Nuvama bullish on tier-2 IT stocks, LTIMindtree among brokerage’s top picks; here’s why
- On LTIMindtree (their top choice in the sector), Coforge, and Persistent, Nuvama has maintained a ‘BUY’ rating. The brokerage has started covering Mphasis at a ‘REDUCE’ due to its comparatively high valuation.
Within the last five years, a select group of high-caliber tier-2 information technology (IT) companies have outperformed their larger counterparts in terms of both growth and margins, said domestic brokerage Nuvama Institutional Equities, in its report on IT services sector update. These tier-2 IT companies that have been handpicked for their exceptional quality are called CLAMP (Coforge, LTIMindtree, Mphasis, and Persistent).
The broker added that during the past five years, especially since the covid breakout, the IT services sector has experienced a paradigm shift. Certain high-caliber tier-2 IT firms have outperformed their bigger counterparts over the past five years, both in terms of growth and margins. Their business profiles have also been significantly derisked and diversified as a result of this.
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The tier-2 companies' stocks have outperformed the tier-1 companies', indicating that the market has also rewarded them. These tier-2 companies consequently continue to trade at a substantial premium to tier-1 companies.
Each has a different story of how they transformed their businesses, but all of them, according to Nuvama, have developed their business models into something that is both comparable to and superior to those of their larger peers.
While mid-cap and small-cap stocks have outperformed all indexes over the past three, six, and twelve months, Nifty IT has underperformed (marginally) the broader index. Some excellent tier-2 IT companies have also generated staggering returns within that.
"We argue the outperformance of mid-cap IT is rooted in their radical transformation—a coming of age from ‘boys to men’, having attained a critical size that passes muster on bidding for large deals. Alongside, and no less significantly, their margin profiles have undergone a reset and businesses are much more diversified. All in all, we remain positive on select quality tier-2 companies, and the IT sector at large," the brokerage said in its report.
Following five pillars form the foundation of Nuvama's investment thesis for these leading tier-2 IT services providers.
Size begets growth, further boosting size
The brokerage claims that the CLAMP companies have evolved from their former status as USD100–500 million businesses with fewer than 10,000 workers. They have risen into the elite group of USD1 billion and above companies with more than 20,000 employees each, thanks to their impressive 20%+ CAGR in revenue over FY21–23. They can participate in most deals because of their larger size, both financially and physically; the larger the size (e.g., LTIMindtree), the more deals they can participate in.
Business profile more diversified now
“CLAMP's business profile has undergone a transformation over the last three years. No longer are they dependent on one client or vertical. Their profiles today closely resemble their larger peers—with BFSI being the largest vertical for most just like tier-1 companies. However, at the same time, the strong presence (or right-to-win) in their niche vertical continues to supplement the growth they would be able to generate from the larger generic segments,” the brokerage said in its report.
Leadership change has worked wonders
Interestingly, IT services are a technology company that is ultimately managed by people despite involving computers and codes. Over the past decade, the brokerage has witnessed numerous instances where the CEO of a tier-2 company has taken on the role of segment head from a tier-1 IT services company.
“Such CEOs bring with them industry best practices, connect with tier-1 clients, and ability to build and nurture a strong team, not to mention the right vision/direction for the company. Overall, we see the impact of CEOs coming from tier-1 companies making a big impact on not just growth trajectory of tier 2 companies, but also in terms of ushering in business diversification and overall optimisation,” the brokerage said.
Margins have undergone a permanent reset
The brokerage claims that during the past three years, the margin trajectory for the IT sector has been quite erratic. Higher offshoring and lower travel and facility costs in FY21–2022 contributed to a sharp increase in margin. Margin corrections were made across the board in FY23 as a result of growing attrition, wage increases, the return of travel and facility costs, and decreased offshoring (compared to FY22 peaks).
Valuations, at a premium, but justified
"We believe the market is ascribing a premium to CLAMP companies as they are no longer the midcap companies of yesteryears, and also likely to report superior growth sustainably over the next three–four years. We also believe that this valuation premium shall hold in the near to medium term because of their growth outperformance and business transformation.
We see glaring similarities between LTIMindtree/Coforge and Infosys/Cognizant of yesteryears, and see these companies traverse the path of these larger peers. Retain ‘BUY’ on LTIMindtree (our top pick in the sector), Coforge and Persistent. We are initiating coverage on Mphasis at ‘REDUCE’ on relatively expensive valuation," said Nuvama in its report.
Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.
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