Despite rallying over 4x in a year, these small-cap IT firms are still value compounders

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Select smallcap IT stocks are fast grabbing the eyeballs of investors, thanks to the metaphoric price rise they have witnessed over the past year. Sample this, Birlasoft, the software arm of CK Birla group, which was trading at Rs 81 on June 5, 2020, fast forward to June 4, 2021, it ended at Rs 333 jumping more than 4x. Similarly, FirstSource Solution surged 3.95x from Rs 37 to Rs 148 during the same period and Coforge has rallied 2.5x to Rs 3,694 from Rs 1,469.

According to Edelweiss, the Indian technology services industry is at the same juncture in terms of prospects where it was post-global financial crisis in 2008. Then, stocks had plunged to historically low PEs in the wake of demand uncertainty. Now, Covid-19 has wreaked more broad-based havoc, bringing the global economy to a standstill of sorts. Both Black Swans have stark similarities—GDP decline, job losses, panic, bankruptcies and swift central banks’ responses. The only exception is that the current one is a health crisis and a technology enabler, while the global financial crisis was a financial monster.

Tech upcycle

The current pandemic to be the inflexion point of a technological revolution. Digitalisation is a more potent catalyst than assurance services and infrastructure management services which had powered IT growth post the financial crisis.

“A distinct trait of this growth would be its margin-accretive nature, unlike the past. It is not hard to imagine higher offshoring (scale) as well as savings owing to lower travel, administrative and sub-contracting costs. The biggest differentiator for this cycle is the acceleration it has triggered towards technology spends and quicker decisionmaking than any other upcycle in the past,” noted a report released by Edelweiss Securities

Value compounders

Under the “Techolution” thesis Edelweiss Securities has laid down 5 Golden rules to analyze companies smallcap companies that can take giant value leap. The rule lay emphasis on hiring a CEO from a large company; he must build a team from tier-1 companies; promoting meritocracy, engaging with large deal consultants, cleaning up tail accounts and building new avenues of growth. Basis these rules the brokerage firm has cherry-picked value compounders.

Birlasoft | Price target: Rs 551

Birlasoft appointed Dharmender Kapoor (DK) as CEO (promoted from COO) in June 2019 post-Anjan Lahiri’s exit. Further, the company has hired all business heads from tier-1 companies and posted them in client markets. Promoted meritocracy at the cost of unpopularity and against industry norms; roped-in large deal experts—CEOs/CIOs; strengthened relations with Microsoft/Amazon Web Services and its biggest perceived negative of higher SAP concentration is now its biggest positive.

Companies $1 billion target has moved from the stage of Dream- to Aspiration and now a Reality this implies a 17%/20% four-year revenue CAGR organically/overall and better margins as costs rationalize.

Firstsource Solutions | Price target: Rs 202

Firstsource Solutions has hired several senior executives (COO, Chief Digital Officer, 2 Presidents and 2 business heads) since the appointment of Vipul Khanna as MD & CEO in August 2019. The company has witnessed substantial improvement in growth and margins since the new team has taken charge. The company has strengthened its digital solutions spanning Analytics & AI, Intelligent Automation (IA) and Customer Experience.

The company will post robust revenue/earnings per share CAGR (compounded annual growth rate) of 20.0%/28.3% over FY20-23E riding digital adoption-led acceleration in BPM industry; its digital leadership; and 90%+ revenue from high growth industries and markets like BFSI, Healthcare, Media & Tech and US & UK.

Coforge | Price target: Rs 5,005

Coforge has posted high growth, order book and margins over the past four years (12.2%/17.5%/70bps); eventually margins may converge with large caps. Over FY21–23E, reversal of discounts given to the travel industry, lower travel costs and operating efficiencies will offset cost headwinds and drive an earnings per share CAGR (compounded annual growth rate) of 31.5%. Moreover, platforms such as Duckcreek trades at an enterprise value/sales of 20–25x (growth trajectory of 20–25%), which has a similar business model as AdvantageGo, implying $800 million in value for AdvantageGo alone, in our view, which counters the valuation argument.

(Disclaimer: The recommendations in this story are by the respective research and brokerage firm. Money9 & its management do not bear any responsibility for their investment advice. Please consult your investment advisor before investing.)