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The trade off faced by IT players: Scale up at the expense of profitability or focus on earnings even if growth slows

10 October, 2013

Most entrepreneurs have encountered the conundrum between scaling up at the expense of profitability or focusing on earnings even if it means slow growth.  This growth versus margin question is even faced by mature IT services companies with already over $500 million in revenue. This set of companies comprises essentially nine players: the big five, TCS, Cognizant, Infosys, Wipro and HCL along with Syntel and MphasiS and the latest contenders to join the big leagues: Tech Mahindra and iGate. The median CAGR over the past four years for this set of companies has been around 19% while the median EBITDA margin is around 23%.

Case in point is Infosys and Cognizant. Infosys has over the years had a laser sharp focus on margins even though admittedly in the last year’s results the company did experience a drop in gross margins. However, over the span of Infosys’ illustrious history, it has seen flawless execution. It has been able to operate over the past few years at an EBITDA margin often higher than 30% which is no easy feat. On the other hand, Cognizant during these years has experienced EBITDA margins slightly higher than 20%, a few hundred basis points below the average for its peer group and significantly lower than that of Infosys.

At closer inspection, one realises that the lower Cognizant margins are by choice. With the exception of last year, when Infosys gross margins fell below 40%, both Cognizant and Infosys have had over 40% gross margins. In fact, Cognizant has actually done slightly better than Infosys on gross margins. However, Cognizant has very oft stated strategy of ploughing back profits over their 19%-20% target back into the business for investment into sales and marketing. This explains why Cognizant’s selling, general and administrative expenses are roughly twice that of Infosys. The investment is primarily focused on hiring client partners with industry expertise, expanding footprint etc.

Taking lower margins has paid off handsomely for Cognizant, at least with respect to growth. For the year ended December 31, 2008, Cognizant had $2.8 billion in revenue while for a similar period— the year ended March 2009—Infosys had $4.6 billion in revenue. This was a significant gap and Infosys had a lead of $1.8 billion. However, if we fast forward today, Cognizant has overtaken Infosys with trailing 12-months revenue of $8 billion versus $7.6 billion of Infosys.  Over the last four years, Cognizant grew at a CAGR of 27% while Infosys grew at a CAGR of 12% and this led to the gap decreasing to a point where Cognizant had caught up with Infosys. For the year ended March 2013, Infosys grew ~6% over the prior year. For March 2014, the forecast is still under 10%. The slowdown at Infosys has taken industry insiders by surprise. The decrease in growth at Infosys has also manifested itself in its net additions to workforce. Infosys hired roughly 6,700 employees in FY 2012-13 compared to 19,000 hired by Cognizant in C2012.

Some of the lower growth was also because it has a much higher exposure to crisis ridden Europe even though the Lodestone acquisition helped Infosys with its top-line. In addition, around 20% of its revenue comes from Energy, Utilities, Communications and Services vertical (EUCS) which has experienced flat/negative growth lately. Cognizant has again been able to avoid this vertical. On the other hand, Cognizant has invested quite a bit into healthcare, where it also did a large acquisition (MarketRX), which has seen very high growth.

Whether or not, the slowdown in growth is reversible, when it does happen it creates an instability that is often not warranted. That can be seen with the higher turnover at Infosys of around 16% versus 11% at Cognizant. Infosys has also seen several senior level exits including Ashok Vemuri, head of North America, who joined iGate and Basap Pradhan, SVP of marketing who left the company to join a start-up. Legendary founder Narayana Murthy has come back to steer the ship.

Infosys now is faced with the twin problems of slowing growth and also lower margins. As Murthy said in a recent investor conference, it was primarily because the company took its eye off the ball from bagging larger contracts and instead tried to go after smaller projects. This probably happened because of the Infosys 3.0 strategy instituted which propelled the organisation to try to achieve a third of its revenue each from consulting, IT services and new technologies (for example, cloud and mobility). The lower growth also meant that the fixed costs could not be spread over a larger base thus impacting the margins. Interestingly, Infosys saw a huge increase in active clients; however, existing clients still contributed roughly 98% of the revenue.

With a very talented management team at the helm, there is little doubt that Infosys will be able to get back on track again. However, it does seem to pose the question whether following a Cognizant like strategy of consciously giving up some of the margins to focus on growth plays out better in the long run? Or could Cognizant also face some of the challenges as it tries to evolve its business to become more global and go into newer technologies, and aspires for a revenue model that does not track the effort linearly? 

(Aishvarye Sinha is Principal and Head, India, The Chesapeake Group- a boutique investment bank focused on the technology and outsourcing services industry.)

To become a guest contributor with VCCircle, write to shrija@vccircle.com.


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The trade off faced by IT players: Scale up at the expense of profitability or focus on earnings even if growth slows

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