IPO REVIEW: Consider L&T Tech Services for long term

It’s been a little over a month since the listing of the Larsen and Toubro (L&T) group’s first information technology (IT) company, L&T Infotech. Since its listing on July 21, the stock has not done well. Partly as all IT stocks have taken a beating, on slowing demand concerns in the presence of headwinds such as Brexit (Britons voting to exit the European Union) and the US elections. Yet, the group has launched the initial public offering (IPO) of equity for its second IT company, L&T Technology Services (LTS).

While memories of L&T Infotech are fresh in the minds of investors, what stands in favour of LTS is its inherent strengths and a better business model. For one, as against a non-differentiated business model of L&T Infotech, this entity is focused purely on the engineering research and development (ER&D) services. This niche positioning means entry barriers are high and that this company could benefit a lot more directly from the L&T parentage than L&T Infotech.

It also has some marquee companies such as BMW, Caterpillar, John Deere, Intel, etc, as clients. As ER&D is a relatively under-penetrated market, with only five per cent of global ER&D spending being outsourced, entities such as LTS have enough growth opportunities. Its relatively lower exposure to the European Union (20 per cent of revenue) is another positive. However, a key concern is LTS’s over-dependence on its top five clients (23 per cent of revenue). The transportation and industrial segments together form 55 per cent of revenue and are key focus areas. It plans to focus on further ramping up its top 30 clients from the $10 million revenue bucket to the $50 million category and any success on this should help de-risk revenue.

While the company is a niche play on the ER&D space, there are others such as Cyient and Tata Elxsi which have a meaningful presence here. Cyient derives 65 per cent of revenue from this segment and has similar revenue as LTS. Cyient, too, has a strong client base, which includes Boeing, P&W, IBM and Airbus. However, its margins and return ratios are lower than of LTS. Although about 100 basis points (bps) of the 13 per cent net profit margin come from currency/hedging gains for LTS, forex gains for Cyient boosted net margins by a little over 150 bps in 2015-16.

Notably, LTS reported a healthy compounded annual revenue growth of 23 per cent over three years; operating  margin has also expanded. The high dividend payouts of over 80 per cent in the past two years have aided its return ratios. Its return on equity of 38 per cent is among the highest in the sector, thanks to the low cash on its books. At the IPO press meet, though, as the management said it would formulate a proper dividend payout policy and keep aside enough funds to fuel future growth, more clarity would have helped. However, since the issue is an offer for sale by the parent, no funds will flow into LTS.

While LTS’ business model is better, at the price band of Rs  850 to Rs  860, the valuations appear full. “Cyient currently trades at 13 times the FY18 estimated earnings, as compared to the asking valuation of 16 times for L&T Technology Services. Essentially, LTS, with the same revenue base in the same segment, is seeking 1.5 times the market-cap,” says Vibhor Singhal, analyst at PhillipCapital. The high valuations could cap near-term upsides for the stock.