In an earlier article we focused on the Big 4 IT companies (TCS, Infosys, Wipro and HCL), identified the four revenue

drivers, and found out which of those were sector versus company specific. Now, this article focuses on the cost structure of these companies with particular reference to employee costs. We examine 1QFY13 QoQ costs to determine whether the core operating cost components are controllable by the company, or are they uniform across the IT sector? Operating Costs and its core components: For the IT services sector, the primary operating cost drivers are: 1. Cost of revenue (CoR): This includes employee related costs, fees to external consultants/subcontracting costs, travel costs, facility expenses and depreciation, etc. 2. Selling, General and Administrative expenses (SG&A): These primarily comprise of employee costs (non-billable/project related employees), fees to consultants, allocation of depreciation costs, travel, marketing, etc. Basically, these are indirect costs, which are incurred over and above the CoR. IT companies are primarily export driven. So, a large portion of their revenues are generated in USD and other foreign currencies. However, most of the operating costs are incurred in Indian rupees. With the rupee depreciation, cost increases as a percentage of revenue could well mask the real situation. Hence, we also focus on the absolute cost increases during the quarter. The table below shows 1QFY13 numbers related to the above two core operating cost components, with particular reference to cost of employees. We also looked at 4QFY12 numbers for which relevant results were similar. So, for simplicity we focused our analysis and discussion on 1QFY13 knowing that our conclusions were validated by 4QFY12 numbers.

Table 1: 1QFY13 Big 4 Operating Cost Related Parameters

Key Operating Costs Parameters CoR as a % of revenue CoR increase CoR increase in employee costs S,G &A as a % of revenue S,G&A increase S,G&A increase in employee costs TCS Infosys Wipro 53.8% 13.2% 15.2% 18.7% 10.5% 10.4% 11.8% 8.3% HCL 9.1% NA NA 6.1% NA NA 60.4% 66.3% 64.8% 49.0% 43.0% 10.7% 11.0% 10.6% 14.0% 5.7% 3.2% NA NA

CoR Employee cost in as a % of revenue 38.3%

11.6% 12.7% 15.8%

S,G&A Employee cost as a % of revenue 12.5%

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Cost of Revenue (CoR): As the table above shows, for 1QFY13 TCS showed a QoQ CoR increase of 13.2% against a USD constant currency revenue (CCR) growth of 4%, and a 15% rupee revenue growth. CoR made up 53.8%

of revenue. For Infosys, the QoQ CoR growth was 11.8% against a CCR decline of 0.4%, and a 9% rupee revenue growth. CoR made up 60.4% of revenue. For Wipro's IT services segment, the QoQ CoR growth was 8.3%, versus a CCR growth of 0.4% and a rupee revenue growth of 9.6%. CoR made up 66% of revenue. For HCL, we compared 4QFY12 (HCL follows a June year end) with 3QFY12. HCL saw a 9% CoR growth against a CCR growth of 4.6% and a rupee revenue growth of 13.5%. All these show that CoR as a percentage of revenue and its increase does vary by company. CoR Employee Costs: In 1QFY13,TCS CoR employee costs represented 38.3% and it increased by 15.2% QoQ. For Infosys CoR employee costs represented 49% and it increased by 15.2% QoQ. For Wipro's IT services segment, the corresponding breakup for CoR and SG&A was not available in their annual reports. But for Wipro Ltd. as a whole, employee expenses in 1QFY13 were 43% and it grew 11% QoQ . HCL too did not report any breakup for CoR and SG&A (HCL follows a June year end). Further, while TCS announced pay hikes during the quarter, Infosys neither implemented nor did it make any future commitment with respect to pay hikes. For Wipro and HCL, the full effect of pay hikes will be more visible in the coming quarters. Another interesting point to note over here is that although the increase in employee costs over the quarter was the highest for TCS, employee costs as a percentage of revenues was in the late 30's for TCS, compared to the late 40's for Infosys, and early 40's for Wipro. These variations by company lead us to infer that CoR employee cost management for project related employees is more of a company specific issue. And even with disproportionate billable employee costs, the companies were basically able to consistently maintain the employee cost structures with respect to their revenues. Selling, General and Administrative Expenses (SG&A): In the case of TCS, SG&A comprised of approximately 19% of revenues in 1QFY13. SG&A related employee expenses made up 12.5% of revenues and grew by 10.4% QoQ. For Infosys, SG&A represented 11.6% of revenues in 1QFY13. SG&A related employee expenses were 5.7% of revenues in 1QFY13 and it grew by 3.2% QoQ. For Wipro's IT Services segment, SG&A was 12.7% of revenues in 1QFY13 and it grew by 14% QoQ. Finally, HCL's SG&A made up 15.8% of revenues and grew at 6.1% QoQ. Overall, TCS seems to present an atypical picture as SG&A ate up nearly 19% of revenues, whereas for Infosys, Wipro and HCL this ratio was in the 12%-16% range. We note that while HCL was smart enough to restrict the SG&A growth to 6% in 1QFY13, the figure was comparatively larger for Wipro at 14%; Infosys and TCS saw a similar growth of approximately 11%. SG&A Employee Costs:

A further drill down (within the limits of data availability) reveals that SG&A employee costs were 12.5% and 5.7% of TCS's and Infosys's respective revenues in 1QFY13. Again, the figures compel us to note that overall SG&A and SG&A employee costs are essentially company and not sector specific drivers. Effect on operating profit: Our objective was to examine the two operating cost components - CoR, SG&A and with a particular focus on employee costs to know whether any uniformity with respect to those exists across the Big4. Having done so, to provide a complete picture, the table below shows the impact on the growth of the respective operating profits (revenues less operating costs) of the Big 4.

Table 2: 1QFY13 QoQ Key Operating profit parameters for the Big 4 IT companies
Sequential increase (in Rs) Revenue Cost of Revenue S,G&A Employee costs within cost of revenue Operating profit TCS Infosys Wipro 12.1% 13.2% 10.5% 15.2% 11.3% 8.6% 11.8% 8.3% HCL 9.1% 6.1% NA 9.5% 13.5%

10.6% 14.0% 10.7% 11.0%

1.7% 10.9% 40.4%

The above table clearly shows that different sequential increases with respect to revenue, CoR and S,G&A across the Big4 had different impacts on the respective operating profits: Less than proportionate increases with respect to CoR and S,G&A compared to revenue in case of HCL magnified its operating profit growth by 40%, whereas for Infosys the result was opposite. Conclusion: Our detailed analysis of operating cost structures leads us to conclude that although the Big4 Indian IT companies offer similar services and operate in same geographies, each of them has control over and manages their operating costs differently. And this naturally has varying effects on their operating profits. We further conclude that the timeless essence of studying each company closely holds true even when companies are in the same sector.