Value picks in mid-cap IT space

A pick-up in growth across key markets of the US and Europe, along with rupee depreciation, augurs well for the Indian information technology sector.

This optimism has been echoed by the managements of most large and mid-cap IT companies in the recent past.

Not surprisingly, IT stocks have been the darling of the markets -- the BSE IT index is up 42.4 per cent since July.

Most large-cap scrips (barring HCL Technologies) such as TCS, Infosys and Wipro trade at handsome valuations of 17-20 times their FY14 estimated earnings.

While mid-caps, too, have participated in this rally, the valuation discount with respect to the large-cap companies remains significant.

These mid-caps now trade anywhere between seven times (Polaris) and 15 times (Persistent) the FY14 estimated earnings.

However, investing in mid-cap IT companies is relatively risky given the volatile earnings trajectory and, hence, analysts believe the consistency premium that large-cap players enjoy over their mid-cap counterparts is unlikely to go down significantly.

Nonetheless, investors can still consider quality names in this space such as Hexaware, Mindtree and NIIT Tech, which have healthy earnings visibility and reasonable valuations.

Hexaware Technologies has made a niche in the airlines vertical and Peoplesoft implementation.

The management remains upbeat about the demand environment and has a strong deal pipeline.

While the top 10 clients continue to show healthy traction, robust performance of the Peoplesoft 9.2 upgrade is also likely to drive growth.

Additionally, the company gets 70 per cent of its revenues from annuity-based maintenance services and is, hence, less susceptible to any cuts in discretionary spends.

The key risk to its growth is an unprecedented fall in demand from any of the top 10 clients, which looks unlikely.

“We expect the company to post a rupee revenue CAGR (compounded annual growth rate) of 18.2 per cent over CY2012-14.

“While the Ebitda is expected to grow by 13.5 per cent in CY2014, net profit is expected to grow by 8.6 per cent, impacted by higher forex losses,” says Ankita Somani, IT analyst at Angel Broking.

She has a target price of Rs 130 on the scrip. For CY14, though, profits are expected to grow by 15-17 per cent.

Also, of the 25 analysts polled by Bloomberg since November, 13 have a buy rating, nine are neutral and the rest (three) have a sell rating on the stock.

Given their average target price of Rs 141, there is upside potential of about 16 per cent from the current level of Rs 122.

Mindtree’s

strategy of focusing on mining existing clients has paid off well.

After closely engaging with its top 20 clients, the company plans to extend this strategy to the next 20 clients.

Mindtree is reducing less profitable and smaller clients (its total active clients have come down from 270 to 220 over the past year).

It plans to double fresher hires to 1,700 this fiscal, reflecting strong growth prospects.

The company expects traction in cloud computing and software products to drive a stable performance of its HiTech business (28 per cent of revenues), while a strong deal pipeline could drive growth for its IT services business (72 per cent of revenues).

While the December quarter operating margins could be impacted by wage raises, analysts expect this metric to improve for FY14, driven by improvement in utilisation rates and rupee gains.

Of the eight analysts polled by Bloomberg since November 2013, five have a buy rating on the stock and three a hold.

While their average target price stands at Rs 1,439, indicating limited upside from current levels, there are additional triggers in the form of a pick-up in the HiTech business, which could lead to the raising of profit estimates and target price of Mindtree.

Valuations at 11 times the FY15 estimated earnings, though slightly above the company’s own historical average one-year forward PE ratio of 10 times, also provide comfort.

NIIT Technologies has a good foothold in the transport segment, with a strong client base in the aviation sector.

The company plans to improve the growth trajectory in the infrastructure management services and BFSI segments and has brought some senior people on board to achieve this.

The company is focusing on large deals, which should help enhance visibility.

“We believe that NIIT Tech is poised for a re-rating. With Sudhir Chaturvedi (former Infosys senior vice-president) taking the lead on the sales front (as chief operating officer), we expect the company to regain focus on developed markets (the US and Europe) as well as strengthen verticals with a larger business opportunity (BFSI, travel and manufacturing)”, says Madhu Babu, IT analyst at HDFC Securities.

He has a target price of Rs 425 on the scrip. Of the 10 analysts polled by Bloomberg since November, nine have a buy and one has a neutral view.

Their average target price of Rs 369 indicates gains of 7 per cent from current levels.

While the slow growth in domestic business (just 16 per cent of revenues) could prove a drag, the other triggers are a pick-up in BFSI and IMS segments as well as higher growth from developed markets as the company steps up its sales and marketing activities.