The Hindu Business Line : Don’t write off the mid-tier players Mid-tier Angle

When it comes to investing in IT stocks, investors clearly place the large players several rungs above the rest. In a market that has spiralled downward, while the big five largely held on to valuations, valuations of many mid-tier IT stocks halved between January and August.

This has widened the valuation gap between mid and large IT companies. In a scenario where investors are scrounging for ‘defensive’ options, the argument that larger players are better placed to weather the rough macro environment certainly holds water. But there are select mid-tier IT companies that may offer healthy stock returns over the long run, without an overdose of risk, due to their niche focus and, in many cases, a domestic demand-driven business.

The valuation gap

The top five IT companies, (TCS, Infosys, Wipro, Satyam and HCL Tech), which traded at price earnings of 16-24 times historic earnings in January, are now in the 15-20 times range. Apart from the fall in their stock prices, this may be attributable partly to the improvement in the earnings due to better realisations as the rupee depreciated to Rs 43 levels in the April-June quarter.

But mid-tier IT companies (such as MindTree, KPIT Cummins, 3i Infotech, Rolta India, Geodesic Information and Tanla Solutions) faced the brunt of the market correction. These stocks, that traded at 16-34 times their historic earnings in January, now trade 8-20 times, with prices dropping 30-50 per cent from their highs.

The reasons for this de-rating are many. Many mid-tier companies have reported heavy forex losses in the June quarter. These companies tend to hedge a larger part (40-70 per cent) of their revenues compared to top-tier ones. Betting on continuing rupee appreciation proved costly as the rupee depreciated to Rs 43 levels, causing a mark-to-market loss.

This apart, the market may have perceived greater pressure on billing rates for mid-tier players if clients tighten spends on their IT-related activities.

Mid-tier picks

On the above scores, there is definitely a cause for concern for mid-tier IT companies that are focussed on the US and Europe and heavily dependent on the BFSI vertical. But there are a few mid-tier companies with niche service offerings and/or domestic focus, which remain good investment options over the long run.

Rolta India: This company derives over 50 per cent of its revenues from India and provides services such as geographical information systems and engineering design services. It has several government, defence and PSU clients. It stands to benefit from opportunities arising out of the possible closure of the nuclear deal.

3i Infotech: Although focussed on BFSI alone, the company generates over 40 per cent of its revenues domestically. The company is products-focussed, leading to better realisations, and offers end-to-end BFSI solutions. Selective acquisition of companies that are focussed on transaction processing in key areas such as cheque payment, may also work in 3i’s favour.

Geodesic Information: Geodesic operates in a niche area in technology. The company derives most of its revenues from developing instant messaging platforms/services and licensing them mainly to enterprises. A net profit margin of 49 per cent, higher compared to other listed, products-focussed technology companies, is a key plus. Each of these stocks may be reasonable ‘buys’ for investors with a 2-3 year perspective.

Apart from these, MindTree and KPIT Cummins, which operate predominantly in 2-3 verticals, are also less dependent on BFSI vertical. With strong manufacturing practice (automotive, semi-conductors, etc) these companies may be continue to be held, as clients in this segment are becoming software-intensive.

Top tier vs mid tier

While frontline stocks may be safer bets on account of their better revenue visibility and the ability to tweak several operational levers such as onshore-offsite mix, utilisation, volumes etc, the business environment continues to be challenging.

Investing in mid-tier IT companies may be riskier. But after the de-rating, select stocks backed by a niche business actually offer better value, as their business may not be directly impacted by macro risks.

K. VENKATASUBRAMANIAN