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Krishnan Thiagarajan

WHEN the stock of Hexaware Technologies, a Mumbai-based medium-sized software company touched a 52-week high of Rs 501 last week, it went largely unnoticed by the investment community. Coincidentally, it came close on the heels of the stock of Pune-based KPIT Cummins hitting a 52-week high of Rs 413 in late July.

Not only did these two stocks soar, they also delivered a handsome return of 35-40 per cent over the past three months, when the broad market inched up less than 5 per cent.

One may be tempted to dismiss the price trends in these two stocks as an aberration. More so in a market in which investor choice has been shrinking dramatically in recent times in the wake of a sluggish monsoon, surging petroleum/commodity prices and rising inflation, raising fears of an interest rate spike.

Widening investor choice

But on digging a little deeper into the universe of mid-cap software service stocks (revenues of Rs 100-750 crore), one finds that for investors with a high-risk appetite, the choice has actually grown.

For every Infosys, Wipro, HCL Technologies and Satyam in the frontline software segment, investors have MphasiS BFL, Mastek, iGate Global and Zensar Technologies to choose from in the mid-cap segment. Slowly, but surely, the number of these stocks that figure in the mutual fund portfolios of diversified and mid-cap schemes have also risen in recent times.

No doubt, the recent run-up in the prices of select medium-sized companies may be attributed to several external variables that have turned favourable for the sector as a whole.

For instance, offshoring has gained near total acceptance in the developed world, recovery in IT spending in the US is opening up opportunities, billing rates are stable, the rupee is depreciating against the dollar and fears of an oustourcing backlash have receded.

But a good part of the uptrend seen in such select stocks as MphasiS BFL, Hexaware, KPIT Cummins or Geometric Software can be traced to the business model restructuring undertaken in the last couple of years since the economic downturn in the US and Europe.

At the same time, some of the medium-sized software stocks, such as iGate Global, VisualSoft Technologies, Zensar or Infotech Enterprises, are either in the restructuring mode or are yet to fully deliver on their promise, in terms of financial or operational performance.

No wonder, these stocks are trading 25-40 per cent lower than the levels touched in early January, when the BSE -IT Index hit a yearly high.

Fundamentals getting stronger...

If we examine the mid-cap software universe, the stock price trends reflect the underlying changes in their business model and strengths emerging from them. Some of the variables which are working in their favour are:

Enhance offshore mix: The potential for medium sized companies to enhance their offshore revenue mix is fairly high.

For companies such as MphasiS BFL, Hexaware or iGate, the offshore mix is lower than 40 per cent, even though it has steadily gone up during the year.

Given the investments made by these companies in delivery capabilities, taking the offshore proportion to between 40-45 per cent may be possible in a one-two year time-frame.

Since typically, higher offshore contribution translates into higher operating margins, there will be a beneficial impact on the bottomline of these companies.

Strong client additions: Over the past two quarters, the client additions for most medium sized companies have been quite strong. The advantage of good client additions is two fold.

One, it helps in providing the necessary flexibility to these companies to identify clients with scale-up capabilities (essentially, taking a 0.25 million client into a $1 million or a $1 million client to $5 million). Two, it will help these companies broadbase their portfolio and reduce dependence on strategic clients.

And also curtail exposure to clients that are vulnerable to rationalisation or billing rate pressure.

Leverage selling expenses: As offshore gets mainstream, there is a greater opportunity for medium sized companies to expand their clientele on a lower selling and marketing expense. As this fixed costs gets spread over a higher revenue base, it will straightaway have a beneficial impact on the bottomline.

Compared to 15-20 per cent for frontline companies, it has been upwards of 25 per cent for some medium-sized companies.

Acquisitions offering the pep: Instead of the big-bang acquisitions of the past (Silverline's acquisition of Seranova or Polaris' integration troubles with Orbitech), companies have been making acquisitions that are filling up gaps in their vertical or technology portfolios, without substantial equity expansion.

Take, for instance, KPIT's acquisition of Panex Consulting to enter into the SAP domain or MphasiS BFL's takeover of Kshema Technologies to enter into new verticals, such as healthcare, life sciences and industrial automation, on which it is not focussed at present.

...but the downside remains

Investing in medium-sized companies is not without its share of risk. After all, it is the higher risk (with its in-built promise of higher profits) embedded in these stocks that offer a higher return to investors. Investors have to watch out for the flip side emerging in the form of:

Client rampdown or replacement risk: Apart from the top five clients contributing over 50 per cent of revenues for most medium-sized companies, some of them also face a client replacement risk or the risk of quarterly volatility in revenues.

For instance, for KPIT Cummins,in the latest quarter, the revenues from Cummins, its largest strategic client was lower than the previous quarter. While the management has stated that this reduction is on account of the non-billing of certain revenues and that the Cummins account will continue to grow, concerns on this score have not disappeared altogether.

Or take Mastek. About a year ago, its revenues took a knock when the completion of a few large projects at the same time led to the revenues falling drastically in the last quarter of 2002-03 and its impact was felt in the first half of 2003-04.

Mastek was unable to replace these large projects with similar orders. Or Hexaware, where over 30 per cent of revenues come from US-based PeopleSoft Inc.

Billing rate pressures: Medium-sized companies remain vulnerable to billing rate pressures from three sides. First, any economic turbulence in the US or Europe can leave them exposed to billing rate pressures from the few strategic customers.

And since these companies do not enjoy the cushion of a substantial client base, it can have a devastating impact on the financials. Two, as clients get more comfortable with outsourcing, they can move from multiple preferred vendors to a set of two or three vendors. Consider, GE, which has TCS, Satyam, Patni Computers, iGate Global and Birlasoft as its preferred vendors.

Using this as a threat, billing rate pressures can be contemplated. Finally, frontline companies that have played the volume game successfully in the last couple of years can start another one to weed out some of the weaker players.

Risk from ownership patterns: For companies such as iGate Global in which the promoter — Mastech Corporation — holds an 87 per cent equity stake, the volatility in stock prices poses a big risk to small investors.

For stocks such as Hexaware or MphasiS BFL, the risk surfaces from selling by FIIs (holding nearly 25 per cent stake in Hexaware) or private bodies (holding nearly 60 per cent — comprising predominantly Chrysalis and Barings, two private equity funds in MphasiS).

In this case, the retail investors may be hit the hardest and the need for portfolio churn becomes even more important.

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