Valuation gap between large and mid cap IT stocks halves

Seven out of the top ten mid-cap IT stocks have almost doubled their prices in the past year

Times are only getting better for the IT sector which is set to deliver another year of robust financial performance in FY15, believe analysts. All round pick up in demand across geographies and businesses coupled with a weaker rupee versus the US Dollar are two key catalysts driving this optimism. This has led to a strong run by most mid-cap stocks in this sector.

"Share price of most Indian mid cap IT stocks has doubled over the past 12 months, shrinking the P/E valuation discount of Tier-2 players versus Tier-1 IT companies to 20%. Historically, the Tier 1/Tier 2 discount has reverted to a mean of 40% as pressure on revenues and margins of Tier 2 firms rein in growth momentum", says Nitin Padmanabhan, IT analyst at Espirito Santo Securities.

Notably, stocks such as KPIT Cummins, Persistent, Mindtree, NIIT Technologies, Hexaware, eClerx and Infotech Enterprises have nearly doubled over the past year. These and other midcap IT scrips such as Polaris and Oracle Financial Services (Oracle) are trading pretty close to their 52-week high (about 2% to 9% lower).

Historically, the mid cap players have traded at a discount to their larger peer set given the risks attached to their business such as inconsistent financial performance, employee attrition, high client concentration (above 55% as against 24-25% for the top four players) and lower return ratios, amongst others. Some companies such as Mphasis continue to struggle with client-specific issues.

While most of these risks are still associated with the mid caps, some companies have created a niche for themselves by offering differentiated services in select verticals/service lines.

For example, NIIT Technologies has a strong presence in aviation and transportation sectors along with strong Intellectual Property (IP); whereas Persistent Systems is present in most of the gen-next technologies such as cloud computing, SMAC as well as IP. KPIT Cummins, on the other hand, has a strong position in the manufacturing vertical.

By doing this, they have reduced competition from larger players significantly and improved their revenue visibility. Strong management with proven execution record, presence in technologies of the future and good corporate governance can be considered for long-term investment, believe analysts. While most analysts are bullish on KPIT, Persistent and NIIT Technologies, their rich valuations could cap significant upsides in the near term.