Buy L&T Technology Services Ltd For Target Rs.2,830 - Motilal Oswal
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Play on ER&D’s growing Digitization
Unique position aided by a diversified portfolio and marquee clients
* As one of the largest pure play R&D outsourcing vendors out of India, we see L&T Technology Services (LTTS) as a key beneficiary of growing tech adoption across R&D and new product development. More importantly, with Digital revenue share of ~50%, it would benefit from high double-digit growth in global Digital ER&D spend (18% CAGR over 2018-23E).
* LTTS has one of the most diversified business mix within its peer group, with low client concentration (top five client revenue share at 16% in 3Q FY21) and five large verticals with over 10% revenue contribution. This, in our view, offers greater resiliency to its business from industry seasonality, which is the biggest structural issue with companies in the ER&D industry.
* While the company will deliver largely flat growth over FY19-21E (1% revenue CAGR) due to COVID-19 and ramp down at key clients (partly due to external issues), we expect a strong growth rebound (19% CAGR over FY21-23E).
* We remain confident of LTTS ability to delivery mid-to-high double digit growth over the medium term, aided by robust growth in global ER&D spends (7% CAGR) over 2018-23E (~2x of growth in IT service spends - Exhibit 8 and 9) due to the growing criticality of Digital in new product development.
* Improving operating leverage, growing appetite for offshore delivery, and higher employee utilization should drive 290bp EBIT margin expansion YoY from FY21E to 17.4% in FY22E.
* We initiate coverage on LTTS with a Buy rating and target price of INR2,830, based on 26x FY23E EPS, c5% premium to our target multiple for L&T Infotech. We believe that the structurally superior industry growth outlook and higher earnings growth (30% over FY21-23E) justifies LTTS’ premium multiples.
Incremental ER&D dollars now driven by Digital spends
* With growing technology integration in R&D, there is a meaningful shift towards embedded engineering. A large portion of this technology spend is now moving towards Digital.
* This increased focus on Digital integration would lead to a greater share of ER&D spend to 40% (USD667b) by 2023 from ~25% (USD293b). This would result in overall ER&D investments growing at 7% CAGR over 2018-23E, more than double the pace seen in the previous five-year period. We see this trend as a key positive for LTTS, which now generates ~50% of revenue from Digital and new technologies.
* We also expect a trained talent shortage in developed economies to continue to drive opportunities in the engineering talent-rich Indian market.
ER&D to grow at a faster pace than IT Services
* While the IT and ER&D services industry have broadly similar sizes, industry data from Gartner and Zinnov indicate a much faster growth (~2x of IT Services) in the ER&D industry over 2018-23E due to high double digit growth in Digital.
* We also see a relatively smaller penetration of ER&D outsourcing as an opportunity for specialists like LTTS to grow faster over a longer period. As per Nasscom estimates, penetration in the ER&D outsourcing industry is currently ~12% of overall business ER&D spends. It should more than double by 2025 to capture 19% share of spends.
* Despite this massive growth, ER&D penetration will still be meaningfully smaller than overall IT Services spend. This implies a much longer runway for the industry to deliver strong growth compared to the IT Services industry.
Unique positioning, strong competitive advantages
* Unlike IT Services, growth in ER&D services is more volatile, given its sensitivity to growth/investment cycles of end-verticals. Accordingly, vertical diversification is a key competitive advantage for ER&D companies to better absorb the sharp cyclical downturns in any vertical.
* LTTS has consistently delivered strong growth in Digital offerings, which now contribute ~50% of its total revenue. The company has developed solutions in all five key verticals, which has helped position itself well in front of clients.
Expect a strong growth rebound
* While the company will deliver largely flat growth over FY19-21E (1% revenue CAGR) due to COVID-19 and ramp down at key clients (partly due to external issues), we expect a strong growth rebound (19% CAGR over FY21-23E).
* After a sharp 200bp dip in margin in FY21E due to COVID-19 led impact, the company should be more than able to recover margin over the next two years due to favorable operating leverage, leading to 30% earnings CAGR of FY21-23E.
* Since the company’s listing in Sep’16, the P/E multiple (one-year blended forward) has averaged to c21x. Our TP of INR2,830 implies 26x FY23E EPS, c5% premium to our target multiple for L&T Infotech on better industry & company growth. We also anticipate improved industry spend environment compared to previous five years. We, thus, initiate coverage with a Buy rating.
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