 "Mid-cap IT valuation: Gap with large peers at historic low")
The valuation gap, measured in one-year forward price to earnings multiple, between mid-cap and large-cap information technology (IT) companies has narrowed sharply in the past year (see chart). As a result, it has reached historically low levels, with some mid-cap companies even commanding premium valuations versus large-cap peers.
One reason is the significant re-rating of mid-cap IT companies over the past year. Oracle Financial, Mindtree, Mphasis, Hexaware, Cyient, eClerx and CMC are trading at 12-22 times their FY16 estimated earnings, as against 15-21 times for the top five companies (Tata Consultancy, Infosys, Wipro, HCL Technologies and Tech Mahindra). In fact, at 22.5 times the FY16 estimated earnings, Oracle Financial trades at a premium to all large-cap IT companies. Mindtree, Cyient, Hexaware and CMC are also trading at a premium to Infosys, Wipro, HCL and TechM (see table).
Improving revenue growth, steady margins and better return ratios posted by mid-cap companies are among the key reasons for their re-rating. Notably, the combined revenue growth for mid-size companies had outpaced those of larger companies by two times between FY12 to FY14. For FY15, though, both groups reported revenue growth of 11.7-11.8 per cent.
Mid-cap companies’ strategy of focusing on select areas rather than competing with the bigwigs in all verticals/services has worked well. NIIT Technologies is a niche player in aviation and transportation, Persistent an early mover in almost all Gen X technologies such as SMAC offerings and product engineering. Similarly, eClerx has carved a niche for itself in knowledge process outsourcing and CMC is tapping growth opportunities in both government and private segments by offering systems engineering and integration services.
“With high valuations, we believe investors should take a stock-specific view. We have a 'Buy' rating on eClerx and believe the moderating client concentration, expanding footprint and niche positioning will aid the company. Though we like Mphasis, Hexaware and Mindtree, we believe they are fairly valued and, hence, have a ‘Hold’ rating on these stocks”, says Madhu Babu, IT analyst at Centrum.
“The tier-2 IT valuation discount for stocks in our coverage versus tier-1 peers has reduced considerably in recent times. It has reduced from 35 per cent (three-year average discount) and 22 per cent (one-year average discount) to 15-17 per cent currently. We believe while tier-2 IT valuations are skewed, tier-1 IT offers considerable valuation comfort,” says the IT analyst at Reliance Securities. In the mid-cap space, the analyst likes Mindtree and e-Clerx.
The macro trend, nevertheless, remains positive. Most analysts believe things are likely to improve as compared to the March quarter.
From Bloomberg data, in the mid-cap space, analysts remain positive on Cyient, CMC and Persistent Systems, with the latter two having the highest upside potential (given the price targets). However, the recent warning regarding the June quarter (including margin pressure on visa costs) performance by Persistent suggests near-term pain. Not surprisingly, the stock fell sharply on Wednesday. As the price target of the remaining mid-cap stocks indicates a potential downside of three to eight per cent from current levels, the options for investors are limited. On the other hand, the upside for the top five players is reasonably good.
One reason is the significant re-rating of mid-cap IT companies over the past year. Oracle Financial, Mindtree, Mphasis, Hexaware, Cyient, eClerx and CMC are trading at 12-22 times their FY16 estimated earnings, as against 15-21 times for the top five companies (Tata Consultancy, Infosys, Wipro, HCL Technologies and Tech Mahindra). In fact, at 22.5 times the FY16 estimated earnings, Oracle Financial trades at a premium to all large-cap IT companies. Mindtree, Cyient, Hexaware and CMC are also trading at a premium to Infosys, Wipro, HCL and TechM (see table).
Improving revenue growth, steady margins and better return ratios posted by mid-cap companies are among the key reasons for their re-rating. Notably, the combined revenue growth for mid-size companies had outpaced those of larger companies by two times between FY12 to FY14. For FY15, though, both groups reported revenue growth of 11.7-11.8 per cent.
Mid-cap companies’ strategy of focusing on select areas rather than competing with the bigwigs in all verticals/services has worked well. NIIT Technologies is a niche player in aviation and transportation, Persistent an early mover in almost all Gen X technologies such as SMAC offerings and product engineering. Similarly, eClerx has carved a niche for itself in knowledge process outsourcing and CMC is tapping growth opportunities in both government and private segments by offering systems engineering and integration services.
“With high valuations, we believe investors should take a stock-specific view. We have a 'Buy' rating on eClerx and believe the moderating client concentration, expanding footprint and niche positioning will aid the company. Though we like Mphasis, Hexaware and Mindtree, we believe they are fairly valued and, hence, have a ‘Hold’ rating on these stocks”, says Madhu Babu, IT analyst at Centrum.
“The tier-2 IT valuation discount for stocks in our coverage versus tier-1 peers has reduced considerably in recent times. It has reduced from 35 per cent (three-year average discount) and 22 per cent (one-year average discount) to 15-17 per cent currently. We believe while tier-2 IT valuations are skewed, tier-1 IT offers considerable valuation comfort,” says the IT analyst at Reliance Securities. In the mid-cap space, the analyst likes Mindtree and e-Clerx.
The macro trend, nevertheless, remains positive. Most analysts believe things are likely to improve as compared to the March quarter.
From Bloomberg data, in the mid-cap space, analysts remain positive on Cyient, CMC and Persistent Systems, with the latter two having the highest upside potential (given the price targets). However, the recent warning regarding the June quarter (including margin pressure on visa costs) performance by Persistent suggests near-term pain. Not surprisingly, the stock fell sharply on Wednesday. As the price target of the remaining mid-cap stocks indicates a potential downside of three to eight per cent from current levels, the options for investors are limited. On the other hand, the upside for the top five players is reasonably good.