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FY23 growth levers intact, but margin can surprise on the upside

Demand environment continues to remain attractive

* LTTS reported a 4.2% QoQ CC growth in 3Q, 100bp below our estimate due to softer Industrial Products (+0.7% QoQ) and Medical Devices (+1.5% QoQ) on a high base of 2QFY22. Operating leverage aided the 20bp QoQ improvement in EBIT margin to 18.6% (In line), despite adding a record 2,135 net employees (+12%), lower utilization (-220bp) and on-site mix (+50bp). It reported an attrition of 17.5% (+100bp QoQ). USD revenue/INR EBIT/INR PAT grew 20%/59%/48% YoY in 9MFY22.

* The management maintained its 19-20% USD revenue growth guidance. It indicated that it is likely to be tilted towards the upper end. Moreover, this guidance includes a planned scale back in part of the company’s Media subvertical, where it will exit a few low margin accounts in 4QFY22. The management said the demand environment remains encouraging and the deal pipeline is healthy. Strong hiring with a record 2,135 net additions (+12% QoQ) provides further visibility on demand.

* LTTS can surprise on the upside (FY23 EBIT margin guidance of over 18%), given that it will gain from: a) a favorable pyramid, due to higher fresher addition (1,900 in 3QFY22); b) better than industry attrition, which is stabilizing ahead of our expectation; and c) pickup in margin in the Telecom vertical (~9pp gap v/s group margin). We expect LTTS to deliver a further 50bp margin improvement over the next two years from our FY22 estimate of 18.4%.

* We continue to view LTTS as a beneficiary of the growing penetration of ER&D Services and the best Tier II IT Services play within our coverage. We slightly lower our FY22E revenue growth estimate to 20% on account of a revenue miss, but continue to remain positive on FY23-24 growth. We have built in a 21%/24% USD revenue/INR EPS CAGR over FY22-24E.

* We lower our FY22-24E EPS estimate by 1-2% due to the 3QFY22 miss. We maintain our Buy rating and marginally tweak our TP to INR6,130 per share (43x FY24E EPS).

Revenue growth below our expectation in 3QFY22

* USD revenue grew 18.4% YoY (est. 19.6%), operating profit rose 44.7% (est. 46%), and PAT increased by 31% (est. 38%) in 3QFY22.

* Revenue rose 3.5% QoQ to USD225.1m (est. 5.2%) in 3QFY22. In constant currency, revenue rose 4.2% QoQ and 19.5% YoY.

* LTTS bagged three deals with a TCV of over USD10m in 3QFY22. This includes one deal of over USD45m.

* Revenue from Digital and leading-edge technologies stood at 56% in 3QFY22.

* Top five/10 clients grew 5.4%/4.6% QoQ. The top 20 clients registered softer growth of 2.8% QoQ.

* Telecom and Hi-Tech, Transportation, and Plant Engineering grew 5%, 4.9%, and 4.2% QoQ, respectively. Growth in Medical Devices and Industrial products were softer at 1% each.

* The management maintained its FY22 USD revenue growth guidance at 19-20%.

* EBIT margin improved by 20bp QoQ to 18.6% (in line with our estimate) in 3QFY22.

* The increase in margin was despite adding a record 2,135 net employees (+12% QoQ), lower utilization (-220bp QoQ), and a 50bp rise in the onsite mix.

* PAT rose 8% QoQ to INR2.5b, 5% below our estimate, due to lower growth and other income.

* Total employee strength stood at 20,118, a record net addition of 2,135 employees. Attrition was up 100bp sequentially to 17.5%.

* FCF stood at INR7.25b in 9MFY22, implying a FCF/PAT of 104%

Key highlights from the management commentary

* The company had two empanelments in 3QFY22. One was with a big technology company and the other was with an Aerospace OEM. The management sees a potential of USD50m in each empalement.

* Within Transportation, demand remains strong across all three sub-segments: Auto, Trucks, and Off-Highway Equipment. It saw one large deal of more than USD45m in the Auto vertical (ESEV) in 3QFY22. This was the third deal in the last three quarters from the same client (combined TCV of over USD90m). The deal pipeline in Auto is steadily improving. In this space, the management sees continued momentum in growth across sub-segments. It also highlighted that spend areas are picking up in Aerospace.

* Within Plant Engineering, growth was led by O&G, FMCG, and the Chemicals sub-segment. In FMCG, demand was driven by higher capex. The management sees a good set of opportunities in the verticals, which will drive growth in coming quarters.

* Though Industrial Products saw a soft quarter, it sees good demand in platform development and data analytics. The deal pipeline continues to remain strong.

* Telecom and Hi-Tech is seeing good traction in 5G. It is seeing huge spends around network and 7nm chips. In the Media sub-segment, margin will improve, but will remain muted in 4QFY22 as the company will not accept some legacy orders. This will result in a one-time impact, but there will be no impact in FY23.

* Within Medical Devices, the management is seeing good traction in robotic surgery and tele-medicine. The pipeline continues to improve.

* The management has maintained its FY22 revenue growth guidance at 19-20% YoY and said that it will cross the USD1b run-rate in 2Q/3QFY23.

* The management continued with its sustainable long-term margin guidance of over 18%. While its current margin performance is trending at over 18%, the management sees a few headwinds from: 1) a gradual increase in travel cost and facility expenses, 2) supply-side challenges and a wage hike, and 3) inorganic investments. Tailwinds to margin include: a) growth and the quality of revenue, b) economies of scale, and c) productivity improvements.

Valuation and view

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

* The management expects strong growth in the medium term, which implies a growth momentum of ~20% over FY21-25E. We view this as an indication that there can be potential upside risk to its USD1.5b revenue aspiration by FY25.

* After a sharp dip in margin in FY21, LTTS has managed to clock a record high margin. We expect it to sustain in a narrow band.

* Our TP of INR6,130 per share implies 43x FY24E EPS. We anticipate improved industry spends compared to the preceding five years. We maintain our BUY rating.

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