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Buy Cyient Ltd For Target Rs.660

Re-rating likely on better margin profile and lack of A&D drag

Inexpensive valuation – Upgrade to Buy

* CYL’s 3QFY21 revenue growth at 4.7% QoQ in USD terms (v/s our estimate of 3%) was led by a 24.8% increase in DLM and 1% (flat organically) increase in the Services business. The management expects growth in 4QFY21 to touch 4QFY20 levels, along with a QoQ margin improvement. It feels its troubled Aerospace & Defense vertical has bottomed out.

* More surprising was the margin performance, as EBIT margin increased 20bp to 11.2%, despite a 190bp impact from wage hike and furloughs. This was led by 600bp sequential improvement in DLM margin (fresh high) to 10.6%, driven by a better revenue mix. The EBIT margin for Services stood at 11.3%, a sequential decline of 90bp.

* CYL’s 3Q growth and 4QFY21 guidance (5% QoQ growth) implies a return to double-digit growth in FY22 (we estimate 14.5% YoY) although on a low base. A bottoming out of the Aerospace business (20% of revenue) should remove a big growth drag. A sales strategy rejig and new incentives (2m shares as ESOPs for senior employees) boosts our confidence on a recovery in revenue growth.

* We were surprised by the massive increase in DLM margin (up 2.2x QoQ), which the management expects to sustain on account of project mix and supply chain optimization. A double-digit margin profile in a segment contributing 20% to revenue would be welcomed by investors and help move the FY22E consolidated EBIT margin to 12.2% (+230bp YoY).

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

* Supported by a better-than-expected revenue and margin outlook, we upgrade our FY21E/FY22E/FY23E EPS estimate by 4.5%/14.2%/6.5%. We also upgrade our rating to Buy on attractive valuation, giving a target multiple of 14x to FY23E EPS (~10% premium to its five-year median multiple), taking our TP to INR660/share, implying an upside of 30%.

Surprises with a sharp margin recovery

* Revenue grew 4.7% QoQ in USD terms v/s our estimate of 3% growth. In CC terms, revenue grew 4.1% QoQ, but declined 10.4% YoY.

* Services revenue increased 1% QoQ to USD115.3m (0.3% in CC). IGP contributed 1.2% to growth in Services revenue. Organically, Services remained flat.

* DLM revenue grew 24.8% QoQ and 72.4% YoY to USD26m.

* CYL won a five multi-year deals with a TCV of USD106m.

* In the Services business, growth was driven by Communications (+5.2% QoQ) and Energy and Utilities (+13.9% QoQ). All other verticals saw a decline. Aerospace and Defense fell the most at -5.7% QoQ (-35% YoY).

* Consolidated EBIT margin stood at 11.2%, up 20bp QoQ and 150bp YoY. This was despite a 100bp/90bp impact from the wage hike/furloughs.

* Increase in margin was led by 600bp sequential improvement in DLM margin, which stood at 10.6%, driven by a better revenue mix. The EBIT margin for Services stood at 11.3%, a QoQ decline of 90bp.

* PAT rose 13.7% QoQ to INR954m, 7% beat to our estimate of INR892m.

* FCF-to-EBITDA conversion in 3QFY21 stood at 85.8%. In FY21 YTD, FCF is highest ever at INR5.7b, up by 119% YoY.

Key highlights from the management commentary

* The DLM business witnessed strong growth during 3QFY21. Some seasonality is expected going forward, but CYL is trying to increase annuity-based revenue to enable better productivity in the business.

* Aerospace and Defense is still lagging. However, traction has picked up in the sector and spends should start coming in now.

* The management continues to see momentum in Communications. It stated that Transportation was soft due to end of a project and expects some pain in the vertical over the next few quarters.

* CYL raised wages for two-third of its associates. This had a 100bp impact on margin. The latter was also impacted by 90bp due to furloughs during 3QFY21.

* The management guided that FY21 will see a double-digit decline (close to 10%). This is taking into account the recovery in 4QFY21 and sequential growth in the services business, except Aerospace and Defense.

* Margin in FY21 is expected to be better than FY20 (50-100bp) and 4Q would see a 100-200bp improvement in margin.

* The company introduced a new ESOP scheme to align the interests of shareholders and employees.

* A trust has been created which would acquire two million shares. The management stated that there would be no dilution. The employees would be granted shares at face value and vesting would happen based on their performance and only when the employee/company achieves certain targets.

Valuation and view – Upgrade to Buy

* Given the COVID-19 situation, ER&D activity in key verticals (e.g., Aerospace & Defense, Transportation, and Semiconductors) witnessed a material slowdown in the past nine months.

* However, spends in verticals like Communication and Energy and Utilities have started picking up, while stressed verticals are on the verge of bottoming out.

* We expect a rebound in ER&D spending. The management’s strategy to leverage these spends, led by a refreshed GTM strategy and increased focus on large deal wins, should dwell well with its growth performance. We expect CYL to deliver 12% revenue CAGR over FY21-23E.

* This, along with the sustainability of higher margin in the DLM business, should lead to a 23.4% EBIT CAGR over FY21-23E.

* Supported by a better-than-expected revenue and margin outlook, we upgrade our FY21E/FY22E/FY23E EPS estimate by 4.5%/14.2%/6.5%. Our target price of INR660/share is based on 14x FY23E EPS (10% premium to its five-year median multiple), implying an upside of 30%. Upgrade to Buy.

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