Engineering R&D segment to outperform IT services players in FY23

Barring Cyient, valuations of most ER&D firms on the expensive side

A mixed January-March quarter (fourth quarter, or Q4) results of companies in engineering, research and development (ER&D) segment notwithstanding - at the heels of macro risks - the Street expects major players in the segment to maintain their growth outperformance, in comparison to their information technology (IT) peers in 2022-23 (FY23). Historically, the segment has been growing at a fast clip (400 basis points), as opposed to generic software services majors.   

Says Amit Chandra, associate vice-president, HDFC Securities, “The ER&D segment is expected to outperform IT services players (in line with historic trends), taking into consideration the size of the outsourcing opportunity. Further, premium valuations, keeping in view the growth differential, are also expected to remain.”

Analysts say only 6-8 per cent of the global ER&D spending is outsourced, in contrast with two-thirds for IT services. This proportion is likely to increase, bearing in mind the dearth of talent in Western markets, shorter product development cycles, and tendency to outsource what was earlier a core function of corporates. 

The ongoing trend is visible in the quarterly orders, deal pipeline, and management commentary by ER&D players in Q4 of 2021-22 (FY22).

L&T Technology Services (LTTS), whose Q4 revenue growth was below expectations, reported its best-ever quarter for deal wins - six of these were above $10 million; one over $120 million; the other over $25 million.

Tata Elxsi, which had the highest sequential growth at 7.4 per cent in constant currency terms across ER&D players in Q4, commented that the deal pipeline continues to be strong, and the current Russia-Ukraine offensive has not afflicted business or the deal momentum.

While Cyient won seven large deals, with a total contract potential of $134.9 million, KPIT Technologies reported deal wins of $125 million. Both companies beat analyst expectations on the revenue and margins fronts for the quarter. 

While most analysts believe the sector will see 14 per cent-plus growth rates over the next few years (even as the structural growth story remains intact), there are macroeconomic and margin pressures that could constrain growth projections for FY23. 

LTTS put out a ‘conservative’ revenue growth target for FY23 of 13.5-15.5 per cent after a 20 per cent-plus growth in FY22. Brokerages have a mixed take on the growth guidance. IIFL Research expects the company to record dollar revenue growth of 18.5 per cent in FY23 on the back of strong large-deal wins. While LTTS is trading at 29x its 2023-24 (FY24) earnings, which is at a 15 per cent premium to mid-cap IT services peers, the brokerage believes the premium is broadly in line with its historical average and is justified, making allowance for longer runway for outsourcing penetration by ER&D services. 

Aditi Patil, research analyst, Prabhudas Lilladher Research, however, believes the LTTS guidance may not be upgraded as was the case in FY22 when the company increased it from 13-15 per cent to 19-20 per cent. The brokerage has downgraded the stock to ‘accumulate’, given the expensive valuations (around 34x its FY24 earnings) against the backdrop of possible moderation in ER&D spending (more discretionary in nature). This is on account of a high inflationary environment, supply-chain issues, and global macro uncertainties. There is little scope for further margin expansion over FY23-24 due to higher manpower costs, return of travel costs, and investments for future growth.

After industry-leading growth in FY22, brokerages expect a strong FY23 showing for Tata Elxsi, galvanised by robust order intake and higher spending in digital engineering. ICICI Securities highlights that the company has superior operating metrics, weighed up against its peers, due to lowest cost of delivery, highest offshore mix, reducing client concentration, and superior client-mining wherewithal. While they like the company for its robust growth profile and maintenance of margin way above pre-Covid levels, valuation is the biggest hurdle for the stock. After a 14.6 per cent sprint on Friday, the stock is valued at 61x its FY24 earnings estimates.

Analysts are bullish on the prospects of KPIT. After a beat on profitability in back-to-back quarters, FY23 margin guidance of 18-19 per cent is the biggest positive, bearing in mind heightened cost pressures, according to PhillipCapital Research. Revenue growth guidance at 18-21, too, is strong.

“We continue to see KPIT as a long-term play on disruption in the automotive industry, led by autonomous, connected, electric, and shared mobility trends, leading to strong R&D spending,” say research analysts Karan Uppal and Vibhor Singhal of the firm. They are ‘neutral’ on the stock, considering the valuation of 37x its FY24 earnings estimates.  

The smallest of the ER&D firms by market capitalisation, Cyient has an ambitious 13-15 per cent revenue growth guidance for FY23. Prabhudas Lilladher Research believes the guidance is aggressive, giving thought to the semiconductor supply challenges that might crimp growth in the design-led manufacturing segment and lack of broad-based growth across verticals in the services segment. Most brokerages and analysts have a ‘buy’ rating, given the lower than 13x valuation on FY24 earnings estimates. Vishal Wagh, head of research at Bonanza Portfolio, believes Cyient is better placed to tap into growth opportunities and is available at lower valuations, compared to peers.