Financial Analysis of the Indian IT Industry

The companies that were selected for the analysis of the IT industry include hardware and software companies that are listed on the NSE or BSE (excluding the Z group). The companies selected were further screened and those companies for which the comparable financial information for the last five years was available were shortlisted. Thus, we arrived at 128 companies, which were further segregated as large, medium and small companies on the basis of the widely-used 80:15:5 principle of their 365 days’ average market capitalisation as on March 31, 2010. There are five large companies whose 365-day average market capitalisation was more than Rs 115 billion as on 31 Mar 2010. There are 30 medium sized companies whose market capitalisation was between Rs 4 billion and Rs 115 billion and 93 small sized companies with their market capitalisation below Rs 4 billion on the said date. During FY09, the large companies constituted more than 69% of the total sales of the sample companies, whereas medium-sized and small IT companies constituted approximately 20% and 11% to the total sample sales, respectively.

Overall sales of IT companies grows annually by 23.8%in FY09

The repercussions of the subprime crisis were felt severely on the worldwide IT spending during CY08. The growth in global IT spend is expected to have tapered to 5.6%11 on a y-o-y basis during CY08 as compared to 7.3%12 registered in the previous year. IT services, which form the single largest segment (37%) of the total global spending on information technology products during CY08, grew by around 5.5% annually as compared to 6.0% registered in the previous year. It is important to highlight that exports constituted over 75% of the total sales of the sample companies and therefore, the moderation in the global IT spend impacted the sector in a significant way. Overall sales of the IT companies grew by approximately 23.8% on a y-o-y basis during FY09. Sales of large companies, which accounted for 69%% of the total sales of IT companies in the sample, recorded a y-o-y growth of 24.5% during FY09.

During FY09, large and small companies bolstered their export income as their share of exports in their total sales increased by 2.8% to 88.7% and 1.6% to 47.2% respectively. On the other hand, medium sized IT companies witnessed a fall in their share of exports by 2.1% to 71.4% during FY09. Export realisation of Indian IT industry is largely influenced by the movement of the Indian Rupee (INR) vis-a-vis other major currencies such as US Dollar (USD), Euro and GBP. The INR exhibited contrasting movement against the USD during the last two years, appreciating by 11% during FY08 but depreciating by 14% in FY09, thus boosting the export realisation of IT companies dominantly having US clients in FY09.

Medium-sized IT companies more aggressive in cost control

The composition of operating expenses of large, mid-sized and small IT companies exhibit significant variation. Large IT companies spend significantly more on manpower as compared to medium and small IT companies. Employee compensation constituted 57.7% of total expenses for the large IT companies in FY09. On the other hand, the share of employee expenses of mid-sized and small IT companies in their total expenses were 34.7% and 19.3% respectively during FY09. Small companies, on the other hand, allocated higher cost on other operational expense (22%) than on manpower during FY09.

The rise in total expenses of many IT companies grew faster as compared to their sales during FY08 and FY09. While large and mid-sized companies did manage to keep a tab on their rise in total expenses, small companies failed to control their rise in costs, which accelerated consistently during FY05-09.

Large-sized IT companies managed their rise in expenses primarily by moderating the growth in employee compensation during FY08 and FY09. Slow down in hiring activity and marginal increase in employee wages eased the employee expense growth considerably for large IT companies in FY08 to 27.1% as compared to its 45.3% growth in FY07. During FY09, employee expenses growth slowed down further to 24.4%. Mid-sized IT companies were more aggressive in moderating the rise in employee compensation as compared to large IT companies as the rise in their employee expenses slowed down to 33.3% and 14.3% in FY08 and FY09, respectively. Employee expenses of small IT companies slowed down marginally to 19.9% during the same year.

Apart from employee cost, travel expenses was the other area where IT companies, particularly mediumsized, cut down their expenses as witnessed in the chart given below. During FY09, these companies reported negative y-o-y growth in their travel expenses whereas large and small companies reported muted growth of approximately 7% and 2.6% in their travel expenses.

Operating profit growth of IT companies hits a roadblock in FY09

The impact of pricing pressure by their clients coupled with escalating costs slowed down the operating profit (EBITDA) growth of most of the IT companies during FY09. The operating profit of the sample IT companies slowed down from 30% in FY08 to 9.6% in FY09 to reach Rs 274.71 billion. During the year, large and midsized IT companies reported a better profit growth as compared to the small IT companies. The net profit of large and mid- sized companies grew by 10.4% and 18.6%, respectively. During FY09, the aggregate net profit of small IT companies fell sharply as 15% of the small sized IT companies reported losses.

Majority of the Indian IT companies generate and keep more than sufficient cash to run their business and are cash rich. The Government of India has also provided IT companies with various tax incentives on exports under the Software Technology Parks (STPs) scheme and Special Economic Zone (SEZ) scheme.

During FY09, interest payments of large and mid-sized IT companies constituted 1.1% and 4.7% of their operating profits, respectively. Small IT companies, on the other hand, had to pay out 9.8% of their operating profits towards interest payment in FY08. During FY09, the losses reported by 15% of the small IT companies inflated the burden of interest, depreciation and taxes at the aggregate level.

Margins of small IT companies shrink during FY09

Large IT companies, whose aggregate profits accounted for 75% of the total companies in the sample, dominated the overall profitability trend of the IT companies. IT companies faced pricing pressure due to the moderation in IT budget expenditure of their global clients during FY09. During FY09, the net profit margin (NPM) of large IT companies eroded by 268 bps to 21% on a y-o-y basis. During the same period, the NPM of mid-sized IT companies declined by 90 bps on a y-o-y basis to 21%.

The profitability of small IT companies was the worst-affected during FY09 as the NPM plummeted by a whopping 558 bps to 5.5% as many companies reported significant losses during that year.

Cash flow from operating activities swell by 61.7% annually for IT companies in FY09

Cash flow generated from operation of IT companies increased more than two times from FY05 to FY09. Operating cash flows grew at a CAGR of approximately 20% during FY05-08 but surged 61.7% on a y-o-y basis to Rs 198.4 billion in FY09.

The net cash flow from operating activities of large IT companies, which constituted almost 80% of the total net cash flow from operating activities of IT companies, increased by 62.3% to Rs 155.2 billion in FY09. The growth in operating cash flow of Large IT companies during FY09 was largely on account of an impressive 74% improvement in cash available from trade and receivables during the year. The receivable turnover ratio of Large IT companies improved from 5.23 times in FY08 to 5.40 times in FY09.

Operating cash flow of medium-sized IT companies grew by 69% to Rs 35.5 billion in FY09. Small IT companies witnessed a relatively slower growth in their cash flow (55.4%) as compared to that of large and mediumsized IT companies during FY09. The aggregate cash flow of small IT companies was reduced as 22% of the small IT companies from the sample reported a negative operating cash flow during FY09.

Large IT companies emerge as most-efficient in turning sales into cash during FY09

The operating cash flow to sales (OCF to sales) ratio indicates the efficiency of a company in realising cash through its sales. The OCF to sales ratio of IT companies in the sample remained above 15% during FY05-09. Large IT companies remained the most-efficient in terms of turning sales into cash during FY05-09. The OCF to sales ratio of these companies improved 6% annually to 26% in FY09. Mid and small IT companies, on the other hand, witnessed a moderate growth of 1% each during the same period.

Average net worth of IT companies grew at a CAGR of 34.1% during FY 2005-09

The average net worth of IT companies grew at a robust CAGR of 34.1% during FY05-09. The strong growth in net worth was led by large IT companies, whose net worth grew at a CAGR of 36.2% during the period. The net worth of medium-sized IT companies witnessed a relatively slower CAGR of 32.8% as compared to large IT companies during the period.

However, the growth in the net worth of most of the IT companies decelerated during FY09. The net worth of large and mid companies grew by 22.4% and 27.1% respectively while the net worth of small companies increased by 14.2% during the year.

Due to slower growth in profits as compared with net worth, the return on net worth (RONW) of most IT companies was low during FY09. On a y-o-y basis, the RONW of IT companies contracted by 330 basis points to 26.3% during FY09. Large IT companies offered the best RONW of 31.7% in FY09, which was lower than 2% as compared with the previous year. Small IT companies witnessed the sharpest fall in RONW among the IT companies, as their RONW fell from 12.6%% to 5.3%%% in FY09. The sharp fall in aggregate profits of small IT companies was largely due to the significant losses reported by many small IT companies.

Dividend payout of IT companies decreases in FY09

IT companies retained a higher proportion of their profits in FY09 as compared with the previous four years. The dividend payout of IT companies, which measures the dividend outgo from the net profit, decreased by 7% in FY09. The dividend payout of large IT companies decreased the most, by 9% to 31% in FY09.

The aggregate equity dividend payment made by the IT companies in the sample declined by 15.6% largely because of the 16.2% fall in dividends of large IT companies in FY09. The dividend outgo of mid IT companies fell the least among the IT companies by 9.7% in FY09. Small sized IT companies witnessed 16.2% decline in their dividend outgo during the same year.

IT companies maintain sufficient liquidity to meet their current liabilities in FY09

IT companies have traditionally maintained a comfortable liquidity to meet their current liabilities as compared with other industries. Current assets, which include cash balance, receivables and marketable securities of IT companies, have been at a comfortable higher level of over 1.4 times of their current liabilities during FY05- 09. The liquidity position of IT companies witnessed a strong improvement from FY05 to FY07 led by large IT companies, having a quick ratio of 1.92 times in FY07.

The impact of global slowdown had a debilitating effect on the current assets of the IT companies during FY08-09. The quick ratio of IT companies fell to 1.49 times in FY09 from 1.66 times in FY08. Large IT companies witnessed the least fall in quick ratio among the IT companies (1.58 times in FY09 as compared to 1.68 times in FY08) while quick ratio of small IT companies fell the most (1.32 times in FY09 as compared to 1.56 times in FY08) during FY09.

Overall Sales of IT companies grew by 5.9% on a y-o-y basis during the nine month period Apr-Dec 09

For the quarterly analysis of the IT companies in the sample, the sample of IT companies was brought down to 90 companies as these companies had comparable financial information for the first three quarters of FY10. Large sized companies constituted 6% of the sample companies while mid sized and small IT companies constituted 29% and 65% of the sample of IT companies selected.

The global economic crisis slowed down the worldwide IT spending that declined by 2.9% during 2009 as compared to 5.5% growth achieved during the preceding period. Consequently, quarterly revenue growth of Indian IT companies tapered to single digit in FY10 as compared to double-digit growth achieved over the last few years.

During the nine-month period Apr-Dec 2009, overall sales of the IT companies grew by 5.9% on a y-o-y basis. Expenses, on the other hand, grew by 1.6 % which helped IT companies to achieve an impressive 21.9% growth in net profits during this period. Amongst the first three quarters of FY2010, the performance of the IT companies was the best in the first quarter of FY2010 (Apr-June 2009) as compared to the same period previous years. During this period, the sample IT companies posted a 9.6% (highest among the three quarters) revenue growth on y-o-y basis as well as a robust 30% y-o-y growth in their net profits. Large sized IT companies were the best performers during the first quarter of FY10 with a 10.5% growth in sales and 38% growth in profits on y-o-y basis. Net profit margin of the sample IT companies during Apr-Dec 2009 was approximately 22.1% as compared to 19.2% during the corresponding period in the previous year.

Generally, on a sequential basis, the first quarter of any financial year has emerged as a difficult period as compared to other quarters. The sequential growth in quarterly revenues continued with this same trend and posted a decline of 1.6% during the first quarter and improved on a Q-o-Q basis by 6% and 6.5%, respectively, in the subsequent two quarters IT companies also managed to maintain over 4.5% growth in PAT, sequentially during the first three quarters of FY10.