Investors, who have invested in mid-cap information technology (IT) stocks, have seen most of their investments rise by 5-15 per cent in the past two weeks as the stronger dollar is expected to result in double-digit sequential revenue growth denominated in rupees for the December 2011 quarter.

Rub-off effect

The domestic currency’s weakness against the US dollar is also expected to have a positive rub-off effect on their margins, boosting the prevailing positive sentiment on these stocks. Like their tier-1 peers like Infosys and TCS, mid-cap IT stocks have had a bad 12 months or so. So, the recent run-up was a welcome reprieve for investors.

However, after Infosys revealed its December 2011 quarter earnings and more importantly, raised a red flag over weak global macro issues, it remains to be seen how long the recent gains registered in mid-cap IT stocks can stay protected.

While experts and analysts appear confident about the December 2011 quarter earnings, the stock market is always forward looking.

Rupee depreciation

With the benefit of rupee depreciation already built into the stock prices of mid-cap IT companies, such as Mahindra Satyam, Tech Mahindra, MphasiS, Patni Computer, Hexaware, MindTree, Infotech Enterprises, Polaris, Persistent and NIIT Technologies, it is important for investors to realise that mid-sized companies are not safe havens.

If Infosys and other tier-1 companies management commentary is of any guidance, the small delays in ramp-ups and flat dollar-denominated revenue growth for the March 2012 quarter are indicators of the industry’s weakness. They also point towards the inability of IT service companies to win contracts during weak economic times.

Challenges

The bigger underlying structural worry for the sector is Indian IT rate of growth (14 per cent year-on-year in Q3 and Q4 for Infosys) is in line with global IT gorilla Accenture that grew 14 per cent year-on-year in the quarter ending in November.

“We feel, post the short-lived excitement around the full-year performance and recovery stories since the Q2 results, Infosys management’s guidance is finally realistic. This should moderate long-term expectations about Indian IT growth driven by market share gains…valuations remain elevated and assume 15-20 per cent long- term growth for the sector that seems to be at a significant risk. The sector is overweight based on recovery assumptions,” said analysts Ankur Rudra and Hardik Shah of Ambit Capital in a note.

The main IT sector worries can be distributed in four buckets. Firstly, macroeconomic slowdown worries have started impacting the IT decision-making process that will severely impact the budget- setting process for 2012. There is some silver lining, such as TPI’s recent report that paints a rosy picture of deal pipelines of IT companies, which are expected to be higher in the second half of FY12.

Secondly, the long-term structural growth story for Indian IT based on market share gains from global behemoths is said to have, even if partially, weakened due to greater scale achieved by competing multinational company (MNC) vendors in India.

Thirdly, in a US presidential election year, large outsourcing decisions are expected to face greater inspection, adding a supplementary headwind to Indian vendors in a phase of business weakness.

There could be some disconnect between client behaviour towards mid-sized companies and the overall macro picture.

Some of that connect/disconnect will appear in form of the upcoming Q3 earnings report card. Angel Broking’s analyst Ankita Somani feels that among mid-tier IT companies, profitability of Hexaware, KPIT Cummins, Infotech Enterprises and MphasiS is expected to grow by 5.1 per cent, 2.2 per cent, 15.3 per cent and 17.1 per cent quarter-on-quarter, respectively, majorly because of strong improvement in their margins and hedges turning into in-the-money.

“For Mahindra Satyam, profitability is expected to fall by 20.3 per cent quarter-on-quarter (q-o-q) to Rs 190 crore due to wage hikes given during 3QFY2011. In case of MindTree and Persistent, profitability is expected to fall by 24.4 per cent and 22.7 per cent q-o-q, respectively, due to lower other income during 3QFY2012,” said Somani.

Mid-sized IT companies are entities that have annual revenue bases of $250 million to around $1 billion. While they are much smaller than the top-tier players, getting business when the business environment is down and satisfactorily serving clients who want more for each pound of flesh are a difficult task.

According to ICICI Securities Retail Equity Research, from a vertical perspective, retail, financial services and insurance (FSI) could be demand drivers in CY12 as companies invest for digital consumers, real-time analytics, regulatory compliance, payment and securities processing.

Although, banks could continue to spend their maintenance budgets, discretionary wallets continue to be scrutinised at the highest level and are released based on priority. In a nutshell, each individual mid-sized IT services company performance across verticals could vary depending on their offerings and portfolio mix.

Some IT analysts, like Shashi Bhusan of Prabhudas Lilladher, already expect some mid-cap companies to openly voice their worries. “We expect positive commentary from Polaris, MindTree and eClerx on client spending, but a cautious tone from MphasiS and Tech Mahindra,” said Bhusan.

As the Q3 earnings for mid-cap IT companies start pouring in, experts recommend that investors should watch out for a few things, such as any drop in revenues from enterprise application services and application development. Management responses on sustainability of growth in strong verticals such as banking, financial services and insurance (BFSI) amid spending deferments by western banks would indicate whether the ride ahead for mid-caps is going to be bumpy or smooth. Last but not the least, updates on campus recruitment and lateral hiring momentum will also give an indirect insight into the demand-supply take for mid-cap companies.

Stock performance

The BSE IT index has dropped 3.80 per cent in the past three months, against a drop of 5.43 per cent during the same year-ago period. Some of the mid-cap and small-cap IT stocks, including Patni Computer, MindTree and Polaris Software, gained 65.77 per cent, 18.66 per cent and 3.73 per cent, respectively.

Hexaware, MphasiS, Tech Mahindra and Oracle Financial declined 5.68 per cent, 2.33 per cent and 0.64 per cent, respectively.

(With inputs from Amit Mudgill)

kumarsroy@mydigitalfc.com