IT Sector: Adoption of digital technologies gives midcaps a confidential edge

The Indian IT services sector has witnessed three key technology spending cycles over the past twenty years. Each of these spending cycles scripted progressive evolutionary growth in the Indian IT industry at large.

The first cycle was in early 2000s when industry rode on the wave of core banking software upgrades in the Y2K phase.

This was followed by spends on enterprises outsourcing to ensure business continuity from mid 2000s to 2015.

Large cap IT companies have been the primary beneficiaries in the initial two technology spending cycles. In the first cycle, the Indian large cap companies we know today benefited from a first-mover advantage, which helped them expand the scale of their operations and broaden their competencies portfolio. This scalability achieved in operations emerged as a prime attributor for tier-I IT companies win large, multi-million dollar contracts that lasted for multiple years.

The year 2015 paved way to the emergence of third ‘digital’ cycle which is prevalent till date. The nature of technology spending in the third cycle has been very different from prior two cycles, where enterprises started splitting their technology projects into smaller chunks. Thus, the nature of spending now became more broad-based across industries from energy & utilities to retail to software. This accelerating adoption of digital technologies across industries enabled midcap IT service companies to leverage their unique capabilities and focused attention to win, retain and grow their client base.

This led to an improvement in the performance of midcap companies as they have utilized this opportunity in the third cycle to consistently grow faster than their large cap counterparts for an extended period.

In the illustration given below one can clearly see how midcap IT companies have managed to grow their earnings in the third cycle as compared to the first cycle over the period of two decades from the beginning CY2002 to the end of CY2022.

Historically, large cap IT cash flow valuation multiples used to be multiples of midcap IT companies. However, in the third cycle that we are referring to the improved operational profiles of midcap IT companies have managed to reduce the valuation gap. As can been seen in the graph below from CY 2009 to CY 2022, midcap companies have closed the premium gap with large cap peers in the IT services space.

However, not all midcap IT stocks have been able to consistently perform well. Therefore, we believe bottom-up stock-picking is necessary to select the winners. Here’s a schematic technique of our framework and our take on the impact of a probable recession.

A recession may force enterprises to cut spending, and the IT service sector is no exception. However, one common theme highlighted across the board from companies’ earnings calls and industry experts is that digital and cloud technology adoption is still at an early stage; it will not be one of the first items to observe a cost cut.

However, the collapse of the Silicon Valley Bank has impacted midcap IT stocks recently which have suffered owing to worries fuelled over the impact of the collapse. This is an event based reaction where panic comes into play. Another reason midcap IT stocks were down was because of the perception of the exposure midcap IT companies have to the BFSI sector in terms of percentage of total revenue. However, not all midcap IT companies have large exposures to one particular sector; most of them have a diversified revenue basket across sectors.

Today, digital technologies enable better customer engagement, conduct analytics to draw insights, automate business processes and gain flexibility from cloud-based storage of data and calling of applications. All of this helps companies extract more revenues, save costs and operate more resiliently, which makes these technology spends necessary to protect and grow companies’ competitive advantages in an increasingly competitive world. This scenario can play out if the companies can give the confidence that they can tide over this rough patch.

Chirag Patel is Co-Head - Products, WhiteOak Capital AMC

Disclaimer: This article has been made for general reading purpose only. The views, thoughts, and opinions expressed in the article belong solely to the author.