Street prefers large-cap information technology firms over mid-tier peers

Better cost management, execution have led to higher multiples for tech majors

A year ago, select mid-cap information technology (IT) companies were trading at a premium to their larger or tier-I peers. Tier-II players such as L&T Infotech, Hexaware, Mphasis and Mindtree were trading in the range of 22-27 times their one-year forward earnings estimates in July. 

In comparison, tier-I players, barring TCS, were trading at their one-year forward price to earnings multiple of 13-18 times. TCS has been the only outlier among the larger IT majors. It was trading at 24 times its one-year forward estimates. Since then, tier-I players (TCS, Infosys, Wipro, TechM and HCL Tech) have gained about 24 per cent while tier-II players have gained less than 2 per cent. The valuations premium has shrunk.

The higher valuation multiple of the smaller software players was on the back of faster growth, improving deal pipelines and growing digital business. This was helping the smaller players post growth rates that were double of that of larger players. In addition to this, niche presence and lower legacy business was helping these firms get better valuations. With growth challenges now, higher costs, a stronger rupee and onsite presence, maintaining margins will be a tall task. 

One of the key segments propelling growth was the digital services business. In the initial phase of the digital roll-outs, smaller IT companies were taking share, especially in the proof of concept stage and digitisation of specific business functions. However, with digital services scaling up, larger IT firms are cornering a higher share. 

Aniket Pande and Rajat Gandhi of Prabhudas Lilladher said the industrialisation of the digital theme made large caps more favourable. They expect these to take market share, compared to mid caps, given the strengths such as a large workforce, early investments in building digital investments, strong execution and the capability to stitch together multiple deals. 

The other reason why the Street is veering towards larger players their ability to minimise the margin pressures that is affecting the sector. Larger IT companies, given their scale, have higher leverage with sales, general and administration expenditure as a percentage of sales at 12-13 per cent, compared to mid size IT companies where it is 17-20 per cent. Madhu Babu of Centrum Institutional Research says mid-cap IT vendors have seen a gradual margin erosion over the past few years despite a steep rupee depreciation. This is due to increasing onsite intensity as well as investments to boost portfolio of offerings. With the rupee advantage no longer available, lower utilisation and higher attrition, the pressure is expected to intensify.  

While larger IT firms have caught up with their smaller peers on the growth rate front, with digital revenues now accounting for 30-35 per cent of their revenues, what will hurt the smaller firms is the lack of trained manpower to execute projects. The supply crunch is expected to weigh on tier-II firms, given their larger dependence on the US, lower gross margins and rise in costs for onsite employees.  

To keep the growth momentum going, mid-cap IT companies are looking at acquisitions and are being merged or acquired, which might affect the near-term multiples. Hexaware announced the acquisition of US-based digital consultancy firm Mobiquity for $182 million while Persistent acquired Herald Technologies for $5.2 million.