Tier-2 IT cos could lose their mojo

Selectively, that did play out. Tier-1 IT companies Tata Consultancy Services Ltd, Infosys Ltd, and Wipro Ltd saw sequential constant currency revenue growth of 2.2%, 2.4% and 0.6%, respectively. HCL Technologies Ltd was an outlier with 5% revenue growth, aided by its software segment in a seasonally strong quarter for that segment. Among tier-2 IT companies, Coforge Ltd and Persistent Systems Ltd stood out with revenue growth of 3.7% and 3.5%, respectively. On an aggregate basis, tier-2 companies have fared better on revenue growth than tier-1 lately, but concerns about the sustenance of this trend are emerging.

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“The revenue growth outperformance that mid-cap IT companies were showcasing, especially post-covid, has started narrowing,” said Kumar Rakesh, an automobile and technology analyst at BNP Paribas Securities India. Revenue growth in large-cap IT companies is likely being supported by vendor consolidation and their strength in cost-takeout projects, he added.

Investor sentiment towards the entire IT sector has soured as recession worries loom, and that could prompt clients to delay their IT spending. Already, some verticals and geographies are seeing weaknesses. But company-specific factors are a double whammy and could dampen the near-term revenue growth prospects of tier-2 IT firms.

For instance, LTIMindtree’s first quarter as a merged entity began on a soft note, with a sequential constant currency revenue growth of 1.9%. “We see the merger as downside risk insurance rather than a growth impetus at this stage,” said JM Financial Institutional Securities. “Absence of scale benefits aside, momentum in individual businesses itself – though now moderating – could sustain 13.5% dollar revenue CAGR for the merge-co over FY23-25E,” added the JM report. Further, it also cautioned of near-term headwinds to the company’s growth, given stress in the hi-tech vertical, which is 24% of its revenue.

Weakness in the mortgage business hit Mphasis’s Q3 revenue growth hard.

L&T Technology Services’ Q3 growth was unimpressive, and analysts caution of medium-term revenue headwinds from its latest acquisition of L&T’s Smart World & Communication business. Coforge Q3 growth was at a multi-quarter low. Persistent’s growth was soft in the context of an extremely strong compound quarterly growth rate in the preceding six quarters, said Nirmal Bang Institutional Equities.

To be sure, the deal wins for most midcap IT companies were robust in Q3. Operating margin performance was mixed in Q3, but overall, the sector’s margin would improve due to easing supply-side pressures and more freshers becoming billable. That said, larger companies are likely to show more resilience if a recession happens. According to Nirmal Bang, tier-2 companies would suffer more also because of a less diversified revenue mix.

The dismal returns of IT stocks in the last year do mirror these concerns, with some tier-2 stocks seeing a steeper decline. Although tier-2 stocks are still trading at higher multiples, the valuation gap with tier-1 stocks has tapered. “The high PE multiples are also a reflection of the market’s view that some tier-2 IT companies will become $5-10 billion enterprises in the next 10-20 years. Once the ‘Digital’ high tide recedes, it remains to be seen which of the current tier-2 sets will continue to show promise,” added Nirmal Bang.