Creating niches

Mid-cap companies are building their capabilities in niche verticals where India’s share is less than 1 per cent

Market potential (in $ bn)

• Engineering services:     842
• Software products:          294
• Infrastructure services:   110

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They’ve never really had it easy. On one side, they had to contend with the likes of large, world-class rivals who seemed to have a far better understanding of the dynamic nature of the global IT services industry. On the other side, they had to deal with skepticism from investors and analysts who didn’t believe they had it in them to survive in the fiercely competitive world of IT services.

But India’s mid-cap IT companies now want to prove their critics wrong. No longer trying to compete on price and scale of operations with their larger rivals (it was a waste of time anyway), mid-cap tech firms are focusing on niche areas and becoming specialist players. In their pursuit for growth, they’re also increasing their management bandwidth (strengthening their management teams ) and internal control systems, both of which had come under criticism earlier. And if these are not enough, an increasing number of them are planning to use their healthy cash reserves to snap up companies to give them the much desired scale and enhance their service offerings. So have mid-cap companies finally got it right this time?

Finding their niche

Life certainly has been tough for mid-cap companies in the past few years. With faltering demand, they’ve found themselves embroiled in contract battles for smaller deals which larger players would normally have ignored during the flush years. It made bagging contracts that much more competitive for these companies. Pricing became nearly irrelevant as most large IT firms offered competitive prices and deal terms on par with their mid-sized rivals. It became increasingly clear that it was unsustainable to compete on price and scale. “The bigger players are getting bigger everyday; there are a lot more people and you can’t fight the battles with the big guys on conventional lines,” says P R Chandrasekar, CEO and vice-chairman, Hexaware Technologies.

So they started to focus on niche areas of expertise, both in terms of industry verticals and services lines, and started to position themselves as specialists in those areas. For instance, Hexaware found its calling in Peoplesoft (an enterprise resource planning (ERP) software) , while Patni looked to insurance. Engineering services beckoned Infotech, while R&D services called out to Mindtree. And KPIT Cummins also saw merit in engineering services. “In the verticals we are focused on, we have built a high level of competency. Our high competence gives us a competitive edge,” says Kishor Patil, CEO and managing director, KPIT Cummins, which has chosen to specialise in three segments within the manufacturing arena – automotive, industrial and hi-tech.

During 2000-08, the addressable market for Indian vendors grew five times, led by rapid expansion of service lines, verticals and geographies serviced. The IT industry derives around 60 per cent of its revenues from the US; almost 50-60 per cent comes from application, development and maintenance and 41 per cent comes from the banking and financial services and insurance (BFSI) segment. But with the penetration of new geographies, service lines and verticals, these numbers are likely to change in the coming years. As per Nasscom, the apex body of the IT industry, up to 80 per cent of the incremental growth in addressable market is likely to be contributed by non-core markets. Growth in addressable market is to be driven by new verticals, new customer segments .

The sheer size of the opportunity is mind-boggling. For instance, take the case of engineering services. Worldwide, technology-related engineering spending is close to $ 850 billion (CY09). Right now, only a small portion of this comes from offshoring. Software products and engineering services revenue exports from India currently stand at $7 billion and are expected to rise to $40 billion by 2020, as per a Nasscom Booz Allen Hamilton report. That translates to immense opportunity for engineering services players.

We have the financial backing of the world’s largest IT company and that’s a significant advantageGanesh Murthy, Chief Financial Officer , MphasiS

Another exciting area is the research & development (R&D) offshore market. The market was worth $9.35 billion in 2008 and is expected to grow by an average 23 per cent until 2012, led by stable global R&D spend and greater offshoring. R&D offshoring currently accounts for two per cent of the $530 billion market. Companies such as MindTree should benefit from the increased proportion of offshore in global R&D spending.

In 2009, spending on global IT services is expected to touch $781 billion and is forecast to rise by 4.5 per cent next year. Indian IT export revenues are expected to reach $48–$50 billion in FY10, still a tiny fraction of the overall market and, thus, still offers more than enough room to grow for Indian players.

“We want to be a billion dollar company by 2014,” says Anjan Lahiri, president and CEO, IT services, MindTree. “There is still significant head room in the pure IT services industry, so we don’t feel constrained for space. The key is to build up overall capabilities and market penetration levels.”

Sugar daddy

While newer services have helped mid-cap companies carve a niche for themselves, strategic relations with top clients have also helped these companies. Some have successfully managed to build long–term relationships with their clients. For instance, Infotech Enterprises has developed strong domain capabilities in the engineering services space (in particular, the aerospace industry) and its top five clients, including Airbus and Boeing, have been with the company for the past 10 years. The company has built a strong revenue stream (multi-year) from these top clients with built-in price increases, giving it not only revenue resilience in tough times but practically no pricing pressure as well.

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Closing in

Improving prospects for mid-caps IT stocks have narrowed the discount to large-caps

Source: Avendus Research

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In some cases, the largest client is also an equity partner. Like Cummins for KPIT Cummins, HP for MphasiS and Citibank for Polaris. In the case of KPIT, Cummins which contributes 33 per cent of its overall revenues, also holds a 15 per cent stake in the company.

For MphasiS, becoming the subsidiary of the world’s largest IT company has definitely opened up significant growth avenues. MphasiS became a subsidiary of Hewlett Packard (HP), when the latter snapped up Electronic Data Systems (EDS), which held a 60.8 per cent stake in MphasiS. Analysts believe MphasiS is likely to benefit significantly from HP’s intentions to move work offshore, and will help it outperform peers in the next couple of years.

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Bargain buys

Most mid-caps are trading below their five-year P/E average of 18 times

			FY09	FY10E	FY11E
MindTree	634	18	45.8	13.5	12.2	2	9.7
MphasiS	677	33	15.6	14.7	13.4	3.3	56.8
Rolta	165	17	9	10.8	9.2	1.9	22.4
Infotech Ent	280	15	16.2	10.9	10.5	1.7	13.8
KPIT Cummins	117	17	13.9	11.4	10.6	1.2	30.9
Hexaware	84	26	20.5	8.9	7.1	1	8.6
Polaris	162	26	12.3	11	8.4	1.2	18.3

Source: Bloomberg; * November 27, 2009; **CAGR for FY2008-12E

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MphasiS’ strong parentage has helped it sustain high growth rates in the recent past and analysts believe that will continue even in this tough operating environment. They also believe HP’s scale of operations gives MphasiS a lot of space to grow. HP’s services revenues for the second quarter of 2009 alone were $8.45 billion. Seventy-one per cent of revenues came from infrastructure technology outsourcing (where networks are managed from a remote site), traditional software application, maintenance and development and BPO services – all areas in which MphasiS has significant capabilities.

The strong parentage also benefits the company when both make a joint bid for projects. “We have the financial backing of the world’s largest IT company and that is a significant advantage for us,” says Ganesh Murthy, chief financial officer, MphasiS.

You cannot compete with the larger players on conventional linesP R Chandrasekar , CEO and Vice -Chairman, Hexaware Technologies

For Polaris, too, having one of the largest banks in the world as its client has helped it rope in some of the top names in the global financial services on its client list. Citibank is the company’s largest customer, accounting for 40 per cent of revenues. The US financial giant is also a strategic investor in Polaris, holding a 39 per cent stake. With about a couple of billion dollars as its annual IT budget, Citibank opens up a whole new world of money-spinning opportunities for the Indian company. “Citibank is a not a client but a market for us which offers significant growth opportunities. We execute mission-critical projects for them,” says R Srikanth, chief financial officer, Polaris Software Lab.

True, the fact that most mid-cap companies have their top 10 clients accounting for about 50 per cent of revenues does seem like an increased business risk. Not necessarily, retort the companies. They claim that in most cases, relationships with top clients are strategic in nature and for them to take their business elsewhere will not be easy.

Proof of that lies in the fact that in the recent slowdown, while mid-cap companies suffered reduction in orders from their clients, they never lost a single client.

Shopping spree

Besides organic initiatives, mid-cap companies have used acquisitions to move into new verticals (Patni’s acquisition of Cymbal strengthened its position in telecom); add to their service lines (Mindtree’s acquisition of Aztec added testing services to the former’s portfolio) and debut in new markets. Acquisitions are expected to remain integral to the growth strategy of mid-cap companies. In fact, analysts say that without buyouts these companies will find it difficult to grow. High cash balances, a desire to grow faster and the availability of targets will see mid-caps make bigger acquisition moves in the next few years, they predict.

Already, the signs of that are visible. According to reports, Patni is chasing an ERP services firm in continental Europe with revenues of $400 million and another company in the US dealing in insurance solutions and boasting about $150 million in revenues. These acquisitions, if they go through, will catapult Patni into the billion-dollar league allowing it to compete more effectively with the top IT companies, say experts.

MindTree, which has set itself a revenue target of one billion dollars by 2014, is also reported to be eyeing acquisitions. Analysts estimate it could make organic revenues of around $650 million by then; the rest will have to come from an acquisition. “Acquisitions will be an important part of our growth strategy,” says MindTree’s Lahiri. “About 25-30 per cent of our billion dollar revenue target will come through the inorganic route.”

MindTree has a track record of successfully digesting company buyouts.Last fiscal, it acquired Aztecsoft, an outsourced product development and independent testing company. And in the past quarter, it acquired the Indian subsidiary of US telecom handset manufacturer, Kyocera Wireless. This was MindTree’s fifth acquisition since 2004.

Nevertheless, integrating acquisitions are not exactly a walk in the park. Cultural issues and difference in business strategies can make the union of two organisations a tricky and, sometimes, painful task. So while the actual acquisition may make headlines, it’s the successful integration into the acquiring company that will set the cash registers ringing.

Cost controls

Besides efforts to scale up revenues and enhance service offerings, companies also had a good handle on costs during the downturn. Operating margins improved considerably as employees were laid off and the rest were utilised more productively across projects. Tech workers were also not given any salary hikes or increments in the past 12 months, which significantly brought down administrative costs by an average 150 basis points of sales.

We are working on improving the quality of revenues and overall marginsKishor Patil CEO and managing director , KPIT Cummins

The cumulative result: several mid-cap companies reported their highest-ever margins and return ratios in the latest quarter. But in an industry in which salary costs make up for up to 75-80 per cent of total costs, cost cutting via salary cuts is the easy part, say analysts. The real test of whether margin levels are sustainable will come when growth returns in a stronger way and companies have to start hiring employees and hike salaries to stay competitive with rivals. Analysts believe that when that happens, some mid-caps will be unable to maintain these extraordinary margins. Nevertheless, companies themselves remain optimistic. They point out that in the boom times, excess capacity was created and the slowdown triggered the move towards cost rationalisation.

Rather than tweaking costs forever, many of them have now decided to focus on increasing contributions from high-margin segments to improve margins. This is definitely a strategy that is sustainable over the long term. “We are working on improving the quality of revenues and this is likely to increase profit margins in the coming years,” says KPIT’s Patil.

Structural changes

Speaking of internal processes and controls, analysts say that this is another area where mid-cap IT companies will have to develop more strongly in the coming years. In the past, some companies have suffered from poor management, leading to weaker internal controls. They are making amends now. Companies such as Patni and Hexaware have brought in new management teams, which have resulted in considerable improvements in internal systems and operational performance.

Others such as MindTree have restructured their business, to take better advantage of the management bandwidth that they have, to bring in better focus in operations. Stronger internal controls should also help companies limit their forex losses, which soared last fiscal as the rupee depreciated. In some cases, these losses stemmed from a reactive hedging policy, which led to increased hedges at stronger rupee levels, while in others, it was driven by faulty internal controls causing select employees to make speculative and risky forex bets. Inconsistent forex hedging policies raises the risks to earnings. In the past two years, profits for mid-sizers fell by an average 23 per cent because of forex losses, according to analysts.

Catching up

Due to lingering concerns about their performance capabilities, a valuation gap between large companies and mid-size and small IT companies has always existed. Large caps were largely favoured over the mid-sizers due to the former’s well-diversified revenue profile, global scale and delivery capabilities. Between 2004 and 2006, the discount was about 45 per cent. This declined to 11 per cent in 2007 – the height of the bull run. In the next two years, the discount rose again to 30 per cent and 50 per cent, respectively. However, the gap is expected to narrow once growth starts kicking in.

Citibank is not just a client for us. It is a market which offers significant growth opportunitiesR Srikanth, Chief financial officer, Polaris Software Lab

And the mid-caps are catching up. Revenues for larger companies grew by 32 per cent and 26 per cent during 2005-2009 and 2007-2009, respectively, while those for their smaller peers rose by 30 per cent and 25 per cent. On the net profit front, larger companies posted an average 28 per cent and 15 per cent growth during the two periods, while the smaller ones clocked in 20 per cent and 15 per cent. As seen in the past two years (2007-2009), smaller companies have it in them to close the gap and if history is anything to go by, they’re likely to do it again soon.

In fact, revenue and net profit growth expectations for both large and small companies seem so similar for the current fiscal and the next fiscal, that the large valuation discount seems unjustified. It’s time for mid-size IT companies to be re-rated, say analysts.

Another possible trigger could be the imminent consolidation in the mid-cap space. While consolidation seems inevitable in the long run, high expectations on the selling price by promoters and the difficulty in acquiring stakes from the open market have deterred potential suitors. Mid-sizers such as Patni and Hexaware have been indentified as potential targets in the past.

Mid-cap stocks are currently trading at a one-year forward P/E multiple of 8-15 below their five-year average P/E (excluding the previous 12 months) of about 18 times. While most mid-caps are doing their bit to differentiate and scale up, companies with the best execution capabilities and strong management are most likely to succeed in the long term.