Mid-cap information technology players may have hit valuation ceiling

Sharp premium over larger peers and ability to maintain margins can cap gains

Mid-cap information technology (mid-cap IT) companies have outperformed their large-cap peers over the past year, with returns of 138 per cent as compared to the IT big boys which enriched investor wealth by 77 per cent. The rerating in mid-cap plays has been sharper over the last six months with the difference stretching to over 121 percentage points.
 
Street expectations from large- and mid-cap IT companies are also reflected in the expansion of the aggregate price-to-earnings (P/E) multiple. A year ago, there was hardly any difference between valuations of the big 5 and the next five IT companies on the one-year forward P/E with the latter trading at a slight premium. This has now increased to 31 per cent; the Street is thus expecting revenue and earnings growth to be better for these companies.
 
Highlighting the reasons for the outperformance of IT mid-caps, Suyog Kulkarni of Reliance Securities says revenue growth of these companies has been consistently higher. This is driven by a higher share of the budgets, client mining, and new deal wins -- especially when the technology cycle is looking up. Mid-size enterprises, which are implementing transformation deals, will also tend to opt for them, he adds.
 
Some of these trends are reflected in the revenue uptick and deal growth in the March quarter. Barring L&T Technology Services and Mphasis, most mid-caps posted higher sequential growth ranging 4.4-7 per cent, while growth for TCS was the fastest among large-caps at 4.2 per cent. While large-cap IT names, such as TCS and Infosys (17-57 per cent respectively), have had a strong uptick in new deal wins, mid-caps have been reporting good momentum. L&T Infotech and Mphasis registered growth of 22-55 per cent in new deal wins last year.

 
Vikas Ahuja and Ashish Agrawal of Antique Stock Broking say: “Mid-caps’ impressive deal bookings and digital growth in the past few quarters position it for strong potential growth over the next 12 months. In addition, digital revenue is now more than 50 per cent for most mid-caps, which can more than offset pricing pressure on legacy IT work.”
 
The outperformance on the revenue growth front is likely to continue in FY22 with large-caps expected to post revenue growth in the 11-16 per cent band and Infosys leading the pack; mid-cap players are expected to see growth of 15-18 per cent.
 
Further margin gains, however, can be difficult to come by.
 
Riding on strong revenue growth and lower costs, most mid-caps also outperformed larger peers on the margin front, gaining 20-150 basis points on a sequential basis. TCS was the only gainer among large-caps; it posted a 20 basis points jump. While revenue growth continues to be strong, analysts warn of headwinds for the margin trajectory for mid-cap companies.

 
Wage costs are expected to see an increase, especially if attrition levels go up. The deal ramp-up in the June and September quarters, reversal of travel and discretionary costs, and shift back to onshoring are other factors that will also weigh on their margins. The extent of operating leverage will only be clear in the September quarter of FY22, says an analyst at a domestic brokerage, citing the case of L&T Infotech. The largest mid-cap player posted growth of 9.5 per cent in FY21, but hiring has also increased by 14.4 per cent.
 
Given the massive outperformance of mid-cap players and sharp valuation premium to larger peers, analysts say further rerating is unlikely. They suggest investors look at companies, such as L&T Infotech which has underperformed its peers since the start of the year and Mphasis.