BSE IT Index, which comprises of the top IT services companies in India, is going south even as the Nasdaq is heading north. Chart 1. The reason is that demand for outsourcing is coming off sharply and IT companies are struggling to grow.
Indian IT sector has to quickly reinvent itself from a commodity driven labour arbitrage business to something much more innovative and technologically up the curve. The IT giants are looking more like sweat shops in comparison to global technology giants that are dominating the world right now.
Table 1 shows the market capitalization to employee ratios for major IT companies. The market capitalization to employee ratio gives a good idea of what the market is willing to pay for innovation.
Facebook with 17,048 employees and a market cap of USD 408.70 billion leads the pack followed by Google with market cap of USD 584.62 billion and 72053 employees. The market is giving a value of USD 23.97 million per employee of Facebook and USD 8.11 million per employee of Google. Apple gets a valuation of USD 6.47 million per employee. Amazon is given a market cap of USD 1.26 million per employee.
As against the market cap to employee ratio of global tech majors, the Indian outsourcing giants are given anaemic valuations per employee. TCS the largest tech company in India has a market cap of USD 71.10 billion with an employee base of 350,000 and per employee valuation of USD 0.20 million. Infosys has a per employee valuation of USD 0.12 million. HCL Tech, Cognizant and Wipro with per employee valuations of USD 0.16 million, USD 0.13 million and USD 0.11 million respectively follow TCS and Infosys.
It is very clear from the numbers above that the market is giving extremely low valuation to outsourcing firms. The companies by itself may be generating high return on capital, working on healthy margins and having strong free cash flows but the fact is that the market is unwilling to bet that the outsourcing model is a sustainable one. The market is also recognizing that outsourcing is highly commoditized and is giving valuations as such.
Growth of Indian IT companies has dropped sharply from over 20% levels to below 10% levels. Many companies are struggling to grow at even low single digits. Guidance on growth post the FY 15 fourth quarter results from the IT majors is not positive. Client budgets are dropping, competition is high and in many cases new technology has obviated the need for dedicated technology support.
What do the IT companies require to do for gaining improved market valuations? Shedding flab, using technology to the maximum extent to replace low skilled labour and venturing into more IPR driven businesses can go a long way into reshaping the companies. However, the most important mind set change required is to stop believing in the labour arbitrage concept.
The global tech innovators have proved that highly paid skilled labour is the most productive and the markets are giving them a thumbs up for that.