Benefits of scale can be leveraged at Tier-1 IT to make necessary investments in newer opportunities and this may help outperform Tier-2 IT in future
Tier-2 IT stocks have outperformed Tier-1 IT stocks by a wide margin over the last year. Assuming an index with market capitalisation-based weights, Tier-2 IT stocks have nearly doubled (up 96%) as compared to the 53% gains notched by Tier-1 IT stocks. What has driven this outperformance in Tier-2 stocks and will this outperformance reverse?
Nomura believes expectations of equalisation in growth and earnings performance between Tier-1 IT and Tier-2 IT is largely captured in the valuation discounts narrowing. But questions on longer term sustainability of growth will still be an overhang at Tier-2 IT, which is likely to limit further narrowing of valuation discounts. Nomura believes that Tier 1 IT scores over Tier 2 IT on the following counts:
(a) Predictability versus volatility: There is greater predictability of revenue growth and margins at Tier-1 IT vs higher volatility at Tier-2 IT.
(b) Diversification vs concentration: Tier-1 IT has more diversified presence across all segments (geography, industry and service line) with higher exposure to faster growing and underpenetrated segments like IMS and BPO, while Tier-2 IT still remains largely ADM (application development and maintenance) centric. ADM is the most penetrated of the India IT service lines.
(c) Benefits of scale can be leveraged at Tier 1 IT to make necessary investments in newer opportunities like SMAC (social, mobile, analytics and cloud), Europe and products/platforms, without impacting margins.
Nomura includes Mindtree (MTCL IN), Hexaware (HEXW IN),
Persistent (PSYS IN), Eclerx (ECLX IN), NIIT Tech (NITEC IN) and Infotech Enterprises (INFTC IN) under Tier-2 IT stocks. For Tier-1 IT, Nomura includes Infosys (INFO IN), TCS (TCS IN), Cognizant (CTSH US), Wipro (WPRO IN) and HCL Tech. (HCLT IN).
Stock market performance of Tier-1 and Tier-2 IT companies over a period of time is summarised in the chart below:
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