Under such circumstances, the MphasiS management (led by Mr Jerry Rao) may also change. For MphasiS, which has put through three acquisitions (of the five) in quick succession and is in the process of integrating them, extensive management changes could prove a distraction.

iGate Global is experimenting with a transaction pricing model for the past couple of years since Mr Phaneesh Murthy took the mantle in mid-2003. But the restructuring of the company is still on, and it may be some three-four quarters before the benefits of this model are reflected. With promoters holding 82 per cent equity, the floating stock is also quite low.

Raising the competitive bar

Some fundamental changes are also happening in the service portfolios of companies under review. The first phase of the mid-cap software story, which started after the 2000 economic downturn in the US and Europe, is slowly but surely coming to a close. Perhaps a revamp is due for software companies that went through a restructuring and rewarded investors handsomely; for instance, Hexaware and KPIT Cummins So far, Hexaware has focussed on serving such under-served markets as the airlines vertical, the German geography and PeopleSoft services. On its part, KPIT Cummins has been using Cummins as an anchor customer and building other Fortune 1000 accounts.

Citing delays in project starts/deferral of IT spending by some European clients, both Hexaware and KPIT have scaled down their guidance sharply (see Table). Clearly, the days of super-normal returns from mid-cap companies in the past one-and-a-half years may be behind us. The second phase of the offshoring story for mid-cap software companies is set to begin. Though the offshoring momentum continues to be robust, the revenue gap between the frontline and medium-sized software companies has been widening.

This suggests that unless Tier- II companies scale up and fill the void created by the top companies, their survival may be in jeopardy. In our view, some key trends are likely to influence the future of mid-cap software entities over the next year:

Sandwiched : Tier-II companies are likely to face pressure from two fronts. From the top, frontline companies are already competing in every single deal that matters in the application development and maintenance space, largely because they have realised this service line offers the best opportunity to cross-sell and expand their relationships into such new lines as engineering services, infrastructure management, packaged implementation, testing or business analytics. The client addition logged by all the frontline companies in the $1-million bracket proves this point.

From the bottom, the heat could come from specialist firms or companies with defined niches — for instance, Geometric Software in product lifecycle management, or Subex Systems in telecom fraud software, or Kanbay International in credit card services, insurance or capital markets.

Inevitably, the fallout of this trend will be:

For instance, Hexaware will have to show that it can replace the revenues from its high-margin India Services Centre run for PeopleSoft, taken over by Oracle earlier this year. The revenues are set to stop from October 31. Similarly, KPIT will have to steadily reduce its dependence on Cummins, its anchor customer, while Geometric will have to build its relationships with OEMs (original equipment manufacturers) and industrial customers for robust and predictable growth.

Generic Tier-II vendors may find it difficult to bag new orders or ramp up their existing client accounts. As their risk taking capability erodes, their ability to experiment with newer pricing mechanisms such as fixed price projects or transaction pricing may also be limited.

Consolidation and flight to scale: As the revenue gap between top-rung and mid-size companies widens, there emerge new triggers for consolidation among Tier-II companies: Practically all the global multinational vendors, such as IBM, Accenture, EDS or CSC, are aggressively adding employees to enhance their offshore capability. Since adding offshore resources is fundamentally a "Build (recruit employees) versus buy (acquire Tier-I/II companies)" decision, at some point, acquisition may turn out to be a faster way to achieve the objective. Similarly, as most global systems integrators or software service vendors, such as Keane, Bearing Point, Atos Origin or Cap Gemini, are in the process of building a strong offshore presence, acquisition may be a quick way to leap into this process. Though the trigger for acquiring a Tier-II company may not be compelling as yet, competitive factors may drive this trend faster than expected.

It is interesting to note that in the Barings equity sale in MphasiS, quite a few Tier-I global and domestic vendors participated in the deal in the initial rounds.

At the same time, over the past three months, a few Indian promoters from the Tier-III vendor category have sold their companies to other Tier-II and III companies. These acquisitions by Tier-II/III vendors are expected to strengthen their scale and capability to compete. For instance, Helios & Matheson's acquisition of vMoksha; Mindtree Consulting's of Linc Software or Kanbay's of Accurum India are bound to raise the competitive bar.

If the valuation of Tier-II companies softens further in the coming quarters, based on performance or other factors, the scope for consolidation across Tier-II companies or by other Tier-I vendors may increase.

And till that happens, the risks associated with investing in mid-cap software stocks will remain fairly high.

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