IT Sector : Cloudy times for tier-1 ?

The Meaty Middle !!

Hardly any sector  stays static for long. All sectors undergo mighty changes over time. More so in the IT space  given the cutting edge products they deal with. The idea here is not to discuss the tectonic shifts  such as digital and cloud (SMAC – Social, Mobility, Analytics and Cloud) that are sweeping across technology space, but to deliberate the fallout of these changes  on the overall industry landscape and gain insights into the emerging investing opportunities if any in the listed space.

Digital has inflicted some serious damage to the incumbents. With large enterprise applications shifting to cloud, phased roll-out (staggered implementation)  is no longer a pipe dream. Earlier, onsite implementations such as ERP, CRM etc, came with large  upfront initial commitments both on hardware infrastructure and on software licenses. Cloud has obviated the need for such large initial investments. With virtualization and cloud, customers can now start with small setup and roll out / scale as the demand grows. This at one stroke , has brought down the ticket size of IT investments by existing behemoths, thereby derailing industry’s large discretionary spend prospects. At the same time, on the positive side, it has opened up new IT spend opportunities  for small and medium enterprises as they have a leeway to start small and experiment. This shift can hardly  be a solace for the tier-1 players as they lack the presence in the SME segment. For tier-1 , the digital woes does not end here. With the core-spend shifting from traditional IT practices  like ADM (Application Development and Maintenance)  to emerging areas of mobility and analytics with lower ticket size , the tier-1’s established edge of providing large pool of skill / resources on demand may not be good enough to weed out competition from smaller players. That is the story so far on the demand side.

Now, let us shift to the supply side.  With its long presence of over two decades, it is easier to infer that  the industry is no longer in its prime. Moving into mature middle age, mid-life crisis has hit much of its top talents hard, esp in the tier-1 companies. With the slim growth prospects, senior talents in the tier-1 find the workspace suffocating and no longer hesitate to move to mid-tier for better profile and prospects. Hexaware and NIIT Tech have benefited from this emerging trend. Both the CEOs are from the tier-1 companies . If the market rumors are to be believed, Zensar Tech is probably the next to follow  and certainly will not be the last. As any seasoned players would know , when senior management moves, they take large account as well, not immediately, but after the cool-off and end of contractual terms.

For mid-tier companies, the largesse does not end there. They have been historically at a disadvantage when it came to hiring engineering talents. Now, with growth slipping for tier-1 amid growing supply from engineering colleges, hiring talent has never been so easy for the tier-2.  Confluence of such varying factors have come together miraculously to conspire a dramatic turnaround for mid tier players. Below exhibit that captures the sequential revenue growth (in USD) for the tier1 and mid-tier vendors over last few quarters reaffirms the inference in the above analysis.

IT_revenue

Key takeaways for investors from above trends:

  • Tier 1 large caps likely to  struggle with muted growth. Low double digit growth is the best case probable scenario for well managed ones.
  • Stock returns will continue to disappoint for large cap ITs, though downside risks are limited given their undemanding valuations. Risk to this call, of course, can come from any serious fall in Rupee.
  • Time is ripe for senior management in IT to diversify from their core ESOP positions into a well diversified portfolio to create alpha.
  • Stock returns in this space are likely to  come more from stock specific (hidden) opportunities in the tier-2 space. For e.g. one year returns from NIIT Tech is over 70%+ compared to negative returns in the tier-1 space (TCS being the worst performed with minus 11%).

Interesting times to watch out for in the listed IT space !!

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Are Great Businesses great Investments?

Great businesses are ought to be great investments? Right . But rarely so in the real investment world . Below chart captures the price movements over last six months  for two great businesses that are in the promising space run by competent management i.e. Sun Pharma and Just Dial . Yet , these stocks have lost quite significantly ( over 35 to 45%)  as can be seen in the chart  . What explains this ?

Great businesses can hardly be  great investments , If all the positives are already in the “price” .   Returns come from mis-priced stories , not from “priced-to-perfection” stocks. If the stocks are priced-to-perfection, with little or no margin of safety , then they can  rudely get rattled on growth shocks  as happened in Sun Pharma and Just Dial .

So watch out for what is in the “price” when you look at blue-chip stories next time !!

Sun_JustDial