How Tier-II Tech Firms Are Faring in Q4

Analysts expect mid-tier IT companies to outperform larger competitors in terms of sequential revenue growth in Q4 of FY22. This is despite the seasonally weak fourth quarter and the higher base of the previous quarter.

Analysts at JM Financial Institutional Equities are penciling in 2.7-5.3% sequential revenue growth in constant currency terms for Tier-I companies. It is expected to be 3.6-6.9% for Tier-II companies. “Tier II technology will again outperform Tier I technology on revenue growth, aided by smaller deal sizes,” analysts at JM said in a report on April 5.

After the outbreak of coronavirus, IT companies opted for rapid digital transformation and cloud migration of customers. Mid-tier companies have been able to grab this opportunity in the form of small deals. In comparison, Tier-1 tech firms have performed sluggishly on large deals. “Contrary to the improvement in outsourcing deal wins (relevant for Indian IT) in Accenture in the last five quarters, Tier-1 IT has seen a decline of 17-65% from the peak in Q3/Q4FY21 and lower in the last three-four quarters. Ambit Capital analysts said in their report on April 5. As such, a strong pipeline of smaller deals, timely execution and better efficiencies are among the factors that have given Tier-II companies an edge over larger peers.

The road has accepted it. In the past one year, the shares of Tier-II IT companies L&T Infotech Ltd, L&T Technology Services Ltd and Mphasis Ltd have gained 48-87% and the shares of Mindtree Ltd and Persistent Systems Ltd have more than doubled.

These stocks have comfortably outperformed the sector index Nifty IT, which has gained 35 per cent. Tier-I stocks Tata Consultancy Services Ltd, Infosys Ltd and Wipro Ltd have given returns of 15-40%.

Thus, valuations of mid-tier IT stocks are at a substantial premium to larger peers. The price-to-earnings (PE) multiplier, based on FY13 earnings estimates, is 31-45 times for mid-tier IT stocks. According to Bloomberg data, the PE of large companies is in the range of 20-31 times.

“Tier-II is likely to continue to outperform Tier-I IT companies in the near-term, but the growth gap is narrowing. The valuation of the former, however, is still very high,” said one analyst, seeking anonymity. Despite impressive revenue growth in the past, valuations of tier-II companies suggest that growth expectations are very high. As growth normalizes to pre-Covid levels, it remains to be seen whether this outperformance continues,” said the analyst mentioned above.

Meanwhile, for FY13, a major downside for the sector is from supply-side constraints weighted on risk margins. The pressure for retention, promotion, return travel costs, and wage increases due to high inflation in the US and Europe is worrying. Also, attrition rates for the entire sector remain high. Hence, a hike in prices will be crucial for the margin outlook.

Kotak Institutional Equities said, “The tailwinds are in the form of price increases, employee pyramid and sub-contractor cost reduction. To bridge the gap, depreciation of Rs. 4% depreciation will bridge the gap and ensure stable margins,” said analysts at Kotak. These factors put the FY23 margin estimate for the sector at risk of being downgraded. “The consensus FY23/24E expectations build margin expansion in companies (ex-Mindtree) from 9MFY22 levels; We see risks to consensus on the reversal of higher supply side risks and discretionary cost savings,” Ambitt said.