With declining margins and attrition challenges, mid-cap IT companies’ shares are being beaten down, even as their large peers continue their northward journey

Noted British economist, EF Schumacher, wrote a book called, Small is Beautiful. The falling stocks of mid-cap IT (information technology) companies and the rising stocks of large companies from the same sector, has proven the phrase wrong. It perhaps indicates that, "Small is (not) beautiful." Big is, indeed!

Stocks of mid-sized IT companies have been falling, even as their large peers continue their northward journey.

In the period from 4 January 2010 till today's trading session on 7 March 2011, the stocks of mid-sized IT companies have wilted by more than 50%. During the same period, the Sensex—after hitting a high of 21,004.96 points on 5 November 2010—has moved up 4%. The BSE IT index, the benchmark index of IT companies, has inched up by 18% in the same period. It closed at 6,168.82 on Monday (7th March).
 
In the period considered above, the share price of Firstsource Solutions Ltd fell by 52%, MindTree Ltd dropped by 46%, MphasiS Ltd was down by 37%, Tech Mahindra plunged by 33%, Patni Computer Systems Ltd fell by 7%. On the other hand, Tata Consultancy Services (TCS) Ltd has moved up by 48%, HCL Technologies has climbed up by 22%, Infosys inched up 16% and Wipro grew by 7%.  

What are the reasons for this sluggish growth? Analysts tracking these stocks say that mid-sized IT companies are caught in attrition challenges, which is pressurising their margins. Other factors like excessive focus on horizontals and vendor consolidation are leading to sluggish growth and the subsequent impact is being seen on their stocks.

According to Abhishek Kumar, associate, Centrum Broking, "There are lot of attrition challenges in mid-size IT companies. Such companies have to pay more to retain their employees, which is not the case for bigger IT companies, as they can afford lower wages due to their brand name."

Elaborating on this trend, Rohit Anand, senior research analyst at PINC Research, told Moneylife, "They (mid-cap IT firms) have not exhibited good financials in a few recent quarterly results, they are bogged down by sluggish revenue growth and pressure on margins due to increase in salary costs because of rising attrition in the industry. Broader markets are not well suited for mid-caps at this point of time. Investors prefer to stay invested in blue-chip stocks, which have a long history of good returns to investors."

On company-specific details, Mr Anand said, "Mid-cap firms haven't announced big deals. There was one big deal announced by Patni, but that couldn't help increase the revenue momentum and it even lagged behind its mid-cap peers in revenue growth. Patni is expected to be muted in terms of share price performance due to lack of revenue growth, much below the industry average. MindTree announced two deals worth $70 million last week, but the exit of the chairman and the lack of leadership at the senior level is putting the company at risk."

The latest quarterly results of mid-cap IT companies were disappointing, as operating profits were down. Again, the operating profit of the large caps inched up. Firstsource Solutions' operating profit for the December 2010 quarter came down toRs20.74crore from Rs30.63 a quarter earlier. Similarly, for MindTree, for the third quarter, it stood at Rs44.96 crore-down by 17% as compared to the second quarter. The operating profit for the latest quarter of the mid-caps as compared to a quarter ago fell by 11% for Mphasis; 10% for Tech Mahindra and 55% for Hexaware. While for Patni, the operating profit for the fourth quarter stood at Rs188.75 crore, an increase of just 1% as against a quarter ago.

Meanwhile, the operating profit on a quarter-on-quarter basis for large-cap companies increased. It grew by 32% for HCL; 9% for TCS and 8% for Wipro. However, for Infosys, growth remained flat.

Despite the stumbling revival of the US economy, mid-cap IT companies have been unable to win contractors and projects due to the current vendor-consolidation process that is going on. Again, the projects are being grabbed by the major IT giants.

"There is vendor consolidation going on in the US and Europe. So contracts are given to one large company instead of many mid-cap companies," said Srishti Anand, an analyst tracking IT stocks at Angel Broking.

Mr Kumar echoed her views, "If mid-cap IT companies have to win a project and compete with the bigger companies, they have to lower their prices. Because of this, they don't enjoy the economies of scale, which leads to higher costs."

Large-cap IT companies, due to their vertical offerings, are able grow with healthy financial results as compared to the mid-sized firms, which only have horizontal concentration. This directly affects the revenues in case clients decide to downsize. "Mid-cap IT companies are skewed in terms of vertical exposure as compared to larger peers having a diversified basket," added Ms Anand.

Going beyond, there is a concern for these companies-as margins are expected to come down even more. Mr Kumar said, "Diversified offering and foraying into domains like banking and manufacturing can enable growth. Otherwise, the pressure on margins will continue from both the supply and demand side."
 
Mr Anand said, "Revenue growth (of mid-cap firms) will lag, compared to large-cap firms and the margins will be under pressure due to further salary costs, already high utilisation and currency headwinds." He added, "Share price performance of mid-cap IT firms will lag that of large-cap firms at a generic level. A few mid-cap IT firms, due to their USP (unique selling proposition), positioning and margin levers might post relatively better results."