Adding my two cents to an already excellent response by @aditya14920251.
These are called Sub-contractor costs. Apart from the value-added and non-value added categories Aditya mentioned, reasons for sub-contracting work are:
- To deliver projects where onsite presence is needed immediately but the T1 service provider doesn’t have the talent available due to visa issues, all employees already staffed on projects, hiring lead time, etc.
- Requirement of a niche skill that the company does not have or does not want to hire immediately. For instance, back in 2018 when blockchain was new to the scene, I worked for an IT consulting firm and worked on developing proof of concepts by partnering with a start-up through a revenue-sharing model. My employer could have easily hired people with blockchain skill sets. However, they were testing the waters first.
Spending on technology is almost always discretionary. Businesses decide to spend a certain percentage of revenue on IT. The percentage depends on the industry (retail and BFSI industries spend heavily on IT). Hence, in good times revenues increase and so do IT expenditures.
However, there were exceptions when technology became a necessity rather than a competitive advantage. Like @aditya14920251 mentioned, Covid forced everyone to go online (read cloud). Hence spending on cloud services was mandatory to survive despite the economy being bad.
Similarly, during 2015-17, concalls of all major US retailers spoke about the “Amazon Effect” wherein brick-and-mortar retailers like Target, Walmart, etc. HAD TO invest heavily in fostering an online presence to survive. Those who couldn’t or didn’t have the financial wherewithal to invest perished (for example Toys R Us).
Similarly, in last couple of years, the threat of EVs has pushed auto OEMs to spend on R&D to come up with new models quicker. Again, every OEM has to do it or face a stiff battle to survive. This trend has been giving a fillip to ER&D service providers across the globe. Please read Tata Tech’s RHP document’s industry overview section. It narrates the story much better than I did.
It is not so straightforward. For instance, in the case of Onward Technologies (an ER&D services provider), they’ve reduced the number of active customers from some 200+ to 90+ on purpose. They want to focus on important accounts. Their top 25 customers bring in 85% of the revenue. I believe it is a sensible move in this particular instance.
Additionally, different industries bring in different margins to an IT service provider. Historically, BFSI and retail have been adopting technology earlier than manufacturing, mining, utilities, etc. So, projects from those two industries have better margins.
To sum up, there are two ways to play IT services (and there are 100 ways to paradise!)
- Go for the biggies, the Tier 1s. – They provide 12%-13% CAGR returns over the long term. One can invest and chill. However, can’t complain when any other run-of-the-mill IT smallcap becomes a doubler in 8 months!
- Look for themes and then smaller IT service providers –
From 2018 to 2022 – Small/Mid IT providers with Cloud capabilities won big
From 2020-2023 – Small/Mid IT providers with ER&D capabilities won big
When BFSI industry bounces back (hoping it happens soon) – Look for IT providers with large BFSI clientele
Hope it helps.
Cheers!
Mahesh
PS: Not SEBI registered. Not an investment advice. I hold positions in IT across the spectrum.
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