At BL Portfolio, we have been cautious on valuations of Tier-II and small/mid-cap IT services companies since the second half of last year following a significant increase in the shares of companies in this group. The companies were trading at a significant premium to both their historical valuations and at a good premium to Tier-1 IT services companies, which had much better margins and wider scale and scope than these companies. Traditionally, these companies traded at a discount to Tier-1 companies. Although these companies were also benefiting from the digitization trend and were witnessing accelerated growth in some cases that was even better than Tier-1 companies, it would seem unfair to extrapolate this over the long term and assign a significant premium. It is and remains so. Some of our book profit calls in companies like Happiest Minds and Root Mobile have done well with the stocks correcting following our recommendation. Both have fallen by around 15 per cent since the book profit recommendation. The Nifty 50 has gained around 12 per cent during the same period. Some are yet to play – Mindtree, Coforge and Persistent Systems, which are up 20, 2 and 10 per cent respectively, while the Nifty 50 is flat since these calls by 2 per cent during the same time period. However, we expect these to continue further as many compressions will come into play in 2022 – given the macro headwinds from monetary tightness and potential risks to global growth if inflation in developed economies persists longer than expected. Since IT services are export-driven businesses primarily dependent on developed economies for growth, they are more vulnerable to this risk and the current assessment leaves no scope for business risks.
For the reasons stated above, investors can also book profits in L&T Infotech (LTI) stock, which is currently trading at 47 times the one-year EPS (Bloomberg consensus) price, which is higher than its 5%. 116 percent premium. Average of one year plus 60% premium over its 2 year average. Even on an absolute basis, its PE is costlier when considering its FY2011-23 revenue and earnings at a CAGR of 23 and 19 per cent. At 47 times, an earnings yield of 2 per cent appears to be a big price to pay even considering growth prospects, when risk-free 10-year government bonds are yielding 6.5 per cent today. Its EBITDA margin is expected to be around 20 per cent in FY13, much lower than that of Tier 1 companies (about 27-28 per cent of Infosys and TCS). When competition intensifies or demand declines, companies with lower margins are at greater risk.
business strong
LTI is the 6th largest Indian IT services company with a successful long-term performance track record and is well positioned to reach the Tier-1 category in the current decade (currently TCS, Infosys, Wipro and HCL Tech are ranked as Tier-1). Its promoters Larsen & Toubro currently hold 74.1 per cent stake in the company.
LTI has well capitalized on the trend of digitization over the years, which has got further impetus after the impact of COVID-19. More than 40 percent of its service offerings are in the new-age cloud, data and digital sectors that could help drive the company’s revenue growth at a rate above the industry for the next few years. The company is investing aggressively in the cloud technology space and partnering with all major cloud companies.
In case of a slowdown in the global economy, heavy reliance on BFSI (Banking, Financial Services and Insurance) verticals versus peers can be a risk. This segment accounts for about 45 per cent of the revenue (about 30 per cent for TCS, Infosys, Wipro and 20 per cent for other L&T IT services subsidiaries – Mindtree). The remaining revenue is primarily split between manufacturing (16 percent), energy and utilities (10), CPG-retail-pharma (11) and high-tech-media-entertainment (11). In terms of geographic exposure, North America accounts for about 67 percent of revenue and Europe 16 percent. The company recently achieved a milestone in Q2 FY22 when it crossed the $2 billion annual revenue run rate.
financial situation
In FY21, LTI registered USD revenue growth of 9.5 per cent versus 13 per cent in FY20. The early quarters of FY11 saw lower growth due to the early disruptions of the pandemic. In FY22, the growth rate is expected to be stronger at around 24 per cent. In INR terms, it registered a revenue of ₹12,369 crore in FY21, a growth of 13.7 per cent. The company’s EBIT was up 36 per cent at Rs 2,392 crore and EBIT margin improved to 19.3 per cent. However, higher earnings growth is somewhat one-sided, as several mid-tier IT services companies saw margin growth driven by lower manpower costs/separate pay growth, and lower travel and marketing expenses in FY2011. For LTI, analysts expect the EBIT margin to decline to less than 18 per cent in FY22 and remain at around 18 per cent in FY23, as some of the reduced costs bounce back. However, this is still an improvement in its FY20 EBIT margin of 16.1 per cent.
For FY21-23, LTI to Revenue, EBIT and Net Profit CAGR is expected to be around 23, 19 and 19 per cent respectively.
Thus, while the company’s business fundamentals and financials are sound, these appear to be substantially more factual at current levels. The risk of multiple compressions is high as interest rates move upward in 2022. Even if the growth happens exactly as expected, multiple compressions may offset its gains resulting in huge returns from current price levels. There is also a need to bear the risks of development from any macroeconomic adverse conditions. Hence, investors can book profits now and look to re-enter after a correction.
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