It is no secret that the big four - Infosys, Tata Consultancy Services (TCS), Wipro and HCL Technologies - of the Indian information technology (IT) sector are facing margin pressures and moderation in revenue growth.CHALLENGES
The client servicing model is changing and costs are rising. The implementation of the proposed US immigration laws, salary increases (employee costs account for 50-70% of IT companies' expenses) and cloud over economic recovery of developed economies (a major source of revenue) continue to hit these companies.
This has made stock analysts and market experts look at mid-level IT companies that are available at lower valuations than their larger peers.
Before we explore why mid-cap IT companies such as Mindtree, NIIT Technologies, Hexaware and Persistent Systems are looking more attractive than the larger IT companies, let's look at what is ailing the IT sector.
The industry's business model is changing. Clients now want IT vendors to not just provide services but also share the risk of failure.
Indian IT companies are known for application development and maintenance work and not so much for product development and consultancy. The challenge for them is to upgrade to the latter high-margin businesses to meet the changing needs of clients.
"The transformation happened two years ago, when the industry moved from time and material to fixed-priced, outcome-based contracts. Now, you have to be on your toes all the time, because if there are delays and you don't understand the requirements of customers well, there can be cost overruns," says Pratibha K Advani, chief financial officer, NIIT Technologies.
Revenues from services on a time and material basis are recognised in the period they are provided. Revenues from fixed-price contracts are recognised using the percentage-of-completion method (they are calculated as the proportion of the cost of effort incurred up to the reporting date to the estimated cost of total effort).
Competition is also on the rise, not just from peers but also from captive IT arms of companies in the US and Europe. According to Nasscom, a body of Indian IT companies, multinational companies set up over 70 captive IT units in 2012.
"Indian IT companies need to upgrade capabilities, get into new services, develop new billing models and become more flexible in their approach towards clients," says Dipen Shah, head, private client group research, Kotak Securities.
Currency volatility is also a big issue as the sector's main revenue source is exports. Though recent rupee fall has been helping the sector as it earns most of its revenue in dollars, experts say these gains will be limited.
"I hear bankers telling us that the rupee will probably reach 60 to a dollar, and if that happens, our bottom lines will gain. But personally, as a CFO, I don't like this kind of volatility because it throws our pricing model completely out of gear," says Advani of NIIT Technology.
Salary increases and the US Immigration Bill are also negatives for the sector. "The wage bill is likely to rise by 10% this year. The impact will be seen in the June quarter results," says Sreenivasa Prasanna, senior director, corporates, India Ratings.
The Immigration Bill, if passed, will increase visa fees, recruitment of locals abroad (who cost more) and salaries of H1B visa holders. It will increase costs for IT companies involved in onsite operations.
Abhishek Shindadkar, IT analyst at ICICI Securities, says, "One of the biggest challenges for the sector is the Immigration Bill. Outplacement at onsite locations will be difficult, as a result of which the proportion of non-immigrant employees will go up."
Most Indian IT companies earn a big chunk of revenue (50-70%) from the US. As much as 64% revenue of Infosys and TCS comes from the US; for HCL Tech, the figure is 60%.HAVING AN EDGE
The challenges mentioned above are not specific to large-cap companies. However, some Tier-II companies are better off than some of the larger ones given the challenges faced by the industry. While the larger companies can offer end-toend services, the Tier-II ones are quicker in adapting to the changing environment. They also operate in niche segments and offer specialised services.
"Their focus is on a few verticals. They have developed significant capabilities within these verticals, ensuring client stickiness," says Dipen Shah of Kotak Securities.
"Mid-tier IT companies have certain advantages such as niche service capabilities, focused client servicing approach and ability to cater to clients of any size. Large IT companies target large orders and compete with global players," says Abhishek Anand, analyst, IT and telecom, Centrum Wealth Management.
Mid-level companies score over the bigger ones in terms of attrition and salary increases too.
"Till two years ago, we used to do a lot of lateral hiring. Whenever we had a vacancy, we would go to the market and hire people with similar experience. But now we have shifted to hiring trainees and people with less than three years of experience. So, we have these boot camps, etc, where we get fresh talent, train them and give them growth opportunities. This keeps employee costs low," says Pratibha Advani of NIIT Technology.
Also, some mid-level companies have a more diverse market in terms of revenue share. For example, NIIT Technology's geographical revenue break-up is 38% from the US, 39% from Europe and 23% from Asia (including India). In 2011-12, Polaris' 46% revenue came from the US, 22% from Europe and 31% from 44 Money Today » July 2013 India and Asia. Besides, unlike the Tier-I companies, which earn most of their revenue from a few large clients, and hence have less pricing power, Tier-II companies handle smaller but more clients, making them less vulnerable to the risk of clients walking away.
Also, some smaller companies such as Polaris Financial Technologies could be the target of acquisition by larger companies. The Polaris stock recently rose more than 15% on reports that companies such as Cognizant and Tech Mahindra were planning to buy stake in it.CHEAPER VALUATION
"Valuations of mid-cap companies are quite attractive; most of the time mid-cap IT stocks trade at a discount to their large-cap peers," say Alex Mathews, head of research, Geojit BNP Paribas Financial Services.
Companies such as Infosys, TCS, HCL Technologies and Wipro are trading at a price-to-earning (P/E) multiple of 15-22, while mid-cap companies such as NIIT Technology, Persistent, Mindtree and Hexaware are at 7-11 times P/E multiple.
Estimates by different brokerages suggest that while large IT companies are trading at 12-18 times 2013-14 earnings, companies such as Hexaware, NIIT Tech and Mindtree are trading at 7-10 times 2013-14 multiples. However, lower P/E should not be the only yardstick for picking stocks. Profitability and performance also matter.
Some mid-cap IT companies have given and are expected (based on estimates of brokerage houses) to give high return on equity (RoE), the net profit earned on each stock. They are also expected to show decent growth in revenue and profit.
IT stocks, long believed to be defensive, have lost that tag due to uncertain economic conditions in the US and Europe and volatile currencies. So, whether you invest in largecap or mid-cap IT stocks, you can expect volatility due to reasons mentioned earlier.
Mid-cap IT stocks, because of cheaper valuation and other 'operational' advantages, look good. However, selecting the right stocks remains the key.