Indian IT companies significantly benefited in the Covid era due to the accelerated shift to digital that led to higher demand for software services. Within this, midcap IT stocks stole a march over their larger rivals, with the shares of some companies earning returns as high as 500 percent in two years.
A combination of factors—attractive valuations, outperformance on revenue growth, new leadership, a sharper focus on a few sectors, and nimbleness—is helping these companies pull ahead, according to experts.
Mid-tier IT firms
While large-cap companies have a market capitalisation of Rs 20,000 crore or more, the market cap of midcaps is between Rs 5,000 crore and Rs 20,000 crore.
As of December 10, 2021, midcap companies such as Mindtree, Persistent Systems, KPIT Technologies, and Birlasoft have yielded gains of 400-500 percent since January 2020. L&T Infotech, Mphasis, L&T Technology Services, and Coforge saw a price gain of 200 percent over what it was at the beginning of January 2020. Of the top mid-tier IT companies, Persistent Systems, KPIT Technologies, and Birlasoft witnessed share price increases of close to 500 percent from the beginning of last year.
In comparison, the top four IT firms’ stock price returns stood between 68 and 160 percent, with Wipro having the highest price return of 158 percent from January 1, 2020.
“Midcaps were trading at a discount to large caps and have caught up now. They have also outperformed the larger companies in terms of revenue growth. While people expected a consolidation, midcaps do well when the overall demand environment is strong. They are more nimble and have been able to quickly adapt to the demand for digital services and discretionary projects,” an analyst who has been tracking the sector for over a decade said.
What is driving this?
Abhishek Sinha, COO and Board Member, L&T Technology Services (LTTS), said there are a couple of reasons why it worked for them. LTTS’ price was 259 percent higher as of December 10 than it was in January 2020.
For one, what works for mid-tier IT firms, he said, was the right size. “You need the right size to manage the business,” Sinha said. When it comes to large-cap IT firms, they are too big, with hundreds of thousands of people that need to be managed. “But if you look at a company of 20,000 to 40,000 people, you can make decisions quicker. You are not a juggernaut, where changing the direction takes time. That is what worked for the midcap companies,” he explained. LTTS employs 17,900 people.
The company’s ability to take quick decisions shows in business results. “At the end of the day, the market does not care about anything but business results. Our ability to provide business results was far easier (because of the size),” Sinha added.
A case in point is the six strategic focus areas for LTTS such as 5G, electric vehicles, sustainability and med-tech that the company revealed in September 2021. These sectors will help reach $1.5 billion in revenue by FY25.
Take Mindtree. After Debashis Chatterjee took over as CEO in 2019, he unveiled a 4x4x4 strategy in December last year, wherein the focus was on four industries, four geographies and four service lines. It is clearly paying dividends, with the stock price up from Rs 1,400 in December 2020 to Rs 4,500 now, an increase of 220 percent. This is despite the huge hit in its travel business, which accounted for 16 percent of the revenue pre-pandemic and 8-9 percent now.
Commenting on this, Chatterjee said in a recent interaction, “I have to focus on what we can do and what is within our control. There will be seasonality in quarters, but our momentum, growth engine, and the foundation that we have laid for growth will continue.”
In a recent interview with Moneycontrol, Sanjay Jalona, CEO, L&T Infotech, said that the company let go of many verticals and focused on a few things that we wanted to do. It also invested in capacity building, both in terms of technology and also leadership.
For KPIT Technologies, whose stock prices increased 448 percent in the two-year period, the reasons are a lot broader. The firm, which caters to the automotive engineering space, the demand is overwhelming. “Every (automotive) company wants to be a Tesla, but is five years behind in terms of technology,” said Sachin Tikekar, president. This means that companies are investing heavily in technologies and prioritising this need, leading to huge demand the company is unable to keep up.
Is the size the only reason why large IT firms are lagging?
Mrinal Rai, principal analyst, Information Services Group, a research and advisory firm, explained, “The mid-tier firms have a history of targeted investments and growth in select segments. They started out never claiming to do everything for everyone but specializing in focused areas and developing a good customer base and referrals.” So the lower employee numbers and localisation approach also make it easier for them to reskill and cross-skill their workforce, Rai said.
“What’s specifically worked for them in the recent past is their new management. Most of these firms have new leaders who have joined from large organisations. These senior executives who have joined large organisations are laser-focused on growth—they know how to grow and expand. They are not bound by legacy contracts or investments,” he added.
As Rai pointed out, most of these firms launched new strategies over the last two years to accelerate growth, and clearly it is working for them. It could be Mindtree's focus on four verticals, geographies and business lines, or LTI’s Jalano’s strategy to focus on fewer areas and grow in them.
Peter Bendor-Samuel, CEO, Everest Group, a research and advisory firm, pointed out that this has also to do with the range of businesses the larger companies serve, compared to the sharp focus the mid-tier IT firms have.
For instance, larger companies have multiple verticals that they cater to, said Bendor-Samuel, pointing out the infrastructure and managed services (IMS) vertical in the IT firms. According to him, while there is demand in the IMS business, it is not as intense as digital transformation and system integration. So these are slowing down some of the large IT firms when compared to the mid-sized firms, he explained.
This fast growth is what is reflected in the stock gains for mid-tier IT companies.
But…
What had worked best for the mid-tier IT firms was working directly in the business functions of clients, rather than just the IT part of it, which was where the large IT firms focused.
An industry analyst, who works directly with top mid-tier IT firms, said, “If you take travel and hospitality, firms like Mindtree directly work on the business function rather than the IT teams of clients. It could be working with the sales team directly to offer discounts, for example,” the analyst said. This gave mid-tier IT companies a differentiation.
However, things have changed since the pandemic. With the line between business and IT functions blurring, it is a level playing field for large and mid-tier IT companies.
This is reflected in the increase in the number of small deals the large IT companies are winning.
While the legacy businesses typically are longer and have a bigger ticket size, digital deals are small and short-term. This would explain the large deal wins to help the clients in their digital transformation journey by Infosys, Tata Consultancy Services, and Wipro in 2020. But over the last few quarters, the number of small and medium deals, a sweet spot for mid-tier IT firms, has increased for larger IT peers as well.
“While there are huge opportunities for both to grow, it will be interesting to see how things play out,” the expert added.
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