Specialized offering, holistic client mining reward mid-caps richly
During the past couple of years, when some of the large cap players like Infosys and Wipro
underperformed due to massive restructuring, client specific issues (BT in the telecom
vertical) and the enduring global downturn, mid-cap and small cap players saw significant
growth opportunities. In fact, such an outperformance by mid-cap players was ingrained in
few internal as well as external factors; on the internal aspect, a clear approach to
specialization and holistic client mining was the key driver while externally, division of large
deals into smaller ones coupled with new business coming in from first time outsourcers
(with small ticket sizes) pepped up the growth.
Most of the mid-cap companies have positioned themselves as specialized players in a
vertical or a practice which enabled them to post a robust growth. Hexaware and NIIT Tech.
made large inroads, riding on their travel and transportation expertise while MindTree and
KPIT Cummins positioned themselves as specialised manufacturing and automobile players
respectively. Moreover, the holistic approach to have separate teams for hunting and
farming clients has reaped significant benefits post 2010 as seen by the massive revenue
growth in top 10 clients for Hexaware, Geometric, Polaris and MindTree. Sustained addition
to non-top 10 clients (under penetrated category) further creamed the scenario.
Fragmentation of large deals, first time outsourcers kindle prospects
On the external side, the primary reason was the fragmentation of large deals into smaller
ones besides a significant rise in small deals (Source: Nasscom) from existing clients and first
time outsourcers which were not suited for large vendors hence found its way to small and
mid-cap specialized service providers. Another notable external factor was the budget
constraint among small clients and first time outsourcers which forced them to outsource a
small portion, but at the most efficient price level which suited mid-cap vendors since their
pricing was cheaper than larger players.
CMC, Persistent and Tech Mahindra: Initiating coverage with ‘BUY’
We consider that mid–caps like CMC, Persistent and Tech Mahindra can provide substantial
returns due to their strategic positioning and attractive valuations. In the case of CMC, we
believe the unique solutions approach coupled with hi-tech offering and TCS parentage
places it in a sweet spot from both revenue growth and margin perspective. Significant
room for offshoring exists, which can be a key margin driver. We sense that it will gain from
the huge potential spending in the government space. We value the company at 12x our
FY14 EPS of INR104, implying a target price of INR1,255 and ‘BUY’ recommendation. For
Persistent, we believe that investments in IP-led business (to increase IP revenues to 20%)
coupled with its `sell with’ strategy with major players like salesforce.com will be a strategic
trigger going forward. We value the company at INR508, implying 10x FY14 core EPS of
INR42 and INR90 cash/share and initiate with ‘BUY’. Following its merger with Mahindra
Satyam (likely to be over in next few months), Tech Mahindra will have a huge base of
~500+ clients. This, coupled with TECHM’s client mining capability (its average of top 10
client is USD91m) will impart a high impetus to the company over and above the significant
operational leverage in terms of employee fungibility which would help enhance utilization
and margin improvement. We value Tech Mahindra at INR1,005, pegging 12X FY14E EPS at
INR84 (implying a target price of INR118 for Satyam – ratio of 1:8.5) and initiate with ‘BUY’.
Mid-tier Indian IT players grow and flex muscle
For the past 15 years, the story of Indian IT has been one of a radical shift in market share
from MNCs like IBM, HP, EDS (now part of HP), Capgemini and Accenture to India-based
outsourcing companies like Infosys, TCS , Wipro , HCL Tech , Cognizant and others. Though
this trend has been on a decline of late, it still provides a comfortable 25%-30% cost savings,
led by the labour arbitrage. While the overall IT services market has posted a 10-year CAGR
of just ~1%, Indian software services revenue has grown at 21% CAGR, largely driven by the
top 5 Indian IT vendors (incl. Cognizant). We would like to note that mid-sized IT vendors,
too, are joining the bandwagon and have contributed to the growth of Indian IT-BPO
services exports in a meaningful way.
As per Nasscom, the Indian IT-BPO sector comprises of 5000+ service providers across
verticals and service lines. While large integrated players (revenues of USD1bn+)
contributed to 44%-47% of total export revenues in FY11, mid-sized IT players (revenues of
USD 100mn- USD1bn) are not far away with a contribution of 35%-37% to total export
revenues.
On why mid-tier growth outpacing large caps
Post the 2010 downturn (when mid-cap companies suffered more than the large caps in
terms of decline in revenue growth), most of the mid-cap players have undergone a
strategic change, repositioning themselves as specialized players which enabled them to
either match or exceed the growth of larger players. For instance, Hexaware and NIIT Tech.
focused on travel and transportation, KPIT focused on automobiles, Persistent on the OPD
space and MindTree on manufacturing space. Based on our interaction with IT experts and
respective company managements, we believe that the above strategy of specialized
offerings has enabled them not only to get invited to new RFPs in those verticals but also to
participate in newer deals from first time outsourcers in emerging markets. Secondly, most
of the companies have adopted a holistic client mining approach, reclassifying respective
sales team into farming and hunting teams with a 3-tier strategy wherein top clients are
being targeted for large deals while non-top clients are farmed for achieving the industry
average growth. The new hunting team is assigned with the task of acquiring new
businesses. We believe that the growth over the last couple years is due to the following
reasons:
• Disaggregation of large deals in smaller deals and significant increase in small deals.
• Strategic positioning as a specialized player with lucid strategy for farming and hunting.
• First time outsourcers and price arbitrage aid mid-tier players as deals get smaller
Disaggregation of large deals: A potential boon for mid- sized players
While the deal activity has remained robust for last few years, there has been a significant
shift in the structure of deals. As per Nasscom, the number of large (mega deals) and mid
range contracts has remained stable since FY02 but those valued at USD100mn or less has
seen a 300% jump since FY02. (Refer Chart 1)
This trend of deal disaggregation has also been substantiated by TPI (Refer Chart 2). Of the
contracts awarded, contracts with a TCV of USD25mn-99mn have surged from 481 in 2008
to 770 in 2011 while contracts with a TCV of more than USD100mn have remained stagnant
at ~224 over the same timeframe.
We believe that this trend of disaggregation has benefitted mid-sized players as it enables
them to participate in newer opportunities. Going forward, we expect this trend of smaller
deals to continue, forced by an uncertain macro environment where clients remain
apprehensive about committing large outsourcing deals.
We believe that contracts worth at least ~USD40bn would be coming up for renewal in CY12
and CY13 each. Of this, at least 30% (at 30% discount) should go to Indian players, implying
new contracts of ~USD8.4bn over a 5-year period and incremental revenue of USD1.7bn per
year going forward. If the trend (of larger deals being broken down into several smaller
deals) continues, mid-sized Indian IT vendors would also benefit along with their larger
counter parts as they would vie for a higher deal pipeline
Positioning as specialists with lucid farming, hunting strategy
Post the 2010 downturn (when revenue growth of mid-caps suffered more than large caps),
most of the mid caps clearly redefined their strategy towards specialization and holistic
client mining (a 3-tier approach). The specialized offering strategy has paid off primarily by
enabling mid-cap players to participate in all major deals in respective verticals, up for
bidding (for instance Hexaware and NIIT Tech. have been leading players in travel and
transportation space while Persistent has positioned itself as a specialized OPD player
whereas MindTree and KPIT have positioned themselves as specialized manufacturing and
automobile players). We have seen the above strategy paying off in the past also with Tech
Mahindra’s focus on telecom vertical which enabled it to work with all top players in the
telecom space like Cisco, BT, Verizon, AT&T and Vodafone. HCL Technologies and Cognizant
experimented the same way with IMS and Healthcare space.
For the last two years, mid –tier stocks have seen a robust growth. However, we would like
to note that though the growth has been broad based across client categories; some
focused on gaining wallet share amongst their top ten clients while others strived to acquire
new clients and mining these clients.
Companies like Geometric, MindTree and Hexaware focus on mining their top ten clients
while Infotech Enterprises, Polaris, KPIT Cummins and Persistent are keen on growth from
beyond the top ten. Our interactions suggest that companies have fine-tuned their
strategies of mining and hunting based on their client profile and scope for growth. Some of
them have even benefitted by simply mining their top clients due to lower penetration
levels and higher chances of growth whereas others have focused their strategies towards
mining new accounts and adding new logos to gain market share. We believe that account
mining involves lower selling and marketing efforts as well as resources.
Although strategies have been varying till now, going ahead, we believe that the focus of
these companies continues to be more holistic growth and our interactions with these
companies suggest that they will focus on increasing the wallet share among their top 20-25
clients. Most of the mid-tier stocks have identified key strategic accounts that will drive
growth from here on, intensifying their efforts in to acquire/mine these accounts.
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