At BL Portfolio, we have been cautious on the valuation of Tier-2 and small/mid-cap IT services companies since second half of last year following significant run-up in the shares of companies in this group. The companies were trading at significant premium to both their historical valuations and at a good premium to Tier-1 IT services companies that had substantially better margins and wider scale and scope compared to these companies. Traditionally, these companies had traded at a discount to Tier-1 companies. Although these companies too were benefiting from the digitisation trend and in some cases were seeing accelerated growth that was even better than that of Tier-1 companies, extrapolating this for the long-term and assigning a significant premium appeared unwarranted and continues to remain so. Some of our book profit calls in companies such as Happiest Minds and Route Mobile have played out well with stocks correcting post our recommendation. Both are down by around 15 per cent since book profit recommendation. The Nifty 50, is up around 12 per cent during the same period. Some are yet to play out – Mindtree, Coforge and Persistent Systems, which are up 20, 2 and 10 per cent, respectively, versus Nifty 50 being flattish to up by 2 per cent during the corresponding time periods since these calls. We, however, expect these too to play out going forward as multiple compression plays out in 2022 - given the macro headwinds from monetary tightening and potential risks to global growth if inflation in developed economies persists longer than expected. With IT services being primarily an export-driven business dependent on developed economies for growth, they are more exposed to this risk and current valuations leave no scope for business risks.
For the same reasons mentioned above, investors can also book profits in the stock of L&T Infotech (LTI), which is currently trading at a pricey 47 times one year forward EPS (Bloomberg consensus), which is a 116 per cent premium to its 5-year average and 60 per cent premium to its 2-year average. On a absolute basis also, its PE is expensive when considering its FY21-23 revenue and earnings CAGR of 23 and 19 per cent, respectively. At 47 times, its earnings yield of 2 per cent appears a big price to pay even after factoring growth prospects, when risk-free 10 year government bonds are yielding 6.5 per cent today. Its EBITDA margins which are expected at around 20 per cent in FY23 also are much lower than that of Tier 1 companies (Infosys and TCS at around 27-28 per cent). When competition intensifies or a demand slowdown materialises, companies with lower margins are at higher risk.
LTI is the 6th largest Indian IT services company with a successful long-term execution track record and well positioned to scale up to the Tier-1 category in the current decade (currently TCS, Infosys, Wipro and HCL Tech are viewed as Tier-1). Its promoter Larsen and Toubro currently holds a 74.1 per cent stake in the company.
LTI has capitalised well on the digitisation trends over the last few years, which has got further impetus post the impact of Covid-19. More than 40 per cent of its service offerings are in new-age areas of cloud, data and digital which can help drive company revenue growth at above-industry growth rates over next few years. The company has been aggressively investing in the cloud technology space and has partnerships with all leading cloud companies.
Heavy reliance on the BFSI (banking, financial services and insurance) vertical versus peers may be a risk to watch out for though, in case of a slowdown in global economy. The segment accounts for around 45 per cent of revenue (around 30 per cent for TCS, Infosys, Wipro; and 20 per cent for the other L&T IT services subsidiary – Mindtree). Balance revenue is mainly split between manufacturing (16 per cent), energy and utilities (10), CPG-retail-pharma (11) and high-tech-media-entertainment (11). In terms of geographic exposure, North America accounts for around 67 per cent of revenues and Europe 16 per cent. The company recently achieved a milestone in Q2 FY22 when it crossed the $2 billion annual revenue run rate.
In FY21, LTI posted USD revenue growth of 9.5 per cent versus 13 per cent in FY20. The lower growth was due to the initial disruptions of the pandemic in the early quarters of FY21. In FY22, growth is expected to be much stronger at around 24 per cent. In INR terms, it reported revenue of ₹12,369 crore in FY21, growth of 13.7 per cent. The company’s EBIT of ₹2,392 crore was up 36 per cent and EBIT margins improved to 19.3 per cent. The higher earnings growth, however, has some one-offs as many mid-tier IT services companies saw margins boost in FY21 driven by lower manpower costs/differing wage hikes, and lower travelling and marketing expenses. For LTI, analyst expectations are for EBIT margins to decline to below 18 per cent in FY22 and stay at around 18 per cent in FY23, as some of the curtailed costs bounce back. This, however, is still an improvement over its FY20 EBIT margins of 16.1 per cent.
For FY21-23, LTI is expected to post revenue, EBIT and net profit CAGR of around 23, 19 and 19 per cent, respectively.
Thus, while the company’s business fundamentals and financials are robust, these appear to be more than adequately factored at current levels. Risk of multiple compression is high as interest rates track upwards in 2022. Even if growth pans out exactly as expected, multiple compression can offset its benefits resulting in underwhelming returns from current price levels. Risks to growth from any of the macro economic headwinds materialising also needs bearing. Hence, investors can book profits now and consider re-entering post correction.
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