Tier-II IT cos may see some derating: Karvy

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R Ravi of Karvy Stock Broking gives his take on the IT numbers. He talks on the valuations of Polaris, Mphasis and Mindtree and the companys' performances along with the other IT biggies.

Excerpts from CNBC-TV18's exclusive interview with R Ravi:

Q: What would you do with Polaris and what would you call its numbers?

A: I think Polaris' numbers were not intrinsically bad but the kind of growth that people were expecting was not matched. The kind of growth that people were expecting from the product segment to deliver, has not come through.

As a result, people are a little nervous and going forward, there is going to be quite a lot of pressure for many of the tier II companies. Because, I believe, in order to grow, you need to add people very aggressively for services company and the company has not been able to do that. So as a result, people are going to view the results little negatively.

Q: So would it be a buy or a hold on Polaris?

A: I have a negative rating on the stock as I believe it is an underperformer and it is going remain for some time. It is already trading at decent valuations and the kind of growth that I am expecting on the current levels, is going to be very difficult for the company to achieve.

Q: Has MindTree been an in line performance this quarter for you?

A: MindTree is absolutely in line. The growth on FY07 or FY08 looks pretty descent, but from an operating margin standpoint, it has not gone anywhere. It is holding at last year's level, and has just modestly inched up. So, it is not showing any great strength and this company is trading at a very hefty valuation. Even if we assume that they grow around 30% next year, they are trading in between 17 and 18 times FY08. It is very difficult to give valuations of that nature for a company. They do not have a presence in many verticals and they do not have larger exposure to package implementation and consulting and other segments as well.

So, I think, valuations between tier II and tier I have to significantly change. Tier II companies will see some derating before we can take fresh positions on those stocks.

Q: In that sense, how would you rate Mphasis ? Is it tier II moving into tier I after EDS, or do you think it is going to remain tier II for sometime and how would you value that?

A: In the case of Mphasis as well, look at it from a valuation standpoint, along with Polaris, Mphasis and MindTree, which will inch up towards Rs 1000 crore over the next one year, we have to see that all of them are trading at valuations, which are quite high.

Mphasis is trading at valuation of close to around 23-24 times next year. Now why should somebody pay that kind of a valuation for a company, which has not even breached Rs 1000 crore mark with margins less than 15%, that is the call we all need to take. Polaris is getting a margin of less than 14%-15%, MindTree is probably around 20%. Mphasis, till Q3, were reporting a margin of less than 14%, all of them are between 15% and 20%.

We have to add the factor that rupee will appreciate more, maybe not in the near future, but probably later. If you factor that into consideration, then all the tier II companies would see certain amount of margin frame cage, even assuming that the US slowdown will happen one year later, what kind of pricing power these companies will have. Tier II companies are trading at quite rich valuations and some of these will see some derating before we can start recommending them as an outperformer or a buy.

Q: I-Flex is the other one you are a bit disappointed with?

A: Absolutely, but one positive of the result was that margins have expanded by 400 bps. The growth was pretty descent, the bottomline was about 6% YoY, and they have reported an EPS of close to around 47, which is also pretty much in line with what we have expected.

It is trading at 30 times, but it is very difficult to give valuations at that level, when you are getting Infosys , TCS , Wipro and others at much lower valuations or probably trading at such valuations. I think investors are going to see the size of the company and ability to navigate in a difficult environment, going forward. That means, larger and larger orders are going to come for tier I companies and even if tier II companies get orders, it will be at much discounted billing rates.

Q: Any surprises or dark horses that sprung up this quarter?

A: One surprise was Subex , its performance in Q4 was a little subdued than expected. I think they written-off a lot of redundancy charges and as a result, the margins have come off significantly. To some extent, Q4 numbers were a bit lower, but on YoY basis, they did do well. Next year also, I think they will do a reasonably strong growth of around 80%.

Q: Any disclosures to make about these stocks we have talked about?

A: None of these.