Unlike some of their larger peers, who are anticipating a slower growth rate in 2012-13, many mid-cap information technology(IT) companies are expecting to expand faster than the 11-14 per cent industry growth rate predicted by the National Association of Software and Services Companies (Nas-scom). Historically, mid-cap and smaller tech companies are hit harder during global slowdowns. This time though, the story looks different. So, what is driving this disparity in performance?
First, unlike in previous slowdowns when mid-cap companies were competing with their larger peers and losing big time, many have now established their own niches and are focusing on relatively smaller sized deals (between $20-50 million), where competition from biggies is much lesser. Further, increased mining of existing clients is enabling them to clock healthy volumes and thus, improve visibility and margins. Their relatively smaller size also enables them to post good growth numbers. While they are growing faster, valuations are also reasonable.
Says Krishna Kumar Karwa, managing director of Emkay Global Financial Services: “Mid-cap IT companies’ valuations are almost at a 50 per cent discount to the large IT players. But they have decent cash flows, as well as dividend payout policies. Many of the mid-cap IT players have grown by 40-50 per cent in the last six-nine months, but from current valuations, I believe they should give you decent returns in the next 12-18 months. We like MindTree, Hexaware Technologies, NIIT Technol-ogies and KPIT Cummins.”
| GUIDANCE | |
| FY13E | |
| Hexaware * | >20 per cent |
| Revenues | >$370 mn |
| KPIT Cummins | 32-35 per cent |
| Revenues | $408-418 mn |
| PAT growth | 15-20 per cent |
| PAT | Rs 167-174 crore |
| Persistent | >11-14 per cent |
| Mindtree | >11-14 per cent |
| * For Hexaware, FY13 guidance pertains to CY12 | |
Having said that, investors also need to bear in mind the risks (like loss of a large client and its impact on financials) associated with mid-caps, which could reflect swiftly on valuations.
Strong growth
Increased traction in deal wins and continued client mining enabled most mid-cap IT players to clock strong volume growth for the March quarter. Hexaware led the pack with a robust 6.6 per cent sequential volume growth (in a seasonally weak quarter for the sector). The company has witnessed continued traction in its enterprise application services, which helped post strong sequential volume growth of 4.8-6.6 per cent in the last five quarters. Likewise, MindTree (volume growth of 4.9 per cent) and KPIT Cummins (volumes up 27 per cent) gained from strength in core businesses. KPIT’s financials also received a boost from last year’s Systime acquisition. Though Persistent Systems witnessed a 1.3 per cent decline in volumes, pricing gains of three per cent and strong sales of propriety products boosted growth.
| STRONG GROWTH, STABLE MARGINS | ||||||||
| In Rs crore | Hexaware | KPIT Cummins | Persistent | Mindtree | ||||
| CY12E | CY13E | FY12 | FY13E | FY12 | FY13E | FY12 | FY13E | |
| Revenues | 1,883 | 2,135 | 1,500 | 2,025 | 1,000 | 1,158 | 1,915 | 2313 |
| Change (%) | 29.8 | 13.4 | 46.6 | 35.0 | 28.9 | 15.8 | 26.9 | 20.8 |
| Ebitda (%) | 22.6 | 22.3 | 15.4 | 16.6 | 22.4 | 22.8 | 15.3 | 17.9 |
| Change (bps) | 440 | -30 | 50 | 120 | 200 | 40 | 350 | 260 |
| Net profit | 345 | 385 | 135 | 188 | 142 | 169 | 219 | 254 |
| % change | 29.3 | 11.7 | 42.1 | 39.3 | 1.6 | 19.0 | 116.0 | 16.0 |
| P/E (x) | 10.9 | 9.8 | 16.7 | 12.0 | 9.9 | 8.3 | 11.4 | 9.8 |
| E-estimates Source: Analyst reports | ||||||||
Utilising margin levers
The trend on margins was mixed for the March quarter. A stronger rupee against the dollar impacted all the players, but most of them deployed other margin levers such as rationalising costs to limit the impact. Despite the margin contraction witnessed by Hexaware in the March quarter, analysts expect the same to hover at 21-22 per cent on the back of strong volume growth and improving utilisation rates.
While Systime contributed largely to KPIT’s top line, the former’s lower margins (10 per cent) restricted overall earnings before interest, taxes, depreciation, and amortisation (Ebitda) margin to 15.8 per cent, which analysts estimate to inch up slowly. Lower employee costs boosted MindTree’s margins for the quarter. In FY13 as well, higher utilisations and increased hiring of freshers will push up Ebitda margin for the company.
Persistent expanded its margins by 260 basis points over the December 2011 quarter, aided by pricing gains, lower costs and a growing pie of non-linear revenues. Going forward, analysts believe strong growth in non-linear i.e. IP business, will act as a key margin lever for the company.
Valuations, outlook
The smaller IT companies remain fairly bullish on the road ahead and reflect more confidence on revenue growth. Hexaware has been delivering consistent financial performance for almost two years. The company has beaten analysts’ estimates in the past five quarters and has witnessed a slew of earnings upgrades since. Going forward, analysts expect Hexaware to see significant margin expansion and high traction in the enterprise applications business. They believe Hexaware will beat its own revenue growth estimate of over 20 per cent for the current year. Most analysts are positive and expect the stock to give 15-20 per cent returns from current levels.
In a report dated April 30, Sandeep Shah, analyst at RBS, who has a ‘buy’ rating on Hexaware with a target price of Rs 150, said: “A healthy large deal pipeline, consistent cost efficiencies, better cash flow management (four per cent dividend yield for 2012 forecasts) and high ROE (return on equity) of 29 per cent for CY12F reaffirm our positive outlook for the medium to long term.”
For MindTree, analysts believe its IT services, as well as product businesses, will do well due to scaling up of clients. In a report last month, Sandeep Muthangi of IIFL Institutional Equities, said: “Since the leadership changes and reorganisation, Mindtree has consistently improved margins and registered robust revenue growth from IT services. We are increasing our FY13/14 EPS (earnings per share) estimates by 11 per cent and target price by 15 per cent (to Rs 648), underpinned by higher margins.” Muthangi expects the company to clock a profit growth of 15.8 per cent and 18.1 per cent in FY13 and FY14, respectively.
A strong deal pipeline, along with good traction in its acquisitions, should drive growth for KPIT Cummins. The company has guided for the highest revenue growth (two times Nasscom growth predictions) for this year. While most analysts remain positive on KPIT, the stock seems to partly factor in the positives. Hence, a correction could prove to be a good entry point.
For Persistent, it has good presence in all new technologies, such as cloud computing, mobility and analytics. Notably, the trend of muted earnings growth in the past is expected to change and analysts are now bullish on its long-term growth prospects.
Haripreet Batra, an analyst at Kim Eng Securities, who has a buy rating with a target price of Rs 420 for the stock, in his April 30 report said: “Persistent is trading at a discount to peers because of no earnings growth in FY12. For FY13, we expect EPS growth to be in line with peers, helping it to narrow the PER (price/earnings ratio) gap.”
