The Hindu Business Line : Mid-cap software stocks: A portfolio perspective

WHILE investing in the mid-cap software service companies, retail investors may need to keep two investment tenets in mind. First, the market has a low tolerance for earnings disappointment or downward revision in revenue/earnings guidance in growth stocks. Two, valuation based on absolute and relative price earnings multiple continues to remain relevant for mid-cap software stocks.

Maybe, when some stocks are in the midst of a turnaround or restructuring, PEMs do become temporarily irrelevant, but once the turnaround is complete, PEMs begin to matter again.

For some medium-sized software companies, such as Hexaware, KPIT Cummins or MphasiS BFL, which give revenue/earnings guidance, the visibility offered by them is fairly strong.

Even the scope for operating profit margin expansion is fairly good, given the possibility of a stronger offshore mix and SG&A (selling, general and administrative) expense leverage.

Our recommendation on select mid-cap stocks are based on these two variables.

Hexaware Technologies has crossed the threshold of being a turnaround story in 2003 and has entered into the steady-state consolidation phase. The stock hit the intra-day 52-week high of Rs 501 last Thursday, but retreated from those levels to close on Friday at Rs 477.

At these levels, the stock is trading at a price earnings multiple of 21.5 times projected earnings of FY05, close to that of its frontline peers such as Infosys. Clearly, this stock's market price will be driven by earnings growth changes rather than PEM expansion in the near term. It may be advisable for investors to prune their exposures in small lots on every uptrend and avoid fresh exposures for now.

We recommend a hold on MphasiS BFL at current market prices. While the ability to maintain growth rates higher than the sector is still strong, the management energies may be expended in driving the success of software — BPO integration model and aligning Kshema Technologies (acquired recently) with the core business of MphasiS in the near term.

Sitting on a robust order backlog and good growth prospects, investors with a medium-term perspective may consider retaining their holding in Mastek. But fresh exposures may be avoided as Mastek remains vulnerable to constant changes in its business strategy, higher client ramp-down/replacement risk and slower growth in the US geography.

In the past, Mastek has disappointed investors with their earnings volatility and downward revision in management guidance.

Since the KPIT Cummins stock has surged nearly 40 per cent in the past three months, investors in it may consider booking profits on at least a part of their holdings. While the business model remains strong and earnings visibility is high, the dependence on Cummins, lower margins in Panex Consulting (its SAP acquisition) and client ramp-down risk can throw up surprises.

iGate Global Solutions is suitable only for risk-bearing investors with a medium-term perspective. Only this class of investors will be able to capitalise on this turnaround play, in which PEM do not hold much sanctity. Second, with the promoters holding at 87 per cent, the volatility in the stock price may also be fairly high.

We do not recommend fresh exposures in Zensar Technologies, VisualSoft Technologies, Infotech Enterprises and Sonata. Investors with a medium-term perspective may, however, retain their exposures in the stock as their differentiated business model evolves.