India’s IT Industry: Current Trends and Future Scope

7.4%. This is how much the Information Technology (IT) sector has contributed towards India's GDP in FY2022. The IT sector is one of the largest contributors to the nation's economy, employing over 5 million people. The global demand for IT services is expected to grow profoundly in the coming years. This growth is being driven by factors such as the increasing adoption of cloud computing, the Internet of Things (IoT), and artificial intelligence.

Despite so much allure, several prominent investors steer clear of this sector when it comes to pooling their capital. Many top stock investors even have a "no-no" or "only 1 stock" rule for the IT sector. Wonder why?

Well, this advancing sector comes with a bundle of complications, enhancing the ever-present distress in the investing community. Highly unstable, complex business models, volatile valuations, and other factors make it difficult to comprehend.

But, as I said earlier, the IT sector is one of the fastest-growing sectors in both the global and domestic economy. This quote from Philip Green, a British businessman, explains the duality of the investors' sentiments in the IT sector.

"Good, bad, or indifferent, if you are not investing in new technology, you are going to be left behind."

To help you smartly invest in this sector, I will discuss the problems in this article and point out the best possible solutions. This way, you can identify the root of the trouble encountered while observing IT stocks and instantly find the right solution to deal with it. Easy peasy, right?

Before we jump onto the troubles investors face, let’s take a quick look at the overall IT industry.

About the IT Industry

Rapid digitalisation of the world is boosting revenue growth of 19% in the IT sector in India, as per the data from the last fiscal year. Consumers are interested in the advancement of digital technology, as several of the latest products and services are attracting immediate attention.

The IT and business services market in India is projected to reach US $19.93 billion by 2025. That is around ₹1,66,016.9 crore.

Not only this, but the computer software and hardware sector in India attracted cumulative Foreign Direct Investment (FDI) inflows worth ₹7,90,683.30 crore between April 2000 and March 2023. The industry is growing Y-o-Y with a CAGR of 15%.

The IT sector in India is poised for rapid growth, thanks to the nation's largest internet user base, which now includes over 76 crore Indian citizens. That is why India is swiftly becoming the favoured investment destination for foreign companies.

The Indian Government is also bringing out advanced schemes and programmes to support this booming industry. The Production Linked Incentive (PLI) Scheme, especially the PLI 2.0, allocates needed capital to IT companies. The scheme comes with a budgetary outlay of ₹17,000 crore for Hardware companies. The future of the IT sector in India looks promising. So, open your Demat accounts coz it’s investing time! And if you don’t have a Demat account yet, then click here to get the best solution based on your investing appetite.

Hurdles in the IT Sector and Their Solutions

Now, it’s time to deal with the most crucial part of the article: the IT sector and its problems. Let’s look at the top 4 issues investors struggle with the most and see the right path to deal with them.

Problem No. 1: Complex IT Sector Business Model

IT company business models are complex and varied. Usually, service-based IT companies have a more complex business model than product-based companies. Infosys, Wipro, Accenture, etc., are some examples of service-based IT companies with complicated business models. Whereas, Apple, Google, Amazon, etc. are some of the product-based companies.

Companies that follow the same basic model can have different approaches, making it difficult to understand how they work. Investing in a business that is difficult to understand is something to avoid. That's a big red flag from investors' "Not To Do" list. ❌

Every company in the IT sector has its unique characteristics when it comes to its business models. Some companies focus on software development and licensing, while others provide hardware, cloud computing services, or digital advertising. Software as a Service (SaaS) companies use a subscription-based model, generating revenue with one product over time, while other companies generate revenue from selling products or services in bulk.

Another thing to note is that IT companies invest heavily in their Research and Development (R&D) department. As the IT sector is rapidly evolving, the need for upgradation is necessary. However, assessing whether a company's R&D investment is paying off can be difficult.

Solution:

Each business model has its own unique dynamics and risk factors. The best way to avoid getting invested in a risky company is to research aggressively. The easiest way to do this is to focus on different segments of the company and its product distribution. And when I say research, I mean to deeply analyse the segments based on the company's ongoing and future planned projects.

Take, for example, HCL Technologies Ltd. India's third-largest service-based IT company, HCL, has three subdivisions in its business segments: IT and Business Services (ITBS), Engineering and R&D Services (ERS), and Products & Platforms (HCL Software). These segments portray the different aspects of the company.

• ITBS: This segment contributes the most to HCL's revenue and provides insights into the company's products, operations, and services.
• ERS: This segment indicates the development of new projects and estimates how the company is using its capital.
• HCLSoftware: This division clarifies HCL's growth potential by comparing its overall product performance, upcoming plans, and other factors.

You can simplify complex business models easily by understanding segments individually. By going through various segments of the company, like R&D, you will be able to know about what new projects the company is invested in. Plus, you will get an insight into how they utilise the funds for various segments. After all, keeping an eye on the company’s segment-wise revenue contribution should also be a priority.

By checking these prospects in a business model, you will get to mark the risks associated with the company as well as the opportunities.

If you want a reliable source to help deduce companies' business models from this sector, say HCL, then Recipe by Finology would be a great place to start. Click here to get the in-depth reports of several companies from the IT industry and more.

Problem No. 2: Complications in Estimating Employee Expenses in IT Sector

Unlike other industries, say real estate or automotive, the IT industry primarily deals with intangible assets. Intellectual property, software code and digital software make up the asset section in IT companies. Employees are also a valuable asset of IT companies, as they come up with development ideas, opportunities, solutions, and upgrades.

This creative aspect of the IT sector gives rise to valuation inaccuracy, as intangible assets are difficult to value correctly. Employee costs are considered expenses and are added to the income statement. However, employees, being a part of the intellectual property of IT companies, contribute the most to R&D spending. In contrast, R&D expenditures are treated as assets and are thus included in the balance sheet. However, not all R&D expenditures meet these criteria, and those that don't are expensed as incurred.

This contrasting complication makes it strenuous for investors to analyse the company regarding financial ratios. Also, remember that employee salaries and benefits are distinct from the value of intellectual property or software developed by employees.

Additionally, the IT sector needs to spend significant capital on reskilling its workforce and other costs. The pie chart above showcases various costs employees, and sub-contracting brings for the company. Employee turnover and the loss of key personnel can also further impact operations. The uncertainty surrounding the intellectual assets of IT companies is one of the main challenges in analysing them.

Solution:

One way to assess the risks associated with the IT sector is to look at the attrition rate of IT companies. The IT sector is known for its high attrition rates, so companies that can reduce them over time are considered a safer bet. This suggests that the company has a strong reputation for upskilling its employees, brand recognition, and growth potential. A low attrition rate can also indicate healthy finances.

Another thing to remember is that every company has different Key Performance Indicators (KPIs) for analysing their growth performance. To simplify this assortment, check the revenue and profit per employee. Based on the direction the revenue and profit per employee are directed, either up trend or down trend, one can estimate where the company is heading.

Check out the infographic below, which shows the top IT companies in India and their attrition rates. 👇

Another solution is to check the current ratio of the company. The current ratio is calculated by dividing current assets by current liabilities. If the ratio is more than 1, it signifies the company's ability to pay off its debt through its current assets. This is a good sign indicating the company's efficiency and growth prospects.

Problem No. 3: High Volatility and Increasing Competition in IT Sector

The IT sector is considered to be one of the most volatile industries present. Market trends, sudden news breakage, and tightening regulatory actions boost the volatility ratio, making investors nervous.  

If one product performs well in the market and sees a rise in demand, other companies strive to bring out its alternative. This noise trader risk results in a rapid deduction of the product's price as well as the stock's value.

A recent example that comes to mind is the release of Virtual Reality Headsets, Ocular Quest Pro by Meta in 2022. We soon saw lower-priced alternatives from companies like Jio, HP, and more. This product caused a huge buzz for a few weeks as competitors showcased bringing out similar features at lower cost. The price fluctuation was crystal clear here.  

High demand for digital technology attracts various businesses into the IT sector, further splitting the market share. The positioning of several startups in the sector confuses investors.  

Solution:

The best counterattack to deal with a volatile industry is to have a strong stomach for the rapid fluctuations of investing in the IT market. Don’t make the mistake of being hasty and making decisions under pressure of the volatile nature of the market. Be persistent and resilient. An additional tip would be to have a diversified portfolio. You can compensate for the risk of a volatile sector by adding stocks from different sectors.

As for the second issue of strong competition discussed above, a good alternative would be to analyse the competitor of the company you are considering investing in. Say, for example, you are interested in HCL. It would help if you delved into a peer comparison with its competitors like Infosys, Wipro, etc. By comparing different grounds, such as financial ratios, revenue per employee, and growth prospects of these competitors with the company, you will be able to grasp a company’s definite standing.  

Alongside this, check how the company has been adapting new technologies and its product demand in the market. A good IT company always comes out with solutions that differentiate it from its competitors. After all, consumers gravitate toward products and services that stand out.

Problem No. 4: Difficult to Analyse the Right Financial Ratios in IT Sector

Many companies in the IT sector prioritise growth over profit. This positive mindset might be a good approach for the business's future prospects, but it makes things difficult for investors to analyse. Usual financial metrics like Net Revenue, Price charts, and other traditional financial ratios, such as the Price to Earnings (P/E) ratio, are insufficient.

Investors with a generative idea of analysing companies based on financials avoid IT companies due to this complication.

Solution:

Since preferred financial ratios are difficult to portray an IT company's potential, several alternatives are present. You can check these ratios along with the P/E ratio:

• Foreign Exchange rates: Many IT companies have partnerships, ongoing projects, and export-import businesses with foreign companies. Thus, knowing foreign exchange rates helps analyse the supply costs to and from different nations.   
• Debt-to-Equity (D/E) ratio:  IT companies often invest in startups and developing technological projects. Thus, taking out debt is necessary to accommodate the capital requirements for these expenditures. D/E ratio is the ratio of debt a company has in proportion to its equity.  
• Gross Profit Margin: The gross profit margin is generated after subtracting the Cost of Goods Sold (COGS). Since IT companies do not have expenses such as daily wages or high raw material costs, their gross profit margins are much higher. By monitoring the y-o-y gross profit margin, you can analyse the profit an IT company is generating.

Along with this, keep an eye on the ongoing market trends, disruptive technologies, regulations, geopolitical occurrences, and inflationary headwinds in client countries. As the IT sector is one of the sectors with the most investments from foreign nations, checking the relations between nations and the regulatory changes are advised.

The Bottom Line

If you ask expert stock investors, “What advice would you give to a beginner investor?" many would suggest preparing for the long game. Investing is all about patience, and the Information Technology (IT) sector embodies that patience. After all, the advanced technology we use today was the result of research and development from a few years back.

Thus, be patient and wise while analysing the IT stocks. Don’t get flustered by the volatile ups and downs. Be persistent in your analysis, and you can ace this industry like a pro investor.

*Disclaimer: The stocks and companies discussed above aren't a recommendation from Insider by Finology and shall not be construed as a replacement for professional advice. Consult a professional or conduct the necessary research before making investment decisions.