Prospects brighten for small IT firms

The big information technology companies may have rolled out decent numbers for the June quarter on the back of an improving demand in financial services and other emerging verticals, but the mid-cap IT space was a mixed bag.

While the bigger peers faced similar issues, smaller companies were more impacted by the slower euro zone revenues, currency fluctuations and rising employee costs.

But the good news is that the business environment is showing signs of further improvement.

"The benefits of this will also trickle down to smaller companies, albeit with a lag effect (of two-three quarters)," says a fund manager. This, in turn, should help them deliver healthy returns.

Euro zone woes

Even though the big-three IT companies - TCS, Infosys and Wipro - did face pressure in Europe, which reflects in their revenues from the region, they managed to grow their total revenues 5-5.5 per cent sequentially in the June quarter due to their well-diversified business models.

Contrarily, the smaller IT companies saw revenues grow at a slower pace of 3.5-4 per cent in the same period.

A mixed bag
In Rs crore	% q-o-q chg in*		EPS		P/E FY11E
	Sales	PAT	FY10	FY11E
Geometric	-5.5	17.2	7.8	8.2	8.6
Infotech Ent	3.6	-35.9	27.0	14.1	11.9
KPIT Infosys	4.6	-6.9	11.0	11.7	12.2
Mastek	-4.2	-83.6	31.4	27.6	9.4
Mind Tree	1.3	-71.0	50.4	35.2	15.1
Persistent Systems	5.4	-13.0	26.1	36.1	12.8
Sonata Software	4.5	-2.9	NA	NA	NA
Zensar Tech	3.9	18.5	59.9	32.1	5.4
Zylog Systems	3.5	29.7	NA	NA	NA
Patni Computers	0.4	-1.6	41.7	43.7	10.9
NIIT Tech	21.8	-1.0	22.0	23.5	7.8
*For quarter ended June 2010; E: Estimates Source: Capitaline, company

In addition, the smaller companies took a bigger hit on the profit front (see table), with many companies reporting a decline in the same.

Companies like Infotech Enterprises and Mastek, which derive 40-50 per cent of their revenues in European currencies, were the most affected during the quarter.

Mounting employee costs also took a toll on IT companies, which observed a dip in operating margins sequentially. On account of multiple service offerings, bigger companies saw operating margins slip 50-140 basis points (TCS, notably, saw an improvement).

However, the same was lower by 300-350 basis points sequentially for smaller companies in the June quarter.

Going ahead, while the bigger IT companies are expected to cope with wage inflation better vis-a-vis their smaller peers, mid-cap IT companies that cater to niche and non-linear services, like internet protocol- (IP) related services, are expected to outperform.

We look at four such mid-cap companies that are capable of delivering healthy returns:

Persistent Systems: Persistent Systems, which operates in the outsourcing software product development space, is seeing improved demand. Infrastructure and systems verticals (contributes 72 per cent to revenues) outperformed and witnessed 8.8 per cent sequential growth in the June quarter, compared to an overall revenue growth of five per cent.

And, with US still contributing a bulk of the revenues (85 per cent) and Asia-Pacific remaining the fastest growing segment, the company's growth prospects look good. Invest with a long-term perspective.

NIIT Technologies: In the June quarter, NIIT Technologies observed traction from US, which contributes more than a third of its revenues. Growth came on the back of a significant intake of fresh orders. The company booked new orders worth $40 million, taking the current order book to $149 million, which is to be completed over a year.

NIIT is looking at IP assets and cloud computing to drive growth. Future growth would also be driven from emerging markets like India and saw its share in the overall revenue pie increase from 10 per cent to 16 per cent. Buy with a medium- to long-term perspective.

KPIT Cummins: KPIT Cummins Infosystems key offerings include Business IT & Intelligence to BPO/KPO. Revenues grew 4.6 per cent quarter-on-quarter (q-o-q), aided by strong demand from manufacturing and the US. KPIT's 'SPARTA' acquisition is bearing fruit with a q-o-q jump of 9.2 per cent in revenues.

However, revenues from Europe saw a gradual consolidation in the June quarter, while still being lower by 23 per cent from a year ago. But wage hikes are expected to dent margins.

Revolo, its hybrid technology solution initiative for automobiles, would also improve its revenue mix and further de-risk its revenue model. Buy with a medium- to long-term perspective.

Patni Computers: Inability to scale up projects in the June quarter were a drag on Patni Computers' revenues. Besides project delays, higher attrition could also be a dampener in project execution.

The attrition rate, excluding BPO operations, surged to 21.5 per cent compared to 13.2 per cent a year ago. The company is also looking at acquisitions to aid growth and the management expects to win one or more deals of more than $25 million in the next quarter.

The stock, which fell 6.4 per cent on Wednesday after the results announcement, can be considered on dips.