Mid tier IT Companies – Play on Consolidation :Centrum

Preference towards Defensive sector: Indian economy is in a critical situation in terms of $ shortage – while exports started de-growing in July, FDI inflows during April-June 2012 quarter has fallen by 67% YoY. Indian Rupee (INR) is also under tremendous pressure whose exchange rate has fallen by 9.6% YoY. In this scenario, implementation of FDI into multi-brand retail and by the foreign airline companies into Indian airline industry is imperative. However, the same is getting delayed due to political impasse. Since the global rating agencies have already issued warning on possible downgrade of rating of Indian economy, there is a significant risk for the INR if status quo on FDI policies continues. We remain hopeful that these FDI policies would be implemented as there is no choice for the government. However, in case, the government fails to implement them, then the exchange rate of INR would fall significantly – in such a scenario we believe that the IT sector especially the mid-cap IT space would emerge as the defensive bet;
Large IT companies to look for consolidation to fuel growth: We believe that there is a strong case for consolidation in the mid and small sized IT companies as a growth strategy especially for tier-1 IT companies. This would lead to a shift in valuations of mid and small size IT firms. Infosys has indicated interest in acquisition and is now open for even bigger opportunity.
Deals size getting smaller and going to more number of service providers: Further there are reports of large vendors in the western world breaking up orders of over US$ 10 billion into smaller ones and placing them with several mid sized IT companies in order to save on project costs.
We remain positive on mid tier IT companies due to 1) strong operational growth which would outpace industry growth rate of 12-14% in FY2013; 2) Improvement in operating margin and RoE and 3) attractive valuation with high dividend yield
Hence, we remain positive on the mid-tier companies such as Polaris Financial Technology (Polaris), Infinite Computer Solutions (Infinite), Hexaware technologies (Hexaware) and Persistent Systems.

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With recent acquisition of Patni by iGate, we believe that there can be further consolidation in the mid and small sized IT companies, going forward. Since, the IT industry growth is tapering off and the big IT companies are posting poor growth, we believe that the major IT players will try and go in for consolidation and acquire mid-sized or small sized IT companies as a strategy for growth. For instance, Infosys eyeing bigger opportunity, we believe that consolidation in the sector would beef up valuation for mid tier IT companies