Small tech firms to benefit from rise in demand, but with a lag

Small tech firms to benefit from rise in demand, but with a lag
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First Published: Mon, May 24 2010. 09 30 PM IST

Updated: Mon, May 24 2010. 09 30 PM IST
Results declared for the March quarter clearly indicated that the demand for Indian offshore vendors is on the upswing, supported both by strong guidance as well as strong broad-based performance. However, mid-tier vendors continue to lag behind tier I vendors on growth.
After March 2010 quarter’s results, investors still grapple with the most important question on when do tier II offshore vendors benefit from the growth in demand for Indian techs as the large valuation gap between tier I and tier II vendors appears too tempting to ignore. We believe that tier II technology vendors will benefit from demand recovery, but with a lag. However, the landscape for them continues to remain difficult with the ever-expanding scale of tier I vendors.
Also See | Valuation Gap (Graphic)
Further, tier II vendors face greater margin downside risks from currency appreciation, supply-side pressures and rising attrition (which should continue in the near term).
We also discuss the potential hit from cross currency moves adversely (though marginal at the current moment with rupee depreciation vs the dollar lending support). However, if the macro environment in Europe continues to worsen, it could threaten our revenue/earnings estimates as decision-making on technology spending takes a back seat and could lead to a situation akin to the second half of fiscal 2009, when disruptive macro events forced Infosys Technologies Ltd, Cognizant Technology Solutions Corp. to cut their annual guidance and led to a sharp fall in stock prices.
However, we see the fluid situation in Europe as an opportunity for Indian technology firms to fortify their European presence by taking advantage of cheap valuations driven by adverse macro environment, weakness in the pound and the euro, and balance sheet strength of Indian companies. Infosys remains our preferred pick in the large-cap information technology universe, followed by HCL Technologies Ltd, Tata Consultancy Services Ltd, or TCS, and Wipro Ltd in that order. Among mid-caps, Tech Mahindra’s valuations appear more reasonable after the sharp correction in the recent months. MphasiS Ltd could outperform in case of deterioration in the macro environment on account of higher revenue/volume certainty driven by dependence on the parent.
Tier I vendors showed strong revenue growth during the quarter, clocking 3-5% dollar-term growth quarter-on-quarter with the growth being more broad-based compared with the growth led by financial services over the past two-three quarters as demand in hi-tech, telecom and manufacturing bounces back. More interestingly, discretionary service lines such as consulting have seen a sharp rebound during the quarter. Tier I vendors continue to remain confident on further increase in demand, especially discretionary services in the second half of calendar year 2010, which should keep revenue momentum flowing in the subsequent quarters.
However, tier II vendors continue to lag tier I peers on revenue/volume growth even after three quarters into the recovery. Despite the recent negative macro news flow from Europe in the recent weeks, tier I vendors appear confident on the business environment in Europe, with Cognizant even raising its annual revenue growth guidance to 25% (against 20% earlier).
We believe that the wage increment cycle (getting implemented in the June quarter) along with cross-currency movements should put near-term margins under pressure and more so for tier II vendors as they appear marginalized compared with tier I offshore and competition from multinationals. Margin vulnerability for tier II vendors is evident from the fact that Hexaware Technologies Ltd’s margins have fallen by at least 15 percentage points over the past two quarters compared with a more resilient performance by tier I vendors.
Despite an eye-popping valuation differential between tier I and tier II vendors, we remain wary of becoming securely constructive on tier II vendors as they continue to lag tier I peers on revenue growth (even after three quarters into the recovery, although they would benefit from the demand recovery with a lag) as well as margin headwinds expected to intensify from wage increment pressures and cross currency headwinds in the near term.
Graphic by Yogesh Kumar/Mint
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First Published: Mon, May 24 2010. 09 30 PM IST