Party in mid-cap IT stocks to continue: MindTree, Zensar gain of over 35%

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Mid-cap IT stocks have been in the limelight, gaining 20-40 per cent over the last month with a large chunk of the gains coming over the last couple of weeks driven by improving deal pipeline, growing digital business and rupee depreciation. While MindTree and Zensar Technologies posted gains of over 35 per cent, Mphasis, NIIT Tech and the L&T software twins gained upwards of 19 per cent. The broader markets were up 5 per cent during this period. The near-term trigger has been the strong March quarter numbers and the improving deal pipeline.

Consider MindTree: the company posted its best performance in 10 quarters with 15.6 per cent revenue growth and a 370 basis points margin gain over the year ago quarter. Despite the sharp gains, analysts believe there is still improvement to be made on the profitability front given lower employee utilisation rates and a higher proportion of senior employees than the sector average. The FY19 outlook by management of Persistent Systems and Cyient, too, has been robust and they are expected to outperform the overall sector.

The bigger investment argument for the mid-cap information technology (IT) firms is the change in demand environment, which is reflected in deal pipelines, the higher share of digital revenues and size of the contracts. Technology research and advisory firms (ISG and IDC among others) expect deal renewals as well as fresh deals to hit the $30 billion-mark over the next year, the quantum of which was last seen five years ago. Phillip Capital’s Vibhor Singhal and Shyamal Dhruve indicate that management commentaries have been significantly upbeat and deal-flow momentum has been the strongest in the last four years. They believe most mid-caps have already turned the corner and should report double-digit revenue growth in FY19 with some reporting the same in FY18 itself.

Analysts at HDFC Securities believe that the top 10 client contribution of mid-cap companies has led to the acceleration in growth (unlike large caps) and offers significant client mining opportunity. This coupled with the addition of new deals and higher deal win rates should reflect positively in their growth numbers. The brokerage estimates a growth rate of mid-teens for mid-cap IT companies going ahead. 

Analysts say the early adoption of digital by the smaller IT companies and a lower revenue base will allow them to be more nimble as compared to larger IT companies given their excess baggage of traditional services. In fact, the shares of the digital services for mid-cap companies are in the 35-45 per cent range as compared to around 25 per cent for large-cap peers.

Analysts estimate that the share of digital revenues for mid-cap companies will cross the 50 per cent-mark by FY20 and this will ensure that they grow at a faster clip than the overall sector as digital revenues are growing upwards of 30 per cent year-on-year.

The other reason for the investor demand for some of the mid-cap IT companies is the significant presence in niche domains, which is helping them withstand the shift to the digital segment. L&T Technology Services and Cyient are the cases in point as their presence in the engineering research and development segment has helped them outperform, given that the segment remains decoupled from the digital wave.

A common tailwind for all companies in the sector is the depreciation of rupee vis-a-vis the greenback. The rupee, which has remained stable in CY17, has depreciated sharply in the current year more so in the last couple of weeks. The recent 3 per cent depreciation of the rupee is expected to lead to a 5 per cent revision in earnings per share estimates of most companies. While companies across the sector will benefit, analysts believe among the mid-caps the key gainers will be MindTree, which is the most sensitive to currency movement given the higher share of offshoring, as well as NIIT and Persistent Systems, given their low base as well as higher offshoring. 

The sharp price uptick over the last few weeks led by price to earnings (P/E) rerating means that mid-cap stocks now trade 30 per cent above their five-year average P/E. Given the large gains in stocks such as the L&T twins and MindTree, it is better to buy them on dips, while considering stocks such as Cyient and Persistent Systems, which are reasonably priced.