Mid-Cap I.T. – Davids Find Valuation Momentum Versus Goliaths

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Mid-Cap I.T. – Davids Find Valuation Momentum Versus Goliaths


India's information technology industry is a classic case of how a few large-cap companies have for long remained in a separate tier, with mid-cap companies, barring a few, not being able to break into the A-list club, in the past two decades. That has led to a margin differential, arguably caused by pricing power, and economies of scale between large-, mid-, and small-cap Indian IT services companies. Now, though, the market seems to be quite comfortable in giving a much higher multiple to a bunch of mid-cap IT companies, vis-a-vis the large-cap ones, banking on higher growth. It is this growth that propelled Larsen & Toubro Infotech Ltd. from a market cap of sub-$3 billion about four-five years back to the current market cap of nearly $10 billion. The market probably believes that some other companies might be able to follow a similar trajectory.

Sample these comments, made in interviews with BloombergQuint by mid-cap IT managements, which show ample confidence about growth.

“Despite the record conversion, we are sitting on a [further] record pipeline. Our direct business grew 17% in a Covid year.”

We believe that as revenue grows, margins will grow. Economies of scale will ensure that if I was at a billion dollars revenue, my margins will be at least 200 basis points higher than where they are currently.

“In the last quarter, we grew 20% in dollar terms and that should give people a directional view about us. The demand environment being what it is today, we should be in the top quartile of growth in the industry, whether it is the Indian IT industry or the global IT industry.”

In its annual report, one company projects that increased hyper-digitisation and technology adoption across industries would open up growth avenues that it is well placed to leverage given its strong relevant digital capabilities.

Many mid-cap I.T. companies are now able to hire senior-level personnel who are experienced and hungry to succeed. The firms now have proven performance in complex deals to showcase to clients in newer geographies. They also enjoy strong enough cash flows to be able to make strategic acquisitions which aid performance in unproven areas. That puts them well poised to service the acceleration that Covid-19 brought to the digital-first transition.

As a recent Morgan Stanley note says, with the confluence of multiple new technologies, potential incremental spending on technology over the next decade could be bigger than in the previous two decades. Covid-19 has accelerated the migration, reflected in the higher shift to public cloud in 2020 versus the previous two years. India IT companies have shifted their business mix aggressively towards digital and are well-positioned.

While Morgan Stanley's view is specifically for large-cap Indian IT, one can see the benefits of some of these factors percolating down to the relatively smaller-sized companies as well. Earlier, the difficulties in the transition from mid cap to large cap were compounded by clients too being classified as Tier-I or Tier-II, which translated into lower pricing and less annuity, These deals were more project-based and/or talent availability and cost-based, and offered no seat at the large deal table. All of these factors, are now seen fading away.

The cornerstone of this price performance and the future outlook seems to be the deal win momentum, the likes of which some companies have not seen before. For Persistent Systems Ltd., the deal wins were large and strong. In H2FY21, Persistent had won deals worth 81% of its FY21 revenues, executable over a 12 month-period and hence reducing the ‘ask rate’ for new wins for robust double-digit growth in FY22.

Standalone larger deals aren't the only path to success for these companies. For Birlasoft Ltd., the new deal-win TCV for Q4 was at $162 million, up 189% QoQ and 142% YoY. For the full year FY21, deal win TCV was at $889 million vs $679 million in FY20, up 30.9% YoY. The management indicated that the Q4 booking had a series of mid-sized deals rather than any single large-sized deal (the largest signed in FY21 was worth $38 million), and that deal size can be grown to 4-5x in the coming years.

The management of Happiest Minds Technologies Ltd. believes that new business for the Indian IT space is at 7-8%, and the rest is repeat business or mining from the same customer or growth through inorganic moves. That offers a sobering reminder that the IT industry is not underpenetrated anymore. So any new business coming into mid-cap IT companies is coming from someone who is doing existing business with the client, and the company has to displace that service provider. Therefore, the ask of excellence and differentiated offerings is very high, which may lead to companies having to invest heavily in capable manpower. This may mean high competitive intensity for a limited talent pool, which might possibly hinder growth and margins.

Barring that, profitable growth is visible. Margins have cranked up, and the new post-Covid normal with work-from-home operations has elevated margins a few notches further.

While the normalcy will return, companies seem to be confident that a lot of the juice due to cost savings will not go away, as they've been able to live with the new normal without any major impact on productivity. There is a case that the margin tailwinds from a distributed delivery model provide headroom to make investments and drive market share gains over the next 3 years.

Indian mid-cap IT seems to have built some muscle that will help it replicate the showing in FY20 and FY21 into the forthcoming future across more clients, across multiple levels in the same company, and across multiple geographies. Happiest Minds, for example, says that many of its large customers are coming back with new initiatives, which they would love to bag, effectively pointing to high client mining. The management says that without any inorganic growth, a 20% growth rate number is something that it wants to keep up for the near to medium term. Birlasoft chimed in with similar confidence, as did Persistent Systems, which is a larger-sized mid cap. Tata Elxsi Ltd. ended FY21 on a high, with a 750 basis point improvement in earnings before interest and taxes margin, 44% net profit growth, 29% growth in the cash balance, and 71% growth in free cash flow, and 100% growth in optimism about the road ahead.

The conclusion seems to be that the market is now comfortable giving consistently higher valuations to mid-cap IT companies. Gone are the days wherein large caps would, by default, enjoy higher relative multiples. The average mid-cap IT company is winning large deals, generating high return on capital employed, rewarding shareholders, and thus gaining confidence amongst participants. Will it catapult some of the mid caps into large caps? The jury may be out on that one, but there has been an example or two of those in the last five years and we may see more in the times to come.

Niraj Shah is Markets Editor at BloombergQuint.

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