The smaller IT companies that trailed their tier-I IT peers for four years but reversed that trend last year are expected to do an encore in the current fiscal, according to Motilal Oswal Financial Services Ltd (MOFSL).

These companies might continue to outperform their big brothers due to improved `client mining’ and better adaptation to the `changing environment and catering to next-gen services’, the report has said.

The MOFSL report pointed out that the tier-I companies had outclassed their tier-II peers in each year during FY07-11. But the trend was reversed last year when the tier-II companies’ revenue growth was higher than that of the tier-I companies. Based on the guidance for FY2013, the tier-II IT companies are expected to outperform tier-I IT stocks for the second straight year in the current fiscal.

The report noted that among the five prominent tier-II IT companies -- Hexaware Technologies, MindTree, Persistent Systems, KPIT Cummins and NIIT Tech -- Hexaware and KPIT were 'set to lead industry growth’. But it did not expect the performance of the other three to be lesser than the `NASSCOM band’ and believed that `this growth outperformance will sustain in FY14 as well’.

MOFSL stated that the YTD stock yield was around 56-82 per cent (except Persistent that gave a 28 per cent return). While Hexaware, KPIT and Tech Mahindra remained strong, margins were a concern with NIIT Tech and Persistent.

On the factors that worked to the advantage of tier-II companies in the IT space, MOFSL said barring Hexaware, across tier-II companies in the past three years, the proportion of revenue from onsite went up by 8-22 per cent 'indicating acceptability of the fact’ that off-shore delivery-led growth was no longer a big differentiator. Another important factor was that the income from the top 10 accounts had grown at a CAGR of 26 per cent in the tier-II companies over FY10-12 as against 19 per cent among tier-I companies. The "disaggregation of large deals" led to higher deals in the $25-99-million TCV bucket, `implying more deals where tier-II get qualified’ that enhanced their actual winning number (of deals). But MOFSL cautioned that it did not see `deal disaggregation as a tenable reason’ for the smaller IT companies to sustain their outperformance as the bigger players might target the same opportunities later.

Motilal’s report mentioned that the growth out-performance by the tier-II IT companies had led to sharp increase in their share prices with the YTD absolute returns in the 59-82 per cent range, other than Persistent Systems where it was 28 per cent. Part of it was because of their lower valuations earlier.

In the past five FYs, the bigger IT players out-grew the tier-II companies every year except in the last year. Given the guidance for the current fiscal, this could be the second year running that the tier-II companies outperform their bigger competitors.

Normally higher offshoring is reason enough to secure contracts. But this model was no more a big differentiator with the MNC IT majors rising to the challenge. Motilal said IBM's estimated headcount in India compared with that of Infosys (as against 18,000 in 2005). Accenture reported its headcount from low-cost locations at 150,000+ employees.

Referring to the growth prospects of the smaller players, Motilal Oswal said it expected the tier-II IT companies to do better than the bigger companies due to improved client mining and due to their nimbleness in adapting to the changing environment and `catering to next-gen services’. Another significant factor was that revenue from the top accounts for the tier-I companies appear to have peaked.

The report said interactions with Randstad India, an HR consulting firm, revealed that while hiring by the tier-II IT companies was intact, it had slowed down in some of the larger players such as Infosys and IBM and hiring was 'much softer YoY at the entry-level and senior-level positions’. Recruitment was also a `more rational and thorough process’ than it was four-five years back with one in eight shortlisted candidates making the grade compared to one in four earlier. With the fall in talent quality among engineering graduates, bigger players were scouting for manpower among non-engineers for activities such as testing and for postings in areas that did not require highly skilled persons.

The report gave a 'buy' rating for Tech Mahindra, Hexaware, KPIT and MindTree, while it was neutral with respect to NIIT Tech and Persistent. Only Mphasis was given a sell rating.

Among the big ticket IT stocks, while TCS drew a neutral rating, Infosys, Wipro and HCL Tech were rated `buy’ by MOSL.

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