In the last one year, L&T Infotech and Mindtree have risen higher than TCS and Infosys
Largecaps have an advantage on scale, but that has not led to higher growth, say analysts
Information technology (IT) stocks are the flavour of the season. Increased cloud adoption aided by the work-from-home (WFH) trend kept them in the spotlight. On Wednesday, the Nifty IT index touched a new all-time high of 33,840.45. Blue-chips and index heavyweights Infosys Ltd and Tata Consultancy Services (TCS) Ltd, among others, also rose to 52-week highs. Infosys and TCS stocks together have a weightage of nearly 50% in the Nifty IT index.
This upward move in large IT stocks is a catch-up rally that was overdue, according to analysts. Tier-I technology stocks have led this rally, but midcap IT stocks are stealing their thunder with mouth-watering returns.
In the last one year, shares of Infosys and TCS have rallied by 79% and 57%, respectively, while those of L&T Infotech (LTI), Mindtree Ltd, and Mphasis Ltd have jumped by more than 100% each. Some exceptional performers such as Persistent Systems Ltd have rallied more than 200% in this period.
The Street has rewarded midcap IT stocks for their robust earnings performance, analysts said. In Q1FY22, tier-II IT services providers have comfortably beaten their larger counterparts on key parameters such as revenue growth. In dollar terms, TCS saw a sequential revenue growth of 2.8%. For Infosys, this was 4.7%. Midcaps LTI, Mindtree, and Mphasis, meanwhile, saw dollar revenues improve by 5.1%, 7.7%, and 6%, respectively on a sequential basis in the June quarter.
The entire sector has been facing margin pressure because of wage hikes and supply-side constraints. However, contraction in margins for some large companies in Q1 was higher than midcap IT services providers. “Large companies have an advantage on scale, full stack offerings, and consolidation, but that has not translated to higher growth. Mid-tier firms have been able to attract quality talent at top leadership levels. Turnaround plays of many mid-tier companies have been driven by bringing external leadership from Tier 1 firms," analysts at Kotak Institutional Equities said in a report. Additionally, in a supply-constrained scenario, mid-tier firms have impressed with strong ramp-up in headcount, the Kotak report said.
The demand outlook for the entire IT sector is improving, but midcaps are expected to continue to outshine larger peers going ahead. The momentum in mid-tier IT will be strong because of the deal bookings trajectory, according to analysts at HDFC Securities. This is reflected in their outperformance versus tier-I firms on revenue and margin, and the trend is likely to continue.
Sharing the optimism, Kotak analysts said quality mid-tier firms can sustainably grow at a faster pace than quality tier-I as demonstrated by firm such as LTI in the past few years. Better growth prospects are also mirrored in their valuations. Some midcaps are trading at valuation multiples similar to large IT shares. In some cases, they even enjoy a premium. The one-year forward price-to-earnings (PE) multiple of sector bellwether TCS is 30 times, according to Bloomberg data. Shares of LTI, Mindtree and Coforge Ltd are trading at a PE multiple of 33-35 times. “The mid-tier valuation premium relative to tier I may sustain, based on its relative outperformance (>500 basis points (bps) growth outperformance over FY21-24E as compared to 250bps earlier)," said the HDFC Securities report. One basis point is one hundredth of a percentage point. HDFC analysts said the year-to-date consensus earnings per share upgrades for this sector were led by tech midcaps.