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Double-digit growth in Services to drive re-rating

Valuations inexpensive; maintain Buy

* Cyient (CYL)’s 1QFY22 revenue de-grew 4% QoQ in USD terms (in line with our estimate). This was led by 20% QoQ decline in the DLM business (on negative seasonality) and a flattish performance in the Services business. The USD3m impact during the quarter was attributable to supply-led issues. The management retained its guidance for double-digit growth in the Services business and 20% YoY growth in the DLM business in FY22.

* Within the Services business, growth in Utilities (4.4% QoQ), Aerospace (2% QoQ), and Communications (2% QoQ) was offset by decline in Rail Transportation (2.5% QoQ).

* The EBIT margin increased 50bp QoQ to 13.1% (the highest in the past six years), led by Services (+100bp QoQ to 14.6%), despite a 180bp impact from wage hikes. Lower SG&A expenses (+180bps) and better operating metrics (+90bps) led to an increase in margins. Margins for DLM fell 290bp QoQ due to negative operating leverage.

* Strong demand in ER&D, Services order intake, and the bottoming out of the Aerospace business (32% of revenue) gives us confidence in its FY22 guidance for double-digit USD revenue growth in Services (our est: 10.1% YoY), albeit on a low base. We expect strong growth over the next quarter, led by deal ramp-ups and a better demand-supply confluence.

* The margin improvement story should continue in FY22, with a 300bp YoY increase from the FY21 EBIT margin of 10.1% – as a strong showing in the Services business would aid overall profitability due to the segment’s higher margins. We expect the management to revise up their current guidance of a 200bp YoY margin improvement.

* We see increasing spends in the ER&D industry and CYL’s strategy to digest these spends as a supporting factor in the near-to-medium term.

* We raise our estimates on better potential margin performance as the management increases its intake of freshers as well as benefits from operating leverage. We maintain our Buy rating on attractive valuations. Our target multiple of 20x FY23E EPS takes our TP to INR1,090/share, implying an upside of 15%.

Largely in-line results; DLM business a drag

* Revenue was up 10% YoY (in-line) to USD144m, EBIT was up 172% YoY to INR1,388m (est: INR1,327m; 160% YoY), and PAT was up 41% YoY to INR1,150m (est: INR 1,075m; +32% YoY).

* Revenue de-grew 4% QoQ USD, in line with our expectation. In CC terms, revenue de-grew 4.3% QoQ CC.

* Services revenue at USD119.3m was flat QoQ and up 6.3% YoY.

* DLM revenue at USD24.2m was down 20% QoQ and up 31.7% YoY.

* Order intake for the quarter grew 20% YoY to USD140.3m. CYL won four large deals with TCV of USD46m (three in Services and one in DLM)

* Within the Services business, growth came from Utilities (4.4% QoQ), Aerospace (2% QoQ), and Communications (2% QoQ). This was offset by decline in Rail transportation (2.5% QoQ). The drag from the DLM business led to de-growth in overall business revenues.

* The consolidated EBIT margin was up 50bps QoQ to 13.1% – the highest ever reported by the company in the last six years.

* The Services margin improved sequentially by 100bps to 14.6%, while the DLM margin declined to 5.9% (v/s 8.8% in 4QFY21).

* QoQ margin improvement was driven by improved operational metrics (93bps) and lower SG&A spends (176bps), partly offset by merit increase (176bps).

* PAT at INR1,150m (+4% QoQ) was a 7% beat on our estimate of INR1,075m, led by higher-than-expected margins and other income.

* FCF generation for the quarter stood at INR848m – a conversion of 43.6% on EBITDA (conversion of 73.7% on PAT). FCF was lower due to lower collections and higher capex.

* The management continues to expect double-digit growth in the Services business in FY22, with growth returning from 2Q; DLM, on the other hand, should grow ~20% YoY.  FY22 margins are expected to improve 200bps.

Key highlights from management commentary

* CYL reported flattish growth in the Services business, while DLM posted decline due to seasonality in the quarter. The Services business was impacted by supplyside issues (loss of USD3m in revenues).

* Order intake grew 20% during the quarter, which gives the management the confidence that demand is robust.

* The Services business is expected to grow in the double digits for FY22.

* Strong high-single-digit growth may be expected in 2Q. The major heavy lifting would be seen in 2Q, while 3Q would be less challenging this year owing to more offshoring.

* Margins are expected to increase 200bps YoY for the full year. For 2QFY22, despite the impact of wage hikes (50–60bps), the management alluded that margins are unlikely to dip.

Valuation and view – maintain Buy

* Given the COVID situation, ER&D activity in key verticals (e.g., Aerospace and Defense, Transportation, and Semiconductors) saw material slowdown last year.

* However, spends in Communications and Energy and Utilities have started to pick up, while stressed verticals are on the verge of bottoming out.

* We expect a rebound in ER&D spending. The management strategy to leverage these spends – led by a refreshed GTM strategy and a higher focus on large deal wins – should augur well in terms of growth performance. We expect CYL to deliver a 15% revenue CAGR over FY21–23E.

* This, along with the sustainability of higher margins in the DLM business, should lead to a 31% EBIT CAGR over FY21–23E.

* We raise our estimates on better potential margin performance as the management increases its intake of freshers as well as benefits from operating leverage. We maintain our Buy rating on attractive valuations. Our target multiple of 20x FY23E EPS takes our TP to INR1,090/share, implying an upside of 15%.

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