Mid-cap software: At the crossroads? - Views on News from Equitymaster

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Mid-cap software: At the crossroads?

Sep 29, 2005

We live in heady times! The markets are literally in stratospheric territory. Foreign Institutional Investors (FIIs) have pumped in over US$ 8 bn into Indian equities this calendar year, economic growth is expected to be robust, inflation and interest rates appear to be benign, affluence is on the rise, corporate profits are growing at an enviable pace despite high crude prices. Simply, all seems hunky dory! Undoubtedly, liquidity has played a big role in this rally. Fund managers and research houses alike have been astounded, not just by the rise itself, but also by the pace of the rise. In fact, the Sensex rose from 7,000 to 8,000 in a mere 55 trading sessions and from 8,000 to 8,500 in just eight sessions! A mind-numbing jump by any standards!

Mid-cap software stocks have certainly had their share of gains in this rally. To put things into perspective, the BSE-Sensex over the past year has gained as much as 54%, while the CNX 500 has also risen by 54%. i-flex solutions, India's premier software products company, has gained 50%, most of it in the last five months, while Geometric Software, a specialist PLM software company, has gained as much as 75%, despite trading subdued of late. Flextronics Software (formerly Hughes Software) has managed to gain a more subdued 21%.

We give a perspective on the mid-cap software space on a macro basis and fathom as to what lies ahead for these players.

Testing times
With offshoring becoming more mainstream, the top players are only getting bigger. They are growing at a fast pace and the gap seems to be increasing between these players and the rest of the pack. In the future, it is more likely that the large clients will go for vendor consolidation and this would only favour the larger players, as they have the scalability to better manage their clients' problems. Even if they lose out on a few clients, due to their more diversified revenue streams, it will not affect them that much.

However, for the mid-cap players, it is a different story. A lot of them have a greater proportion of business coming from key large clients and if they lose out, it will affect them more. The major differentiator will be skills in a niche area. Companies like i-flex and Geometric score on this count, as they are leaders in their respective fields and entry barriers are high. The next round of consolidation in the industry could see some major shake-ups in the mid-cap space.

Companies like Geometric, Hexaware and KPIT Cummins Infosystems had all given profit warnings in previous quarters and this has clearly affected sentiment. Concerns about scalability and execution risks are also abounding. Clearly, some of these companies will have to take a call on what they need to do to grow in a sustainable manner over the longer term. They will have to be either merge with or be taken over by larger companies, or will have to take over other mid-sized players themselves. As mentioned above, the key factor will be strengths in a niche area.

Being gobbled up!
Even companies with niche skills have been attractive targets for takeovers. Companies like Flextronics Software (formerly Hughes Software, taken over by Flextronics of Singapore, one of the world's leading electronic manufacturing services providers) and i-flex (taken over by Oracle, the world's leading enterprise software company) are telling examples. It thus appears that while the big players will only get bigger and the niche players will either hold their own in their area of expertise or get taken over by large MNC companies, the middle rung companies will be the ones stuck in the middle! They will undoubtedly find it difficult to survive.

Mid-cap software companies like Polaris, Hexaware and KPIT Cummins have seen difficult times of late. Undoubtedly, the consolidation process will happen, sooner or later. It is not going to be easy to compete against the likes on Infosys, TCS, Wipro, and Satyam et al, companies that have annual revenues between Rs 35 bn to Rs 100 bn. In comparison, KPIT Cummins' FY05 revenues were around Rs 2.5 bn. These companies will either have to merge among themselves or get taken over by larger competitors.

It is very clear that these companies will have to think out of the box if they want to survive in a highly competitive industry, where geographical barriers do not exist. Therefore, as an investor, one must consider and take a critical look as to why one would want to hold on to these stocks. Possibly the only reason why investors might consider holding on to these stocks is waiting for news of a possible merger with a larger company. But then, this would amount to speculation and not investing. Therefore, we believe that investors will find more value in larger companies or niche players for a long-term investment horizon.

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