What makes an IT services business valuable from a shareholder perspective?
The mega successes of IT services businesses like Infosys, Wipro and HCL among many others have inspired a whole generation of entrepreneurs to starting services businesses. Right from the mid-90s, services businesses have continued to proliferate and pepper the streets of nearly all tier 1 cities and increasingly a large number of tier 2 cities. The sector generated nearly Rs. 220,000 crore in 2011 turnover and continues to clock impressive growth – it grew 21% in 2011 over 2010 and at a compounded annual growth rate (CAGR) of 27% since 2005.
The market continues to be fragmented internationally as well as in India. There are a few large players – top 5 players control over 50% market share, top 10 control 60% – and a much longer tail of small ones. Just driving around Noida towards Sector 62, once can spot scores of such companies typically staffing anywhere between 10 to 250 people. Out of the total estimated workforce of 1.5 million, nearly a million belongs to the top 10 players. The remaining workforce – over half a million young men and women – are spread across thousands of companies.
Lot of such small businesses make for great lifestyle businesses. In a company with a couple of steady customers being served by 50 odd engineers, there’s a lot of margin to be made on a month-to-month basis. Assuming negligible investments towards growth, low attrition and, engineer margins at ~Rs. 15,000-25,000/engineer/month. an owner can take home a cool Rs. 7.5-10 lacs/month. A lot more money than most employed professionals in any sector would make. And it’s your own business with further potential for growth. If you are one of these entrepreneurs, great for you. Keep at it ! This is not very different from a boutique business owner owning a standalone store at a great location.
The problem starts when such entrepreneurs want to grow these businesses. Sometimes driven by necessity (existing customers may not be stable), and sometimes by ambition, entrepreneurs want to invest sales money to scale these businesses. That’s where prospect of external (investor) money come in, and you start hearing things like shareholder value, valuation and all the related terms. All of a sudden, this highly cash flow positive boutique business doesn’t seem that valuable any more. When compared on a revenue-to-revenue basis with say, an E-commerce company, it would turn up about 10x shy.
The reason lies in that thing – scalability. The ability of a business to grow. Services businesses are like 2-headed monsters. On one hand they need a perpetual supply of great engineers and on the other hand (and in perfect synchronization) a set of matching customer orders. You have to bell the cat at least on one of these two issues and hence the holy grail of services business scalability is the ability to forecast business. If your customer can tell you their needs 6 months in advance, you will be able to most likely plan for it. Hell, even 2 months would be good!
Thus, a services business with better forecasting will be more scalable over a period of time. Even better if this forecast keeps growing in a predictable way. Shareholders value future – the promise of a better tomorrow. So what kind of customers provide long term visibility that can be forecasted and has the ability to grow predictably – its not recently funded startups in the Bay Area or the constantly changing “social media” companies. It’s the large companies with their fixed budgets. Think American Express, Boeing, BMW… you get the drift. These are the companies who make these decisions at the beginning of the year and stick to these allocations all year – more or less. These are the companies you can walk the corridors of and get more business by developing more BU relationships. Obviously it’s hard to get into these companies (more on this later in this series), but if you can get in, they provide the endless stream of predictable business that a services company strives for. They result in scalability. And hence shareholder value. If you are a Rs. 50 crore service business, your best valuation case is that you have 4-5 customers, each giving Rs.10-15 crores in business and which is but a small percent of their technology spend – hence a potential for a lot of growth. Your worst is 100 customers, all maxed out and, wavering.
Shareholder value for services businesses gets created by long-term large customer relationships. Everything else is just a way to get there.
This is the first post in an ongoing SBR series that seeks to demystify the India based IT service industry. We welcome your comments and inputs.