IT sector to benefit from Startup layoffs?

Hello Everyone,

Sorry I have been writing my newsletters randomly these days instead of a Sunday but there is so much happening that I cant wait till Sunday to share it :)

Over the last week you saw how government risk played out in the Steel & Sugar sector and how the stocks reacted brutally. I covered a primer on both the sectors in my newsletter, hope you got the chance to read it & if you have not, do that post todays letter. Let me come to the point now, I am sure most of you'll would have read about the big lay offs happening in the start up eco system. Todays newsletter is on how can this be a small positive for the under performing IT sector.

Have you noticed the under performance of the IT sector? i.e. Infosys is down 25% vs Nifty down 8% in the last 2 months.

There are 2 most talked about reasons for the current IT sector under performance,

(A) Interest rates increase & hence reset of valuations

(B) Operating margins shrinking because of the ‘Great Resignation’

(A) Lets talk about valuation reset first,

(i) One way of valuing stock is using the DCF method. 

• You project the future cash flows of the business for the coming 3-5 years & discount it at a particular rate to arrive at today’s value of the business 
• Lets say for example, Expected Cash Flow of the business, 

Year 1 – 1000 

Year 2 – 1400 

Year 3 – 2000 

If I discount it at 6%, today’s value of the business is 3,868 but if rates increases & I discount it at 8% the value drops to 3713 (Google NPV calculation if you want to know how I arrived at 3868 & 3713)

(ii) So, valuation drops in a rising rate market assuming everything else is constant. IT stocks globally because of the COVID ran up a lot in the assumption that the future cash flow is going to be very high thanks to digitisation & hence are falling more now vs other sectors due to valuation reset in a rising rate environment.

(B) Lets talk about the Great Resignation now,

(i) Below are the reported attrition rates amongst the top IT companies,

• Cognizant - 31%
• Infosys - 27.7%
• Tech Mahindra - 24%
• TCS - 17.4%

(ii) Attrition leads to 2 problems, reducing margins for the IT companies,

• Salaries increase in retaining or hiring new talent
• Margin reduction because utilisation falls, Infosys utilisation fell from 88.5% to 87% in Q4 FY22

(iii) Where is the talent going you may ask?

Since the last 2 years, a lot of new age tech start ups were offering 2-3x salaries, ESOP’s etc., attracting talent from the old IT services companies which caused the Great Resignation.

(Q) What’s happening to the start up eco system?

• Valuation reset because of rising rates is hurting publicly listed tech stocks & VC’s / PE’s are losing big time on their 'listed portfolios'
• Because the peer tech stock is losing valuation in the listed world, it is putting pressure on the valuation of the 'unlisted companies' as well. VC's/PE's are expected to lose big monies because of the valuation reset.
• Tiger Global is expected to be losing $17B, almost 2/3 of the cumulative gains it made in the start up investing since it was formed in 2001
• Softbank is estimated to lose $18.6B on its public portfolio upto March 22. 

This is the cause of the drying liquidity in the start up eco system

(Q) What is the second order effect of mounting losses, drying liquidity & lowering valuations?

- Layoffs

(Q) How can this benefit the IT sector?

• Liquidity drying at the start ups can rationalise hiring & hence attrition at large IT services companies. Ofcourse there was poaching amongst the services companies as well but at least one leg of the start up eco system will stop flooding the market with higher salaries
• Crazy offers, ESOP’s at the start ups may be ditched for more stability in the traditional services companies
• This can probably, improve the operating margins for the IT sector in the coming 3-4 quarters

Valuation reset will still put downward pressure on the sector but at least something to cheer about for the IT sector investors :)

P.S. - Thank you Chanchal Agarwal for some very interesting data points that I have used in this newsletter.

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Until next time,

Kirtan Shah

Founder & CEO

Credence Wealth Advisors