IT Sector Big 4: 1QFY13 Operating costs analysis Background: In an earlier article we focused on the Big 4 IT companies (TCS, Infosys,

Wipro and HCL), identified the four revenue drivers, and found out which of those were sector versus company specific. Now, this article focuses on the cost structure of these companies with particular reference to employee costs. We examine 1QFY13 QoQ costs to determine whether the core operating cost components are controllable by the company, or are they uniform across the IT sector? Operating Costs and its core components: For the IT services sector, the primary operating cost drivers are: 1. Cost of revenue (CoR): This includes employee related costs, fees to external consultants/subcontracting costs, travel costs, facility expenses and depreciation, etc. 2. Selling, General and Administrative expenses (SG&A): These primarily comprise of employee costs (non-billable/project related employees), fees to consultants, allocation of depreciation costs, travel, marketing, etc. Basically, these are indirect costs, which are incurred over and above the CoR. IT companies are primarily export driven. So, a large portion of their revenues are generated in USD and other foreign currencies. However, most of the operating costs are incurred in Indian rupees. With the rupee depreciation, cost increases as a percentage of revenue could well mask the real situation. Hence, we also focus on the absolute cost increases during the quarter. The table below shows 1QFY13 numbers related to the above two core operating cost components, with particular reference to cost of employees. We also looked at 4QFY12 numbers for which relevant results were similar. So, for simplicity we focused our analysis and discussion on 1QFY13 knowing that our conclusions were validated by 4QFY12 numbers.

Table 1: 1QFY13 Big 4 Operating Cost Related Parameters Key Operating Costs TCS Infosys Wipro HCL

Parameters (1QFY13) CoR as a % of revenue CoR QoQ increase CoR Employee cost in as a % of revenue CoR QoQ increase in employee costs S,G &A as a % of revenue S,G&A QoQ increase S,G&A Employee cost as a % of revenue S,G&A QoQ increase in employee costs 53.8% 13.2% 38.3% 60.4% 11.8% 49.0% 66.3% 8.3% 43.0% 64.8% 9.1% NA

15.2% 18.7% 10.5% 12.5%

10.7% 11.6% 10.6% 5.7%

11.0% 12.7% 14.0% NA

NA 15.8% 6.1% NA

10.4%

3.2%

NA

NA

Note: Click here for quarterly results of the IT sector

Cost of Revenue (CoR): As the table above shows, for 1QFY13 TCS showed a QoQ CoR increase of 13.2% against a USD constant currency revenue (CCR) growth of 4%, and a 15% rupee revenue growth. CoR made up 53.8% of revenue. For Infosys, the QoQ CoR growth was 11.8% against a CCR decline of 0.4%, and a 9% rupee revenue growth. CoR made up 60.4% of revenue. For Wipro's IT services segment, the QoQ CoR growth was 8.3%, versus a CCR growth of 0.4% and a rupee revenue growth of 9.6%. CoR made up 66% of revenue. For HCL, we compared 4QFY12 (HCL follows a June year end) with 3QFY12. HCL saw a 9% CoR growth against a CCR growth of 4.6% and a rupee revenue growth of 13.5%. All these show that CoR as a percentage of revenue and its increase does vary by company. CoR Employee Costs:

In 1QFY13,TCS CoR employee costs represented 38.3% and it increased by 15.2% QoQ. For Infosys CoR employee costs represented 49% and it increased by 15.2% QoQ. For Wipro's IT services segment, the corresponding breakup for CoR and SG&A was not available in their annual reports. But for Wipro Ltd. as a whole, employee expenses in 1QFY13 were 43% and it grew 11% QoQ . HCL too did not report any breakup for CoR and SG&A (HCL follows a June year end). Further, while TCS announced pay hikes during the quarter, Infosys neither implemented nor did it make any future commitment with respect to pay hikes. For Wipro and HCL, the full effect of pay hikes will be more visible in the coming quarters. Another interesting point to note over here is that although the increase in employee costs over the quarter was the highest for TCS, employee costs as a percentage of revenues was in the late 30's for TCS, compared to the late 40's for Infosys, and early 40's for Wipro. These variations by company lead us to infer that CoR employee cost management for project related employees is more of a company specific issue. And even with disproportionate billable employee costs, the companies were basically able to consistently maintain the employee cost structures with respect to their revenues. Selling, General and Administrative Expenses (SG&A): In the case of TCS, SG&A comprised of approximately 19% of revenues in 1QFY13. SG&A related employee expenses made up 12.5% of revenues and grew by 10.4% QoQ. For Infosys, SG&A represented 11.6% of revenues in 1QFY13. SG&A related employee expenses were 5.7% of revenues in 1QFY13 and it grew by 3.2% QoQ. For Wipro's IT Services segment, SG&A was 12.7% of revenues in 1QFY13 and it grew by 14% QoQ. Finally, HCL's SG&A made up 15.8% of revenues and grew at 6.1% QoQ. Overall, TCS seems to present an atypical picture as SG&A ate up nearly 19% of revenues, whereas for Infosys, Wipro and HCL this ratio was in the 12%-16% range.

We note that while HCL was smart enough to restrict the SG&A growth to 6% in 1QFY13, the figure was comparatively larger for Wipro at 14%; Infosys and TCS saw a similar growth of approximately 11%. SG&A Employee Costs: A further drill down (within the limits of data availability) reveals that SG&A employee costs were 12.5% and 5.7% of TCS's and Infosys's respective revenues in 1QFY13. Again, the figures compel us to note that overall SG&A and SG&A employee costs are essentially company and not sector specific drivers. Effect on operating profit: Our objective was to examine the two operating cost components - CoR, SG&A and with a particular focus on employee costs to know whether any uniformity with respect to those exists across the Big4. Having done so, to provide a complete picture, the table below shows the impact on the growth of the respective operating profits (revenues less operating costs) of the Big 4.

Table 2: 1QFY13 QoQ Key Operating profit parameters for the Big 4 IT companies Sequential increase (in Rs) Revenue Cost of Revenue S,G&A Employee costs within cost of revenue Operating profit

TCS

Infosys

Wipro

HCL

12.1% 13.2% 10.5%

8.6% 11.8% 10.6%

9.5% 8.3% 14.0%

13.5% 9.1% 6.1%

15.2%

10.7%

11.0%

NA

11.3%

1.7%

10.9%

40.4%

The above table clearly shows that different sequential increases with respect to revenue, CoR and S,G&A across the Big4 had different impacts on the respective operating profits: Less than proportionate increases with respect to CoR and S,G&A compared to revenue in case of HCL magnified its operating profit growth by 40%, whereas for Infosys the result was opposite. Conclusion: Our detailed analysis of operating cost structures leads us to conclude that although the Big4 Indian IT companies offer similar services and operate in same geographies, each of them has control over and manages their operating costs differently. And this naturally has varying effects on their operating profits. We further conclude that the timeless essence of studying each company closely holds true even when companies are in the same sector.

IT Sector: Revenue analysis of the Big 4 (1Q FY13) Background: In light of the recently announced 1QFY13 results, this article compares the quarter-on-quarter (Q-o-Q) revenue drivers of the Big 4 Indian IT companies, with a view to understand which of these drivers were sector specific versus company specific. The Big 4 are, of course, HCL Tech, Infosys, TCS and Wipro. Revenue and its key components: Across the IT services sector, revenue growth can be attributed to the following factors/drivers: 1. Volume (person hours worked), 2. Realization/Pricing (the billing rate charged to customers), 3. Utilization (the ratio of the total billable employees who actually worked on projects to the total number of employees available to work on projects for a particular period), 4. Currency (the translation gain/loss that occurs while converting the revenue from the respective local currency to Indian rupee). The table below summarizes the results of the Big 4 based on the above parameters.

Table1: 1QFY13, Q-o-Q growth of key parameters

Q-o-Q growth of key parameters Volume Realization/Pricing Utilization Rupee against US $

HCL Tech 4.6% 2.7% -2.8% -10.0%

Infosys 2.7% -2.9% -1.4% -10.0%

TCS 5.3% -1.2% 0.7% 10.0%

Wipro 0.8% -0.5% 1.8% 10.0%

Note: For HCL we used 4QFY12 as its last financial year ended in June, 2012.

With reference to the table above, we note the following: Volume: While HCL Tech and TCS reported Q-o-Q volume growth to the tune of 4.6% and 5.3% respectively, Infosys's volume growth was sub-par at 2.7%. And, Wipro's woes continued with a volume growth of only 0.8%. For Wipro, 1QFY13 was in fact the third consecutive quarter in which it continued to underperform its peers with respect to volume growth. Realization/Pricing: The Q-o-Q pricing decline for Infosys was more pronounced at nearly 3%, while TCS and Wipro saw price declines of roughly 1% and 0.5% respectively. Interestingly, during the same period, HCL Tech saw a price increase of roughly 3%. Note: The Q-o-Q constant currency growth figures of each of the Big 4 IT companies and their respective figures for volume growth were used to calculate the effect on pricing. Utilization: Q-o-Q analysis reveals that utilization for Infosys and HCL declined 1.4% and 2.8% respectively. At the same time, utilization for TCS and Wipro registered increases of 0.7% and 1.8% respectively. These figures do not consider the deployment of trainees. Currency: The rupee depreciated by approximately 10% against the US dollar during the last quarter. The impact of this was uniformly felt across the Indian IT sector, including HCL Tech, Infosys, TCS and Wipro. Conclusions: Sector or Company Specific drivers? Volume: Our assessment indicates that volume growth has been non-uniform across the Big 4, and so it is more of a company specific rather than a sectorwide factor.

Pricing: We believe that pricing decline has impacted the entire sector. In an earlier article we pointed out why pricing can affect the industry as a whole, and that Infosys may be setting the stage for a price competition. We hold that view even though HCL Tech has seen a price increase, while the other three companies have experienced price declines as expected. Utilization: This too seems to be company rather than sector specific with each of the Big 4 IT companies performing differently in terms of efficiency. While the relatively higher volume growth for HCL at a lower utilization is commendable, the sequential increase in volume and utilization for TCS appears to be on expected lines. Wipro seems to be doing its best to improve on the efficiency front, as its volume growth has been dwindling. And, Infosys's utilization seems to have fallen behind. Given the current challenging and competitive environment, we believe that the Big 4 IT companies will focus on volume growth, while compromising on the pricing front.