Nomura initiates coverage on L&T Tech with a ‘reduce’ call, sees 15% downside; here's why

After around 25 percent decline in L&T Technology Services (LTTS) in the last 1 year, global brokerage house Nomura has initiated coverage on the stock with a ‘reduce’ call and a target price of ₹3,050, implying a downside of 15 percent. The brokerage firm has cited rich valuations as one of the main reasons behind the call.

LTTS leads in India’s pure play Engineering Research and Development (ER&D) space with: i) one of the most comprehensive sets of portfolios; ii) deep domain expertise across key verticals from internal/external investments; iii) an impressive set of clients across verticals (57 of top 100 global ER&D spenders); and iv) high digital revenue contribution (56 percent in FY22), however, in the near term, Nomura noted that it is watchful about LTTS' integration with Smart World & Communication (SWC), a business unit of Larsen and Toubro (L&T) and a slowdown in the ER&D industry.

SWC offers solutions in the areas of end-to-end communications, city surveillance, and intelligent traffic management systems for the government and enterprises. It reported revenue of ₹1,098 crore (17 percent of its revenue), 8-10 percent EBITDA margin, and 100 percent India revenue concentration in FY22, informed Nomura. The rationale for the acquisition was to enhance LTTS’s capabilities in the 5G network architecture and conceptualisation.

While the valuation of the acquisition at 0.7 times its sales and eight times its operating profit is not demanding, experts believe that its inferior client profile, low margins, and high working capital are key negatives. At 8-10 percent, SWC’s margins are much lower than LTTS’ 21.5 percent and, thus, will dilute the latter’s profitability profile, they said.

Nomura expects a 14 percent dollar revenue CAGR over FY22-25F (9 percent excluding SWC, vs 12.7 percent reported over FY17-22) with a 100 bp margin contraction, leading to a 15.2 percent EPS CAGR. “LTTS trades at 26.4x FY25F EPS, which we believe is expensive,” it noted.

Post the SWC acquisition, Axis Capital also downgraded the LTTS stock from ‘buy’ to ‘add’ and cut its target price by 11 percent. Nuvama Research, too, had a negative stance on the acquisition. It remains cautious on the entire sector in the near term due to the likely impact of a slowdown or recession in the US and EU on the discretionary spend-based ER&D business.

Nomura also believes that the macro slowdown will weigh on discretionary ER&D spend going ahead. While LTTS has an attractive portfolio, it will be tested during slowing macro and SWC integration, noted the brokerage.

"LTTS is India’s largest ER&D-focused player, with one of the most comprehensive sets of portfolio offerings. Its focus verticals include transportation, industrial products, telecom and hi-tech, plant engineering and medical devices. All verticals in FY22 contributed double-digit revenue to the company, with transportation at 32 percent (highest) and medical devices at 12 percent (lowest) revenue contribution," stated Nomura.

At the start of FY22, LTTS identified and announced six strategic targets to help define, guide and consolidate the company’s focus and investment avenues over the long term.

The six strategic growth areas include electric autonomous and connected vehicles, 5G, AI, digital manufacturing, MedTech, and sustainability. These six focus areas constitute LTTS’ long-term vision of defining the trends in the ER&D space, and will act as drivers for technology-led growth over the next decade, highlighted the brokerage.

It further pointed out that LTTS has over the years developed deep domain expertise across verticals through both internal and external investments. Acquisitions of Smart World Communications (SWC), Orchestra Technology, Graphene Semiconductor Services and Esencia Technologies have helped develop telecom, semiconductor and chip design and embedded software offerings, it added.

The brokerage expects LTTS to record a 14 percent USD revenue CAGR over FY22-25F vs a USD revenue CAGR of 12.7 percent reported over FY17-22.

"Our forecast builds in LTTS’ continued outperformance against its pure-play ER&D peer-set, with a leadership position, a comprehensive portfolio stack and digital engineering revenue contribution of 56 percent (as of FY22)," said the brokerage.

However, it also noted that LTTS’s FY21 EBIT margin (%) contracted 200bp YoY to 14.5 percent due to an industry-wide slowdown (COVID-19 induced) and weakness in top clients' performance, with its top 5 clients’ revenue contribution falling to 17 percent from 22 percent in FY20. The company's EBIT margin (%) in FY22 recorded a strong rebound to 18.3 percent with normalizing demand, but for FY24F, it expects margins to be under pressure given the margin-dilutive SWC acquisition and sees a gradual recovery in FY25F with a 17.3 percent EBIT margin.

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