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With the recent spate of results/outlook from large-cap and mid-cap IT services companies indicating a greater than anticipated slowdown in business for FY24, many companies in the sector still do not offer sufficient margins of safety, despite the correction in stocks from peak levels.
Further, as we had pointed out in our ‘Big Story’ in bl.portfolio edition dated April 23, 2023, investors need to assess current valuations against average valuations in pre-Covid years as growth prospects taper down to what was witnessed in that period.
Based on this, we are adding L&T Technology Services (LTTS) to our list of stocks to avoid for now, in the sector. While the company’s past performance has been quite good and long-term fundamentals are attractive, the valuation is not. Trading at a one-year forward PE of 31 times, the valuation is expensive, given expected growth is only average and not high.
Current consensus (Bloomberg) expectations are for the company to deliver FY23-25 earnings CAGR of 12-13 per cent. Assessing this in the backdrop of looming global economic slowdown, which can cause greater than anticipated disruptions in client technology spends, the scope for downgrades to this earnings expectation is high. This makes the risk-reward unfavourable at current levels.
On a trailing basis, the stock trades at a PE of 34 times. That’s a 48 per cent premium to its pre-Covid average valuation (from IPO in 2017 to February 2020) of 23 times. Given growth in pre-Covid years too was quite good and even better versus recent years, current valuations appear more of a hangover of the easy money policies of the pandemic years, and thus are likely to continue on the downward trend.
This is a valuation call. Given good execution track record of the company and long-term prospects for its business, the stock can be considered at more attractive valuations in the future.
Business
LTTS is a global pure-play engineering research and development (ER&D) services company. ER&D is a sub set of the broader IT services and consulting space and can be considered to be more specialised and niche.
ER&D companies provide services to manufacturing, technology, and process engineering companies to help them develop and build products, processes and infrastructure required to deliver products and services to their end customers. ER&D companies work closely with clients across the product development chain and reduce time to market as well as costs for client’s end products and services.
LTTS provides these services across five verticals – Transportation (35 per cent of revenue), Industrial Products (19 per cent), Telecom & Hi-tech (19 per cent), Plant Engineering (16 per cent) and Medical Devices (11 per cent). In terms of geographic exposure, North America accounts for 62 per cent of revenues, while Europe, India and rest of the world account for 16, 14 and 8 per cent respectively.
In recent years, the company has seen broad-based growth as different structural themes have been driving demand across verticals – CASE (connected autonomous,shared,electric) in Transportation; digital manufacturing and green energy in Industrial Products, digital care solutions in Medical etc. For FY23, though, Transportation was a distinct outperformer with 21.6 per cent growth versus other verticals growing in the 2-16 per cent range.
Not immune to slowdown
The themes driving business prospects are structural and likely to sustain for many years from now. To that extent, the growth for ER&D companies will continue to be higher than the broader IT services space. However, they are not immune to the current slowdown
This is already reflected in the outlook of LTTS for FY24. After delivering constant currency (CC) revenue growth of 15.8 per cent in FY23, the company has guided for CC growth (excluding impact of acquisitions) at a much lower 10 per cent plus for FY24. Large-sized deals won in FY23 were also lower Y-o-Y, reflecting client caution.
Further, some of the verticals can be more cyclical and the impact to ER&D players can be felt with delayed effect. For example, results of ER&D companies reported so far indicate spending by auto OEMs in transportation vertical remain robust.
However, automotive is a notoriously cyclical industry that goes through more pain than many other sectors during downturns. Thus, the probability that the current slowdown will not impact spending of auto OEMs in transformational projects at some point in time during this slowdown, is low. It may be a question of ‘when’ and not ‘if’.
Another risk that LTTS may have to contend with is how aggressive the large-cap IT companies are going to get in the ER&D space to increase their deal wins.
They too have a strong presence in this space and as they try for offsets to the deceleration in their business and clients look to consolidate vendors to save costs, mid-cap players can get impacted. While LLTS is well-positioned to ride through the uncertainties, the risks are not priced in at all at current valuations and the stock offers no margin of safety.
A recent thing to note is the settlement that LTTS entered into with the US Department of Justice, a few weeks back. The company paid $10 million, settling allegations relating to US visa rule violations during 2014-19. This may have some temporary minor impact on business prospects.
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