The markets have turned pessimistic due to inflation, a commodity crunch, and geopolitical concerns amid conflicting reports on whether Russia would invade Ukraine or not. No Indian listed company has been left unscathed in this. Even IT services companies’ stocks are trading with deep cuts. Still, these companies are trading at higher valuations compared to their historic averages. This makes a lot of IT services companies attractive for investors who may be on the prowl for buying the dip.

We earlier wrote about top-tier IT services companies here, where we looked at what their prospects could be going forward. Now we look at what could be the prospects for mid-tier IT services companies like Tech Mahindra, L&T Infotech, Mindtree, Mphasis, Persistent Systems, and Coforge.

You might be surprised that we added Tech Mahindra to the mid-tier IT services company bucket. The top four IT services companies (Tata Consultancy Services, Infosys, and HCL Technologies) are either above or at the $ 10 billion revenue annual run rate. But Tech Mahindra, even though it’s larger than L&T Infotech with an annual revenue run rate now within a touching distance of $ 6 billion, is still smaller than the big four. At current levels, Wipro’s market capitalisation is more than double that of Tech Mahindra’s market capitalisation.

So, what does the future hold for these mid-tier companies? And what should investors keep in mind before they buy the proverbial dip?

Revenue growth is chugging along on strong demand. But there are a few wrinkles

It’s now pretty clear that IT services companies are seeing a remarkable upsurge in demand. In calls with investors and analysts, the management of almost all companies is gushing about the surge in demand, the pipeline of orders, the long runway of growth, etc.

If we look at quarterly revenues over the past five quarters for these companies, it’s hard to argue against the fact that the going is good.

Although we prefer to look at revenue growth for IT services companies on a quarter-on-quarter basis, the magnitude of YoY revenue growth in Q3FY22 for L&T Infotech (29.3%), Mindtree (33.7%), Mphasis (24.0%), Coforge (37.8%) and Persistent (36.2%) is quite impressive.

Of course, there is a base effect at play here that produces such a large YoY revenue growth number. If we look at the QoQ revenue growth for Q3FY22, only L&T Infotech (8.6%), Mphasis (7.5%), and Persistent (9.2%) grew more than 5%. The thing to note here is that Q3 is usually a seasonally weaker quarter for most IT services.

Attrition jumps, keeping management on their toes

This fast-paced revenue growth is what pushed up the valuations of these stocks over the past 18 months. But one concern is the rising attrition of employees. This is a persisting issue over the past few quarters that is affecting every technology company in India, and dare we say globally.

Niche skills to upgrade clients’ technology stacks to be digitally agile are in short supply. This is pushing up the cost of hiring as IT services companies in India are also having to compete with start-ups that are flush with cash in a bidding war for talent. This phenomenon is most prevalent among employees in the 3-6 year experience bucket, according to L&T Infotech’s management.

What seems to be common among L&T Infotech, Mphasis, Tech Mahindra and Persistent is the strategy to tackle this spike in attrition. They are looking beyond tier 1 cities and turning to tier 2, 3, and 4. The hypothesis is that employees who are currently working from their hometowns are more comfortable living there. To help them work out of those locations will help limit the attrition while keeping them on the company’s rolls for longer and support margins. While L&T Infotech recently started a campus in Coimbatore, Persistent is looking to hire from places like Thiruvananthapuram, Visakhapatnam, Bhubaneswar, Vijayawada, etc.

Naturally, the spike in attrition is impacting the margins of the mid-tier IT services companies.

But Mphasis’ EBIT margins stabilized after being somewhat volatile over the past few quarters.

One more way these companies are trying to tackle this surge in attrition is through hiring freshers. As revenue growth slowed before the pandemic, many IT services companies went slow on hiring freshers from colleges. And when the pandemic hit India in 2020, these companies probably didn’t anticipate the surge in demand for talent, which the companies call a “supply-side” problem. Unless this stabilizes, margins will continue to remain under pressure.

Many of these companies are hiring freshers and training them, which would mean many of them would be on the bench. This will likely impact utilization levels of employees, which in turn would impact margins for a transient period. But when the demand for talent from projects increases as deals ramp up, the utilization levels will rise as will margins. The common theme across the industry coming from management interactions with analysts is this attrition problem, and the resulting impact on margins will sustain for a few more quarters. But companies are now essentially hiring ahead of demand coming on stream.

Coforge is the only company that seems to stand out in terms of attrition, with its trailing-twelve-month attrition at nearly the same levels as TCS.

Ramp up of deals, offshoring, and operating leverage are the next triggers

Investors looking at investing in mid-tier IT companies need to know that they are essentially (over) paying for higher valuations because their growth is expected to be rapid. Coforge is talking about breaching a billion dollars in revenues as a whole in FY23, while Tech Mahindra is talking about creating billion-dollar verticals in BFSI, manufacturing, healthcare, and hi-tech.

It's difficult not to look at these assertions as pies in the sky. But if we look closer at the deals, the numbers are impressive — Coforge bagged over $800 million of deals in 9MFY22, while Mphasis is bagging over $200 million deals every quarter for nearly two years now (with Q3FY22 net new deals being $335 million). L&T Infotech feels that without winning large deals, because of the propensity of clients wanting to hire expertise by breaking up deals into smaller pieces, the company is well placed to win a large number of small deals.

Once these deals ramp up, it will be difficult to bet against a stellar performance by the mid-tier IT services companies over the next year or more due to operating leverage kicking in. This will push up profits as well. But keep in mind that this doesn’t mean that investors should overpay for these shares. Before the recent negative market sentiment, these businesses were already richly valued, and their value kept rising. Instead of worrying about missing out, investors should be cautious with the allocations they make to this cohort of promising, but expensive companies