Five years ago, Phillip Capital had highlighted in a report that most midcap information technology (IT) companies will find it difficult to withstand competition in the rapidly evolving technology landscape – and hence, their promoters might look to sell themselves out.
The brokerage had further hypothesized that if one or more of these midcap IT companies could be brought together to merge with another, they could lead to the formation of a formidable IT company, which could perform much better than the individual components, and would also command valuation premium.
While that did not materialise then, the brokerage in a recent report showcases this happening now – five years later.
Over the last few quarters, promoters of multiple midcap companies like Mindtree, NIIT Tech and KPIT have exited their businesses. The acquisition of Mindtree by Larsen & Toubro (L&T) Group and NIIT Tech by Barings PE group are definite precursors to these acquired entities eventually merging with group IT companies.
It expects the trend to continue, and more consolidation to take place in the IT midcap space over the next few years.
Over the last five years, there have been various consolidations in the midcap IT space:(1) Acquisition of the promoter stake in Hexaware and NIIT Tech by Barings PE.
(2) Acquisition of the promoter stake in Mphasis by Blackstone. (3) Demerger of KPIT Tech and merger of its IT business with Birlasoft. (4) Acquisition of Mindtree by the L&T Group, paving the way for a future merger with L&T Infotech.
(5) Acquisition of Polaris by Virtusa.
The brokerage believes that promoters of midcap companies exiting their businesses signal that the businesses and their valuations have peaked out. Over the last two years, the IT midcap companies have outperformed their large-cap counterpart significantly – registering double-digit growth, as compared to mid-single-digit growth by large-caps.
However, with the digital technology cycle now entering its early majority phase and deal sizes gradually increasing, midcaps will find it extremely difficult to grab deals from large-caps, the report stated.The brokerage lists four primary reasons for this series of promoter exits from midcap IT companies:
1) Lack of succession planning. 2) Scale becoming critical for future growth. 3) The high pace of technology evolution.
4) Expensive valuations.
In the last five years, private equity players have also invested heavily in the Indian IT midcap space. Companies with niche strength in focused domains – either horizontals or verticals – are attracting stronger attention from PE investors whose primary target is to improve overall portfolio value by turning around the operational performance of the company, the report explained.
They target companies that have differentiated domain expertise and capabilities, but are performing below-par, primarily due to size issues or lack of professionalism in approach, it added.
"Recent transactions of Mindtree and NIIT Tech are clear evidence of a high level of competition that most midcap IT services companies are facing presently. Despite strong financial performances over the last few quarters, concerns about the sustainability of this performance has begun to loom large," the brokerage said.
In these turbulent times, the brokerage expects most midcap IT companies’ promoters to seek a timely exit. It also expects a few of these companies to either merge together to form a formidable force or some of the large IT services companies acquiring one of them. There have been many similar acquisitions in the last six months, and it expects many more over the next few quarters.
Accordingly, Phillip Capital expects M&A activity to continue over the next few years and the 'remaining' IT midcaps to be targeted for larger peers and also for private equity firms.
"Companies like Cyient and Persistent have been struggling to grow their businesses and have been constantly losing market share. Cyient could be a perfect target for companies like L&T Technology Services or HCL Tech. But Persistent Systems might find it difficult to fit into most other business models, given its unique offerings. Also, we believe small-cap companies like Sonata Software and Zensar – with unique value propositions in niche domains – could also be potential M&A targets," the report noted.
Over the last one year, most midcaps (excluding NIIT TECH) have undergone significant correction, and no longer appear as expensive as they did, a year ago. While the growth, too, has tapered down over this period, the brokerage believes select midcap stocks currently offer a favourable risk-reward profile, along with event-based opportunities, offered by potential M&A activity in these stocks.
Phillip Capital upgrades L&T Technology Services, Mindtree and Cyient to 'buy' based on potential turnaround opportunities and attractive valuations. It continues to find valuations expensive for L&T Infotech and NIIT Tech.
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