Issues plaguing the midcap IT sector

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Issues plaguing the midcap IT sector

Speaking to CNBC-TV18, Sandeep Muthangi of IIFL said a severe supply side pressures is playing havoc with the midcap IT companies, who are on the verge of seeing delivery disruptions.

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Excerpts from Bazaar on CNBC-TV18 Watch the full show » RELATED NEWS Vibhav Kapoor suggests sectors to play in a corrective mkt See Sensex at 22000 by year end: Deutsche Bank Why is Bowen Capital bullish on NBFC stocks? ALSO READ See what other experts are saying about markets See what FIIs are saying about the markets See what Udayan Mukherjee is saying about the markets

The struggling midcap IT sector has not found any respite in the past few months. And the ongoing mayhem in the markets is  adding to the injury, dashing all hopes of a revival in the near future.

Speaking about the sector to CNBC-TV18, Sandeep Muthangi of IIFL said a severe supply side pressure is playing havoc with the midcap IT companies. These companies are on the verge of seeing delivery disruptions, which will once again hurt the already falling margins. Unlike their larger peers, revenues of midcap IT companies will continue to suffer.

Here is the verbatim transcript of his interview with CNBC-TV18's Udayan Mukherjee. Also watch the accompanying video.

Q: Generally speaking why are you saying that midcap IT companies will not deliver strong earnings growth?

A: Midcap IT services firms have a role to play in Indian IT, they give better management access, there are niche companies etc. But right now what we are seeing is severe supply side challenges; they are prevalent across IT industry because demand has picked up, attrition is there, people are moving around etc. But they are especially severe with respect to the midcap IT companies. You have companies having 35-40% attrition level. Though the demand is good you cannot maintain your level of profitability with such high kind of attrition numbers. So that is one particular challenge that we are seeing at midcap IT services firms.

Also, going forward, if you look at the MNC recruitment in India, it is picking up very strongly. Some of the MNCs had cut their headcount during the slowdown, they are recruiting large numbers and that is also affecting the midcap IT services firms. Even the campus slot, if you look at them, they go to campuses, they recruit freshers and they have a certain slot which they get slot zero-slot one kind of slots in the campuses, but because recruitment is so heavy from the larger players, they are not getting good slot from the campuses. Going forward, this also could be an issue for the midcap IT services. These are some of the supply side challenges that you are looking at.

Q: So are you saying that their costs will go up significantly to retain talent or there could actually be delivery disruptions because good talent is simply not available to the mid rung and the lower rung?

A: Delivery disruptions. We have seen with some of the midcaps that there were delivery disruptions in the past two-three quarters. Also, what I think will happen is you will backfill these resources, you will deliver on time, but with costly laterals. That is what is making it very tough for you to maintain the profitability.

The other challenge is if you look at the structure of the demand that is coming now, it's a bit different fundamentally. You are seeing a lot of vendor consolidation exercises. You are also seeing lot of deals where multi sourcing is preferred and midcap IT services vendors are not very well diversified; they are specialised, they are very good with certain clients, they are very good with certain services, but when a diversified deal comes up then the largecap vendors have a very distinct advantage. So, multi sourcing, vendor consolidation is also affecting their growth rate to an extent. That is why if you look at the past six-seven quarter their revenues have fallen more than the largecaps during the slowdown and they are still lagging the largecaps during the recovery phase. So, this tells you what we can expect from the midcap IT vendors, going forward.

Q: So you are saying that even as largecap companies are showing fairly significant demand growth or volume growth, you should expect to see volume growth tapering off as midcap companies struggle to get their share of the pie from the demand increase?

A: Tapering off, I would not say because demand is buoyant, but would it lag the demand, the revenue growth at larger vendors or not? That looks to be a case for me that their revenue growth could start lagging that of the larger vendors.