Mid-cap IT firms outshine larger peers

Mid- cap information technology (IT) stocks outperformed the Nifty IT and Nifty in the December quarter.

While the mid- cap IT pack has generated returns of over 25 per cent during this period, led by stocks such as L&T Infotech and KPIT Technologies, which have gained over 40 per cent each, the Nifty and Nifty IT have generated returns of 7-10 per cent.

The larger tier-1 information technology (IT) companies are struggling to grow their revenues. The second tier set of companies have been consistently been ahead of them. In the December quarter, for example, while larger IT companies might post revenue growth of under 2 per cent, mid-tier companies would grow at double the rate. Analysts expect this trend to continue.

The revenue growth outperformance, according to Kawaljeet Saluja and Jaykumar Doshi of Kotak Institutional Equities, has been due to the companies’ ability to attract senior management talent, improve delivery capabilities and mature to structure complex contracts. Higher digital and automation segment penetration as well as ramp-up in deal wins have helped consolidate this trend.

“Smaller firms have been more nimble at transforming their business models and tapped high growth segments such as digital, automation and analytics, which form 30-40 per cent of their revenues, while it is 20-25 per cent for larger IT companies,” says an analyst at a domestic brokerage. This is expected to help the companies grow their revenues and earnings faster than their larger peers.

While earnings growth for the mid-range companies are in the 13 per cent range over the next two years, it is 7.5 to 8 per cent for larger IT companies. Though mid- cap IT companies have rallied quite a bit, as a pack they are still trading at a discount to larger IT names if FY20 numbers are taken into consideration.

Analysts say mid-tier IT companies with strong delivery capabilities, investments in digital segment and ability to increase deal size will stand out. Most analysts prefer names such as L&T Infotech, Hexaware, Mindtree and Mphasis in this space and have upgraded their estimates for some of them. Ambit Capital recently upgraded the earnings per share estimates of L&T Infotech over FY18-20 by 5-7 per cent to factor higher revenue growth on the back of healthy deal pipeline and higher forex income on the outstanding forward contracts. Further, the brokerage has increased its target price to ~1,240, which is 17 times its one-year forward price to earnings estimate.

Given its large presence in the digital space, revenue growth for Mindtree at 14 per cent is expected to be better than the industry for FY19, led by higher deal wins and a strong pipeline. Reducing losses in its acquisitions and improving execution should expand its profit margins from an estimated 12 per cent in FY18 to 15 per cent in FY20. The stock is trading at 18 times its FY19 earnings estimate.

While these stocks have outperformed, investors have to be cautious and keep an eye on the revenue uptrend as well as margins as some of the companies have been inconsistent over the past few quarters. Any sharp uptick in the rupee will also translate to lower revenues.