The golden middle

In a rapidly changing digital world, mid-cap IT firms have more headroom to grow than large-caps

When Sanjoy Jalona, an Infosys veteran of 15 years, quit and joined the much smaller L&T Infotech in August 2015, we should have known. Or when Sandeep Kishore left HCL after 27 years and joined Zensar Technologies as its CEO, we should have realised the tide was turning. 

Indian mid-cap IT companies, which had been in the shadows of Tier-I companies, have emerged to create a niche for themselves in the digital transformation race. Tier-I companies have long used their advantage of scale to snag multi-billion, multi-year deals in traditional services, while mid-cap companies waited for their turn in the fringes. But over the past couple of years, the tables have turned. 

Mid-tier companies finally have managed to outpace their larger peers in revenue growth and, what’s more, win deals against Tier-I companies. Over the next two years, some of the mid-caps such as NIIT Technologies, L&T Infotech, Zensar and Mphasis are on track to grow at 14-18%. Larger companies, on the other hand, are looking to post more sedate growth rates during the same period. For instance, Wipro, Tech Mahindra and Infosys in particular, are expected to witness single-digit revenue growth over the next two years. Yes, the growth does come on a larger revenue base. But, what makes the growth of the mid-cap IT companies impressive is that it is coming in the digital or emerging technologies space. 

As a large number of companies are lining up for a digital makeover, demand for emerging technologies, such as cloud, AI, blockchain and IoT among others, is on the rise. According to a report by Prabhudas Lilladher, in FY11, digital services accounted for only 3-4% of the overall revenue of Indian IT companies. However, these services now account for about 30% of overall revenue. “Digital services will be a key revenue driver for Indian IT companies as clients look to increase their revenue productivity and reduce cost,” says Aniket Pande, lead analyst, Prabhudas Lilladher (See: Topline synergy).

Nasscom has forecast that globally, enterprises will increase their spending on technology and business services from $2.8 trillion in FY14 to $4 trillion in FY25. Digital expenses will be 40% of this figure, growing at an average of 24% over this decade.

There is money to splurge, and what is working in favour of mid-cap companies is that clients are willing to experiment with new vendors for digital projects. “The need for agility in our clients’ businesses to counter ever increasing competitive pressure and launch products and services quickly is driving a very different pattern of technology consumption,” says Nitin Rakesh, CEO, Mphasis. 

While the large, transformational projects that require big investments are still going to Tier-I companies, there are several customer-experience deals under $25 million that are falling into the mid-cap kitty. These deals drive up their volume growth and help them compete with the big guys. According to analysts, about 30-40% deals won by mid-cap IT companies over the past two years have been in the digital-transformation space, with the average deal size being around $15-25 million.

These often started out as short-duration proof-of-concept assignments. It gave mid-caps a chance to prove their worth and make a play for a larger slice of the pie. For instance, in the recent March 2019 quarter, L&T Infotech hit paydirt; the firm snapped multi-million dollar transformation deals with an engineering-equipment manufacturer and reinsurer. The combined deal value was over $100 million. 

Internal shift

While the demand landscape changed to suit mid-caps, the companies, too, did their bit to make the most of it. There was significant management change when senior leaders from large-cap companies were brought on board. In some cases, these improvements were ushered in by private equity players, who bought a significant stake in the company.  

Under the new leadership, they chased deals aggressively and chose the areas they were competent in. “Their level of competitiveness has certainly improved,” says Ravi Menon, lead analyst, IT services and internet, Elara Capital. “They now understand that to compete with large firms, they should have discipline and not blindly chase revenue,” he adds. 

For instance, Apax Partners picked up more than 23% stake in Zensar Technologies in 2015 and HCL’s Kishore joined the mid-cap that December. Zensar trimmed down by selling its Asia-Pacific business, and began focusing on its high-value geographies such as the US, Europe and South Africa. It increased its focus on winning deals in retail, hi-tech manufacturing and insurance.

“We underwent our own (digital) transformation, which helped us relate better with the change that our customers are going through. The demand environment is very different from what it was five to 10 years ago. Customers are investing in areas of business relevance, and not blindly in technology,” says Kishore, CEO, Zensar Technologies. The company has created more than 30 digital platforms for over 50 business processes, covering talent acquisition, HR, finance, sales and quality management systems among other things. Its deal pipeline over the past 12 months tops $1 billion, with the company winning deals worth $750 million in FY19 alone. Digital business, which contributes about 45% of its overall revenue, accounted for nearly 80% of the incremental growth in FY19. 

In 2016, Blackstone Group bought a majority stake in Mphasis from Hewlett Packard (HP) in a $1.1-billion deal, and quickly brought in Nitin Rakesh, who was the CEO of Syntel. When Blackstone took over the company, there were concerns about revenue growth from the HP/DXC channel. DXC Technology came into existence after the enterprise business of HP merged with Computer Sciences Corporation (CSC) in 2017. However, Mphasis has managed to increase the overall revenue contribution from the HP/DXC channel from 23% in FY17 to 28% in FY19, thanks to a higher contribution of solutions and services.

It changed its focus to emerging technologies, which has paid off. Mphasis won new deals worth $616 million, 79% of which came from new-gen services in FY19 alone. These services contribute about 46% of its core revenue, clocking a growth rate of about 45% in FY19. Analysts expect the company’s revenue to grow at around 15% over the next two years. 

The private equity firm helped Mphasis since it was introduced to other Blackstone’s portfolio companies who went on to become Mphasis’ clients. “Strong execution of some of the large deals won in FY18 in the Blackstone channel has doubled the revenue growth of Mphasis,” says Rakesh.  

Similarly, in April 2019, Baring Private Equity picked up about 30% stake in NIIT Technologies and Sudhir Singh, who was earlier with Genpact and Infosys, was roped in. This is Baring’s second significant investment in the IT mid-cap space. In 2014, Baring had bought 71% stake in Hexaware, buying out the promoters’ stake. 

NIIT Technologies, too, identified three key growth areas — travel and transportation, banking financial services and insurance -— all of which grew in mid-double digits in FY19. “While both mid-tier and large companies have capabilities in cloud, IoT, automation, blockchain and what have you, it is the ability of a company to understand the processes in a client’s business and provide digital technologies in real-time that will decide winners,” says Singh, CEO, NIIT Technologies. He believes the company rightly chose to stick to domains they understand well.  The company focuses on automation, cloud, data and integration, apart from building platforms and partnerships. 

As for L&T Infotech, it was grappling with leadership change when Infy veteran Jalona stepped in. As head of manufacturing at the Bengaluru-headquartered company, Jalona was overseeing over $2 billion of annual business. L&T Infotech, which was planning to list, was then struggling with a high churn of senior leadership. 

Under Jalona, the firm revamped its sales team, adding some of the best names from Tier-I companies. As a result, in FY19, the digital business, which brings in 38% of the firm’s overall revenue, grew by 31%. Overall revenue growth was 29%. It made L&T Infotech the fastest growing mid-cap IT company. Increasing contribution from the higher margin digital business also pushed its overall operating margin up — from 17.3% in FY18 to 19.9% in FY19. 

“The ownership and management change have seen companies making significant investments in relevant capabilities. These are starting to pay off in some companies, with their sales growth momentum picking up and many new deal wins,” says Motilal Oswal’s Ashish Chopra, who tracks IT services at the firm (See: Picking up pace). Indeed, over the past two years, Indian IT mid-cap stocks have outperformed the broad industry, which has delivered 7-9% return. 

Revamped to boot

The new CEO brigade, which came from large IT companies, was familiar with managing billions of dollars in revenue. So, it was able to mine existing accounts better by rebuilding teams, chasing more audacious deals and buying out companies. “Technical skills are no longer a competitive advantage. Today’s winners have developed organisational and account development capabilities that include shaping the client’s agenda and identify ways in which they can add significant value. Only companies capable of participating in such strategic-level dialogues can develop relationships strong enough to span multiple lines of business,” says Peter Schumacher, CEO, Value Leadership Group.

Many of them overhauled their sales engine. For instance, in L&T Infotech, before Jalona took over, project heads and managers doubled up as the sales guys. The company revamped its sales leadership, and it led to L&T posting an average growth of 15% over the past three years. 

NIIT Technologies, during the past eighteen months, has replaced all three geographical heads and delivery heads with experienced hands from larger companies. “With new leadership at the helm, we were able to get more feet on the ground, but more importantly, people with a more expansive growth agenda. They were going after $50 million deals,” says Singh. 

Companies are also working to move up the value chain. For instance, Cyient, which focuses on aerospace, semi-conductors and medical equipment, has been helping its clients with design for years. “To get a larger share of customer spend, we have acquired a lot of capabilities to build as well as manufacture. We also invested in new business accelerators to be competent enough to provide end-to-end solutions to our clients,” says Ajay Aggarwal, president and CFO, Cyient. 

The new managements haven’t shied away from acquisitions to expand their line of services. “It is tough to grow a capability organically, especially when demand is increasing exponentially and you’re competing with large firms,” says Menon. 

For instance, Pune-based Persistent Systems has done more than four acquisitions since 2015. Zensar followed suit with four high profile buys since 2015. The latest one is the US-based Cynosure for $33 million. NIIT Technologies has made two acquisitions since 2015 — Incessant Technologies and RuleTek — which helped them win clients in business process management and new deals over $10 million. NIIT Tech’s recent acquisition of Wishworks IT consulting, which is into digital integration, will help strengthen its digital capabilities. 

Not all the buyouts were amicable. There was high drama when L&T, the engineering conglomerate and parent company of L&T Infotech and L&T Technology Services, went for the first-ever hostile takeover in the Indian IT industry. It bid for Mindtree, which clocked a billion dollar in revenue in FY19. L&T bought around 20% stake from VG Siddhartha and Café Coffee Day, its largest shareholder. L&T now has a 60% stake in Mindtree. With the engineering conglomerate taking over the reins, three founders including the CEO Rostow Ravanan, chairman Krishnakumar Natarajan and COO NS Parthasarathy chose to leave the firm they co-founded 20 years ago. As Mindtree puts together a new leadership team, the stock tanked nearly 13%, on concerns that the management transition will impact its performance in the next few quarters. 

Growth pressure

While mid-cap companies have been cruising in terms of revenue growth, the pressure to acquire talent, rising visa costs and cost of building local capabilities are likely to put pressure on their bottomline. 

“Margin pressure due to salary hikes and visa costs are an industry-wide phenomena, which we can only be offset by improving internal efficiencies,” says Cyient’s Aggarwal. The company is working with an external firm to improve its overall productivity over the next 12 months by cutting unprofitable clients, centralising marketing and optimising the people supply chain. Mid-caps have to cut the frills even while spending on necessities — building capabilities in emerging technologies and competing for talent with large-cap companies. But that still does not address the visa problem, says Chopra. “They have to build campuses overseas and hire local talent. For the larger companies, given their balance sheet size, these investments will not hurt them as it does the mid-caps. The mid-caps will have no choice but to bite the bullet,” he adds. 

Both large and mid-cap companies are moving closer to their clients. For instance, Zensar has opened five overseas development centres in the US and two more have come up in Mexico and Canada. “I don’t see the immigration situation changing soon. You can no longer build a business by shipping people from India,” says Kishore.

Despite these challenges, analysts expect mid-cap Indian IT companies to report 14-18% increase in revenue and an average profit growth of 15% in FY20. Over the years, the discount (average 30-40%) that the mid-caps were trading at against the large-caps has disappeared. The market has noticed their strong growth prospects and rewarded them with a better valuation. Now, some of them even enjoy a premium multiple.

Analysts prefer companies such as L&T Infotech, NIIT Technologies and Mphasis, where the deal pipeline will ensure a better-than-industry revenue growth over the next few years, and the higher digital contribution will offer some margin protection. But they don’t come cheap. L&T trades at 20x its FY20 earnings — only at a discount to TCS. Analysts expect the company’s average revenue growth at 15%, with 19% operating margin over the next two years. NIIT Technology is a tad cheaper at 17x its FY20 earnings, which is a premium to HCL Tech and Tech Mahindra, and at a marginal discount to Infosys (14x FY20 earnings). Analysts expect the company to clock an average growth of about 16% over the next two years. Zensar trades at 15x FY20 earnings. The smallest of the lot, it has a significant pipeline that analysts believe will drive revenue higher by about 20% and will improve net margin to 16% over the next two years, as the company divests its low-margin Asia Pacific business and the higher contribution of digital deals kicks in. 

While their growth momentum will definitely keep the stocks in the limelight, any slowdown at the macro level could impact the performance of these companies. For now, IT mid-cap companies are not losing sleep.