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Buy L and T Technology Services Ltd For Target Rs.5,670

Structural theme remains on track

Upward revisions on guidance front to continue

* L&T Technology Services (LTTS) reported 6% QoQ CC growth in 2QFY22, above our estimate of 5% QoQ CC, led by a broad-based performance across verticals. Operating leverage led to EBIT margin improvement of 110bp QoQ to 18.4% (above our estimate of 16.8%), despite strong employee additions (+6% QoQ) and lower utilization (-110bps). It reported better-than-expected attrition of 16.5% (+200bps QoQ).

* The 350bps increase in the FY22E USD revenue growth guidance to 19–20% (v/s 15–17% in 1Q) came as a welcome surprise. While we were anticipating a raise, the quantum has surpassed our estimate of 19% and indicates a robust demand environment for engineering and R&D (ER&D) services.

* Moreover, the management commentary of continued strength in end demand suggests growth could significantly exceed the upper end of the revised guidance. We continue to see LTTS as a beneficiary of the growing penetration of ER&D services and the best Tier II IT services play within our coverage. We bake in 21.2% revenue growth for FY22E and expect the company to continue to revise its guidance upwards over 2HFY22. LTTS should continue to deliver 20%+ USD growth in FY23 as well.

* The 2Q EBIT margin performance was also stronger than expected, as the company reported all-time-high profitability despite rising supply-side pressures. With the management’s plan to onboard 2,000 freshers in 2H (in addition to 1,200 in 1H), the total employee strength should increase 22% YoY. This should further limit any tailwinds from growth and higher profitability in the low-margin Telecom and Hi-Tech vertical. We expect margins to remain range-bound at current levels in FY22. Given the low base of FY21, the FY22 EBIT margin should improve 380bp over FY21–23E.

* We see LTTS as a key beneficiary of the growing tech adoption in ER&D – it should grow ~2x IT Services over FY18–23E. Moreover, with Digital at 55% of revenue, it should benefit from the ~18% growth in Digital ER&D spending over this period. We build in a 22%/39% USD revenue / EPS CAGR over FY21–23E. We value the stock at 47x FY23E EPS and maintain a BUY rating.

Strong operational beat and guidance upgrade

* 2QFY22 USD revenue grew 22% YoY (v/s est. 21%), operating profit rose 64.6% YoY (v/s est. 49%), and PAT increased 39% YoY (v/s est. 35% YoY).

* 1HFY22 USD revenue / INR EBIT / INR PAT grew 21%/66%/58% YoY.

* Revenue at USD217.4m in 2Q was up 5.7% QoQ (v/s est. 4.7% QoQ); in constant-currency terms, it was up 6% QoQ and 22.3% YoY.

* During the quarter, LTTS won five deals with TCV of USD10m+, including two USD25m+ deals.

* Revenues from Digital and leading-edge technologies stood at 55% in 2Q.

* Growth at 8.8% QoQ was driven by the Top 10 clients; the Top 11–20 clients were relatively soft and grew 1.8% QoQ.

* Medical Devices, Industrial Products, and Transportation spearheaded the sequential growth of 10.2%, 8.4%, and 6.4% QoQ, respectively. On the other hand, Telecom and Hi-Tech was relatively soft with growth of 1.4% QoQ.

* The FY22 USD revenue growth guidance was revised up to 19–20% (from 15– 17%).

* The EBIT margin improved 110bp QoQ to 18.4% (160bp above estimates) for 2QFY22.

* Margin improvement was seen despite the wage hike impact, offset by operational efficiencies.

* PAT came in at INR2.3b (+6.4% QoQ and 3% ahead of our estimate) on strong operational performance, partially offset by lower other income.

* The total employee strength stood at 17,983, with 1,010 employee net additions. Attrition spiked 200bps sequentially to 16.5%.

* For 1HFY22, FCF stood at INR4.23b, implying FCF/PAT of 95%.

Key highlights from management commentary

* In terms of verticals, Transportation would see continued growth momentum across sub-segments. Within Plant Engineering, a good set of opportunities would drive growth in the coming quarters. Industrial Products would be one of the fastest growing verticals this fiscal. Telecom and Hi-Tech was relatively soft, impacted by project delays in the Media sub-vertical. The management expects growth traction to improve in the coming quarters. The Medical Devices segment has a good pipeline that would help drive continued traction.

* The management has raised the revenue guidance to 19–20% YoY (v/s 15–17% earlier) for FY22.

* The company is seeing positive response from clients on CY22 budgets. However, there are concerns related to supply chain issues, labor shortages, and cost inflation.

* 3Q has some seasonal headwinds from furloughs, but the management expects broad-based growth to continue. Higher-than-normal furloughs, if any, would be customer-specific and not broad-based.

* The management has highlighted its long-term margin outlook of 18% by FY25. While the current margin performance is trending higher than 18%, the management sees certain headwinds from 1) the gradual increase in travel costs and facility expenses, 2) supply-side challenges and wage hikes, and 3) inorganic investments. Tailwinds to margins include a) revenue growth and the quality of the revenues, b) economies of scale, and c) productivity improvement. Within segments, there is further scope for margin improvement in the Telecom and HiTech vertical.

Valuation and view – industry-leading growth and operational metrics

* Digitization is driving accelerated spends in ER&D, and LTTS should benefit from this owing to its 1) strong capabilities, 2) multi-vertical presence, and 3) solid wallet share. We expect LTTS to deliver strong revenue growth over the coming years, and we retain it as our top pick in the Midcap IT Services space.

* The management has a strong medium-term outlook, implying growth momentum of ~20% over FY21–25E. We see this as an indication that there could also be a potential upside risk to its aspiration of USD1.5b in revenues by FY25.

* After a sharp dip in margins in FY21, LTTS has managed to clock all-time high margins. We expect this to sustain within a narrow band.

* Our TP of INR5,670 per share implies 47x FY23E EPS. We anticipate improved industry spends v/s the previous five years. We maintain a BUY rating.

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