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Mid-cap tech firms under threat?

By T N Ninan
October 20, 2007 17:15 IST
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It may be that we have all been looking in the wrong direction. As the rupee has climbed against the dollar, as salaries in the tech sector have continued to go up, most people have focused on the quarterly results of the big boys of the tech world - TCS, Infosys, Wipro and the like. As it happens, these have come through with passable second-quarter numbers for sales and profit growth.

The growth rates are not what investors had got used to seeing them deliver till a year ago, but they are good enough to live with at the reduced share valuations that prevail today for the tech sector. But that is not where the problem lies.

Look instead at the mid-cap tech firms to see the mayhem wrought by the "scissors crisis" of revenue under downward pressure because of cheaper dollars and costs facing upward pressure in more expensive rupees. What has got squeezed between these two moving blades are margins and profits.

Companies like Hexaware, Polaris and Aztecsoft have reported quarterly profit drops ranging from 22 per cent to 39 per cent. To be sure, there are others like Mastek and Sasken that have continued to report increased profits (22 per cent in one case, 14 per cent in the other), but it is clear that the warning signs are flashing.

Look at the ratios, and there are other lights flashing - Hexaware has a net profit to sales ratio of about 10 per cent, while Polaris is down to 6 per cent. Both numbers are significantly lower than the profit ratio for the corporate sector as a whole (14 per cent for the companies that have announced results so far) and you understand why the market is disenchanted with tech stocks. The stock prices of some of the mid-cap firms have crashed by between a half and two-thirds from the high points of the last 52 weeks, compared to drops of 20-30 per cent for the big boys.

The short question is, are the mid-caps threatened? Not if you read what they are saying, for they report new customers, top line growth, and the assurance of more revenues. But it is hard not to conclude that the reality facing big and medium firms is quite different today. TCS has just bagged a $1.2 billion deal; HCL Technologies may be about to bag a half-billion dollar deal.

These are markets that the medium-sized companies cannot even aspire to. At the same time, staff churn in the medium-sized firms is about twice as high as it is for Infosys or TCS; and their profit margins are significantly lower, so their ability to pay more to retain people is in question, as is their power to renegotiate contracts to neutralise the falling dollar.

That is not the end of their problems. Many of the mid-cap firms are usually in a single market (the US) and often in one narrow vertical space, so they are more vulnerable than firms with a more diversified business base. And they usually do not have on-site staff to the same degree that the big boys do, which becomes a natural cost hedge when the dollar is falling.

The question that poses itself is whether the industry is set for consolidation. Perhaps yes - if you are competing in the same market, then the big firm has a natural advantage in terms of a better brand name and perhaps better delivery capability, and certainly a bigger cost cushion.

The safety for small and medium firms lies in either going up the value chain, or focusing on smaller niches - like architectural or design outsourcing. But for those who are stuck in the low-value business process outsourcing segment or its equivalent, the future looks tougher than before. If the rupee continues to climb, as many have forecast, then these trends will get accentuated. And those who merely track the big boys or follow Nasscom's headline numbers on the industry's still respectable growth rates will be missing the underlying story of a large number of players struggling to stay abreast of the game.

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T N Ninan
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