a call option fit into the above approach ?
There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.
During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.
At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it
Buying insurance
In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock
The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)
With the above point in mind, I had make a decision based on the following factors
- Strike price of the index put
- Duration of the put
The Strategy
At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.
An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).
I ended up buying the December contract for 100 with a strike price of 4500.
The result
After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.
The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.
Conclusion
Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.
I would personally buy options under two scenarios
- The market appears considerably overvalued and options are underpriced due to low volatility
- I wish to hedge a specific stock position which I plan to sell in the next few months.
I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J
Monday, November 02, 2009
Competitive analysis of IT companies
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
ENTRY BARRIER - No. 1 Factor deciding industry profitability |
|
Asset specificity | Low. Mainly buildings and facilities. |
Economies of Scale | Economies of scale important in recruitment, training and staffing, especially for outsourcing |
Proprietary Product difference | None - IPR / knowledge base for vertical is the only differentiator |
Brand Identity | To a small extent for specific verticals. However not too critical |
Switching cost | High |
Capital Requirement | High now, especially for the mid-size and large deals |
Distribution strength | NA |
Cost Advantage | High - but available to all. Scale adds to this advantage |
Government Policy | NA |
Expected Retaliation | High |
Production scale | NA |
Anticipated payoff for new entrant | Moderate at the low end |
Precommitted contracts | High |
Learning curve barriers | Moderate |
Network effect advantages of incumbents | None |
No. of competitors - Monopoly / oligopoly or intense competition (concentration ratio ) | Intense competition |
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:
RIVALRY DETERMINANT | Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past |
Industry growth | moderate |
Fixed cost / value added | Low |
Intermittent overcapacity | Low |
Product difference | Low |
Informational complexity | Medium to Low |
Exit Barrier | Low |
Demand variability | Low |
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
SUPPLIER POWER | None - Input is manpower |
Differentiation of input | None |
Switching cost of supplier | None |
Presence of substitute | None |
Supplier Concentration | None |
Imp of volume to supplier | None |
Cost relative to total purchase | None |
Threat of forward v/s Backward integration | None |
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 | % Sales contributed by Top 5 account. High for smaller companies |
Buyer conc. v/s firm concentration | Varies for companies. Tier II companies have higher Buyer conc. |
Buyer volume | High for Tier II companies |
Buyer switching cost | High for buyers |
Buyer information | High |
Ability to integrate backward | Low. The reverse is happening |
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
Substitute product | Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable |
Price sensitivity | High for low end work |
Price / Total Purchase | High |
Product difference | Low |
Switching cost | Medium |
Buyer propensity to Substitute | Medium to high |
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
- As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
- 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.
- 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 :)
Competitive analysis of IT companies
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
ENTRY BARRIER - No. 1 Factor deciding industry profitability |
|
Asset specificity | Low. Mainly buildings and facilities. |
Economies of Scale | Economies of scale important in recruitment, training and staffing, especially for outsourcing |
Proprietary Product difference | None - IPR / knowledge base for vertical is the only differentiator |
Brand Identity | To a small extent for specific verticals. However not too critical |
Switching cost | High |
Capital Requirement | High now, especially for the mid-size and large deals |
Distribution strength | NA |
Cost Advantage | High - but available to all. Scale adds to this advantage |
Government Policy | NA |
Expected Retaliation | High |
Production scale | NA |
Anticipated payoff for new entrant | Moderate at the low end |
Precommitted contracts | High |
Learning curve barriers | Moderate |
Network effect advantages of incumbents | None |
No. of competitors - Monopoly / oligopoly or intense competition (concentration ratio ) | Intense competition |
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:
RIVALRY DETERMINANT | Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past |
Industry growth | moderate |
Fixed cost / value added | Low |
Intermittent overcapacity | Low |
Product difference | Low |
Informational complexity | Medium to Low |
Exit Barrier | Low |
Demand variability | Low |
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
SUPPLIER POWER | None - Input is manpower |
Differentiation of input | None |
Switching cost of supplier | None |
Presence of substitute | None |
Supplier Concentration | None |
Imp of volume to supplier | None |
Cost relative to total purchase | None |
Threat of forward v/s Backward integration | None |
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 | % Sales contributed by Top 5 account. High for smaller companies |
Buyer conc. v/s firm concentration | Varies for companies. Tier II companies have higher Buyer conc. |
Buyer volume | High for Tier II companies |
Buyer switching cost | High for buyers |
Buyer information | High |
Ability to integrate backward | Low. The reverse is happening |
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
Substitute product | Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable |
Price sensitivity | High for low end work |
Price / Total Purchase | High |
Product difference | Low |
Switching cost | Medium |
Buyer propensity to Substitute | Medium to high |
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
- As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
- 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.
- 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 :)
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