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Is there room for mid-tech?
Arun Rajendran
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January 10, 2005

While tech heavyweights have propelled the Sensex rally till now, there are some mid-caps, which still look like value propositions.

The last time we wrote about mid-cap IT stocks in August 2003, the setting could not have been more different. For starters, the Sensex was trading around the 3500 levels and big investors were pulling out of IT stocks.

In fact, positive developments in other sectors like banking, oil, pharma and steel had seen infotech's share of trading turnover (on BSE and NSE) fall from 75 per cent in January 2003 to 35 per cent in August 2003. Large-, mid- and small-cap IT stocks witnessed a 33-50 per cent y-o-y decline in market-cap in the period.

Cut to the present and the disparity hits you in the face. The Sensex has touched the highest-ever levels and is not showing any signs of descending below the rarefied 6,000 mark and make no mistake, IT has been the backbone of the rally, say analysts.

The market-caps of large- and small-cap IT stocks have risen by 41 per cent and 56 per cent respectively while that of the mid-cap segment has surged around 23 per cent.

"There is a lot of euphoria among IT stocks on the whole, thanks to the inflows," says Sandeep Shenoy, strategist, Pioneer Intermediaries. Although gains in stocks were across the board, the buyers differed.

The top-rung IT stocks were snapped up by FIIs while a lot of retail money seemed to have gone into mid- and small-cap players. Apart from the euphoria in the stock market, IT firms have other reasons to cheer.

Client additions among the larger companies have been impressive, and analysts view that as an indication of the optimism lying ahead. The trend among the IT bellwethers is generally known to be a proxy for the prospects of the industry as a whole. The moot question is - would the gains in the sector percolate to mid- and small-caps?

Micro view

A striking contradiction has been the sales and net profit figures across the IT industry. While mid-caps moved up the least in terms of market-cap, their cumulative sales growth of 19.6 per cent and bottomline growth of 84 per cent were not a far cry from the 30 per cent sales growth and 26 per cent bottomline growth of large-caps.

Small-caps, on the other hand, posted an impressive bottomline growth of 542 per cent on tepid sales growth of just over 9 per cent (see chart on page 6). Clearly, the tunraround in the performance of some mid-caps is not captured in the stock prices.

Taking the trailing 12 month (ended September 2004) sales and bottomline figures into consideration, iGate, Mastek, Visualsoft Technologies and Blue Star Infotech [Get Quote] turned in shabby performances while Geodesic Information Systems [Get Quote], Aztec Software, Tata Elxsi [Get Quote], CMC, Zensar and Rolta posted inspiring numbers.

VisualSoft and Transworld International, too, witnessed a 45 per cent and 38 per cent decline in their market-cap. On the other hand, companies like Mascon Global [Get Quote] and Aztec Software bounced into the black this year and posted smart gains on the market-cap front, too.

All has not been well in large-caps as well with i-flex solutions and Polaris [Get Quote] slipping 28 per cent and 21 per cent respectively in terms of market-cap. Moser Baer [Get Quote] and MphasiS BFL also witnessed a slippage in market-cap.

All the four companies had seen a 4-30 per cent slippage in bottomline. On the small-cap front, Nucleus Software, Onward Technologies [Get Quote], Zicom Electronics, Zenith Computers [Get Quote] and KGL Systel were among prominent gainers in terms of market-cap, thanks to decent financial performance.

Expansive vistas

"The addressable market in IT is huge," says Dheeraj Sachdev, portfolio manager at ASK Raymond James Securities.

"No doubt that small- and mid-tier companies are losing out to the larger IT companies on scalability and size, but specialisation and differentiation are two watchwords that would stand them in good stead and, combined with competent execution skills, make for a killer combination that cannot go wrong," he adds.

But potential investors in mid- and small-caps should hold their horses. Most analysts admit that the lack of predictability in earnings of mid-cap stocks has not changed. Large-caps' scalability, size and revenues, which have been growing at a faster clip than mid- and small-caps, turn the tide in their favour, they add.

So what do mid- and small-cap companies have going for them? Sachdev admits that most mid- and small-caps are witnessing an improvement in clients and order size as in the case of Zensar Technologies. Billing rates have also been firm to stable.

"There is a lot of business out there, especially for niche players in the IT space," says Priya Rohira, IT analyst at Refco Securities.

In August 2003, Shenoy had predicted that the wheat would be separated from the chaff  going forward and the rest would be bought by the large-caps.

The scenario today is not radically different but Shenoy insists that companies are definitely moving in that direction. "A shakeout among mid- and small-caps is imminent and one can look forward to a lot of acquisitions and mergers."

Valuations - flush with cash

Analysts say valuations are all over the place. "Right now the sector is flush with money," says an industry watcher. "Money chases its own ideas, regardless of factors like scalability and valuations, which makes the scenario really scary," he adds.

Larger companies in the sector like Infosys [Get Quote], Wipro [Get Quote] and TCS [Get Quote] currently enjoy higher P/Es in excess of 26-30 times than the smaller ones like Geometric, D-Link and KPIT Infosystems where the range is around 11-15 times.

However, despite this, analysts continue to back the prospects of large and niche players. "This is because generic mid-sized or small-sized IT firms would struggle to move into a higher growth trajectory, due to cost pressures and issues of scale," says Duvurri.

Also, larger companies have advantages like experience in taking up large projects besides having better delivery models.

When it comes to offshoring, clients could see their costs coming down substantially. So, in that case it makes sense for them to hire a fairly large Indian player like Infosys who may be slightly more expensive than the smaller players.

Analysts say success hinges on domain capability, ability to deliver services on time and capability to ensure business continuity by managing attrition to satisfy clients' requirements.

Even amongst niche players, analysts prefer companies having exposure to segments where large companies are not very aggressive. A prime example would be the banking, financial services and insurance segment, which is a competitive one (aptly reflected by MphasiS BFL's inability to accelerate growth of its IT services business).

Analysts bet on airlines, logistics, healthcare and the government as some of the avenues where large companies are not focusing in a major way, thereby offering opportunities for smaller firms to grow as in the case with Hexaware [Get Quote].

However, there are instances when niche players can also falter as in the case with Infotech Enterprises [Get Quote] which got into the engineering services segment where its over-dependence on a couple of major clients worked against it.

Another stock that disappointed high expectations was Visualsoft, which faltered as it failed to acquire new clients and its BPO business didn't take off.

Margin call

However, analysts say mid- and small-caps would have to tide over negatives like poor margins and higher receivable days in the short term at least. Margins are not going to be the calling card of mid- and small-cap IT companies because of one reason - attrition.

"Top IT companies have been hitherto recruiting freshers, but that is about to change and they would aggressively target middle-level employees," says a senior analyst from a leading brokerage.

This, they say, would arise from the shortage of middle-level IT employees. "Increased staff costs arising out of retaining employees would weigh down margins of mid- and small-cap companies," he adds.

However, once again specialisation would come to the rescue of these companies in minimising their vulnerability to the poaching by larger IT players.

Presently large IT players have operating margins ranging between 26-32 per cent while the range could vary from 16 per cent to as high as 30 per cent for some mid- and small-caps.

However, it is predictably the niche players among mid- and small-caps, which enjoy margins that are in the higher band. Analysts say mid- and small-cap IT companies would have 6-8 per cent lower margins than tier-one companies due to factors like the kind of work that they are into and the ability of the large players to negotiate price terms with their clients.

We spoke to analysts to filter out the small- and mid-caps to come up with companies with sustainable business models, which are value propositions in the sector.

Although the money flowing into the sector has spiked up the prices of stocks that may not deserve premium valuations, there are some stocks that analysts recommend.

Their picks include niche favourites like Geometric Software and Hexaware to promising players like Zensar, KPIT Cummins and D-Link and the newly listed Datamatics.

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