L&T Technology Services Limited (LTTS) is a global leader in Engineering and research & development (ER&D) services, owned by Larsen and Toubro (L&T). LTTS has its dominant position in key segments such as transportation, telecommunication, industrial products, plant engineering and medical devices.
LTTS stands differentiated from other traditional and large IT players in its area of focus. While most IT majors gain significant revenue from service verticals such as BFSI, healthcare and retail, LTTS is a ER&D services focused player and derives revenue from segments such as transportation, telecom, industrial products and medical devices, to name a few. The growth in these segments is currently led by key trends such as Industry 4.0, intelligent mobility (connected and autonomous), digital healthcare, and sustainability.
The accelerated investment that the world is witnessing (capex, industrial and digital solutions boom) post Covid in these areas makes LTTS a candidate worthy of choosing at this point of time.
Detailed reasoning
#1 An ER&D services company focusing on high growth opportunities
LTTS is a global leader in ER&D services with dominant position in key verticals such as transportation, telecommunication, industrial products, plant engineering and medical devices. It has 57 of the Global Top 100 ER&D spenders as its clients. Unlike other IT services, this is a segment that require specific skill sets and carries the advantage of long-term client stickiness. Its employee strength comprises of 20,000 engineers spread across 110 innovation and R&D centres globally.
LTTS derives majority of its revenues from North America (62.5%) followed by Europe (16.5%), India (13.6%) and remaining from rest of the world. Transportation is by far its largest vertical contributing to 32% of revenues followed by telecom and hi-tech at 21%, Industrial products at 19%, plant engineering at 15% and medical devices at 12% of its revenues in FY22. The company is seeing traction across these verticals whereas transportation, telecom and hi-tech are seeing accelerated growth with the adoption of EV, 5G and AI.
While the global ER&D market is expected to grow from $1.5 trillion to $2.6 trillion between FY20 & FY26, LTTS’s addressable market within this is expected to grow from $86 billion to $128 billion during this period. Though the addressable market growth appears modest, the digital ER&D spend within that (35%) is expected to grow at 19%, outpacing the legacy ER&D spending growth of just 2% by a huge margin. Digital ER&D spends is expected to grow from 35% of total ER&D spends to 59% by FY26 and this represents bulk of the growth opportunity for LTTS.
#2 Focused approach with identification of 6 drivers of growth
As the worldwide prospects for the ER&D industry is on an upward trajectory, LTTS has identified 6 areas, within its core verticals, that will act as key drivers of growth over the next decade. These are – Electric autonomous and connected vehicles (EACV), 5G, AI, digital manufacturing, med-tech, and sustainability.
LTTS has seen significant traction and deal wins in the EACV space in the last 2 years. These include a $ 45 million engagement with a leading US-based EV major, and a $ 100 million project with an air mobility services provider. It has also recently won a 5-year, multi-million-dollar deal, from BMW Group to provide engineering services for its suite of infotainment consoles targeted for its family of hybrid vehicles.
With the worldwide acceleration of 5G rollouts, LTTS is well-poised to leverage its chip-to-cloud capabilities to play a leading role in driving the adoption of 5G private networks. AI on 5G has emerged as major area of focus, with the company driving the next-gen integrations in collaboration with two of the leading global companies active in the domain. It has collaborated with Qualcomm to deploy end-to-end solutions for the global 5G Private Network Industry utilizing their combined core expertise in the Hi-Tech & Telecommunication domain. With AI already transforming the global business landscape, combining it with the power of 5G networks will enable robust use cases in a quick, secure, and cost-effective manner.
There is also rapid acceleration in global demand for digital manufacturing technologies in the post pandemic scenario where businesses are refocusing on driving industrial automation, value engineering, and frugal manufacturing. LTTS is leveraging its digital manufacturing expertise to drive the projected $300 million greenfield expansion in Europe for a US-based agribusiness and food company, which is a testimony to its capabilities in this space. Another area that is getting increased attention in the post pandemic world is MedTech where LTTS is leveraging its domain capabilities across digital-driven solutions and software, its deep understanding of the stringent global regulatory frameworks, and its new product design capabilities – to deliver next-gen MedTech solutions.
#3 Size, scale and balance sheet strength to help win large deals
The IT services business of L&T Group comprising LTI Mindtree and LTTS has become the 5th largest in IT services by revenue and market value with the integration of Mindtree with LTI. But LTTS will remain a separate entity, as confirmed by the management. Its specific focus, as a provider of ER&D services clearly differentiates it from LTI Mindtree in terms of key segments in which they operate. The large size of the IT business as a whole for the L&T group may also help LTTS in winning large deals going forward. This apart, LTTS also has a healthy balance sheet that is cash rich.
#4 Healthy track record of growth and profitability
LTTS was carved out of parent L&T and listed in September 2016. In the last 6 years since then, the company has grown its revenue and profits at a CAGR of 14% and 15% respectively combined with healthy cash flows and return ratios. While this may appear to be a normal growth, there has been a tilt in the growth rates post Covid with FY22 growth coming at 18% and heading for similar growth in FY23. Considering the accelerated spending in the key segments that LTTS is catering to, and also the deal wins in FY22, it may continue to grow at these rates going forward compared with the 14-15% growth in the 6 years post its IPO.
Risks to the recommendation
#1 Considerable slowdown in US and Europe
A recession in US is not good news for Indian IT services industry as companies may slow down spends in the early phases of a recession. As companies witnessed accelerated spends in the aftermath of Covid, a prolonged slowdown in spends cannot not be ruled out. At the same time, comments from large IT players that segments like manufacturing are doing well and compensating for slowdown in BFSI merits giving attention to a player like LTTS. This apart, the Dow Jones industrial average index is also seeing industrial companies doing well in the US market despite a slump in technology shares. These suggest that LTTS may be more immune in the event of a slowdown.
#2 Acquisition of the parent’s business segment may cap margin expansion
On January 12th 2023 LTTS announced that it plans to acquire the Smart World & Communication (SWC) Business of L&T. LTTS believes that this acquisition will enable it to combine synergies and take offerings in Next-Gen Communications, Sustainable Spaces and Cybersecurity to the global market and win and execute large scale transformational programs in India and globally in the 5G space. It is eyeing 65 % of SWC’s revenues in the coming years from international operations (from the current 35%) in the coming years while lifting its margin profile to match that of LTTS.
The acquired company has an annual revenue of INR 1,000 Crores while the EBIDTA margin profile is sharply lower than LTTS at 8-10%. It also has higher receivable days. This caused the street to worry about the margins and the quality of acquisition. The management has guided an overall impact of 1.8-2% on EBIT margins from Q1FY24, upon consolidation of this acquisition, and expects to restore margin gradually in the next 8 quarters, by Q1FY26.
We think this concern may fade away if the industry doesn’t face significant headwinds and LTTS is eventually able to leverage the acquisition to its fullest. Still, any growth disappointment in the existing business of LTTS will accentuate the margin impact on earnings and may lead to some de-rating in the near term.
Valuation
At the times of this call, the stock traded at 31 times trailing earnings; lower than the mid-cap IT average PE of 37 comprising LTTS, Persistent, Tata Elxsi, Coforge, Mphasis, Oracle and KPIT. At the same time, it is still expensive compared with its own historical average of 25 times pre-Covid.
While a further 10% correction may make it attractive, we believe this valuation is not too stretched considering the higher growth rates post Covid and the possibility of that continuing going forward.
Suitability
This recommendation is suitable for long term investors with moderate risk appetite.
Disclosures and Disclaimers
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