CLSA on L&T Technology Services - Recent deal wins improve the long-term growth outlook

L&T Technology Services (LTTS) has announced two large deal wins over the past week, including a US$100m, five-year deal from a US oil & gas major. More deals could follow as CLSA’s recent management interactions indicate a strong pipeline. The wins add to the steady (albeit slow) demand revival in the ER&D services market and should drive a meaningful improvement in revenue growth and margin. CLSA raised their FY22/FY23 Ebit by 8%/10% respectively. L&T Technology Services has been a minor participant in the sector rally, underperforming the Nifty IT Index by 16% over the past six months. The improved outlook should correct this. Hence, CLSA upgrades L&T Technology Services to outperform from underperform and raise their PE-based price target to Rs 2020 from Rs 1750.

Deal traction improves growth visibility:

Interactions with Amit Chadha, deputy CEO of L&T Technology Services, indicates that while a structural demand recovery for engineering and R&D (ER&D) services is still weak in key segments such as aerospace and oil & gas, LTTS is aggressively pursuing proactive proposals on cost take-outs and digital engineering. The strategy appears to be working; LTTS has announced two large deals in the past week, including a US $100 mn, five-year deal from a US energy major who is an existing client. The momentum could continue as L&T Technology Services  indicated a strong pipeline including multiple large consolidation deals.

Worst appears to be behind for L&T Technology Services ER&D services:

L&T Technology Services hopes to match Q4 FY20 revenue/EBIT margin in Q4 FY21. While this appears a tall order - a 4.8% revenue CAGR over second half of FY21 - the ramp-up in deals won in first half of FY21 and normalisation of supply side constraints in the offshore development centres (ODCs) it runs for most of its large clients should help (typically, ODCs have a minimum revenue commitment and hence, higher revenue visibility/realisation). L&T Technology Services also indicated no abnormality in the seasonal furloughs in Q3 of FY21.

Inelasticity of cost structure should now help L&T Technology Services:

The cost structure for ER&D services is relatively less elastic vs IT services. As such, EBIT margin for L&T Technology Services in Q2 FY21 was still 240 bps off the pre-pandemic levels in contrast to most IT services players, which were 100-200 bps higher. Hence, CLSA expects margins to improve as revenue growth resumes, even after absorbing wage hikes and the normalisation of visa/travel cost reversals in FY22.

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L&T Technology Services share price Upgraded to Outperform:

Given the tepid outlook for ER&D services and its premium valuations, L&T Technology Services share price has underperformed the broader sector and currently trades at 1sd below its long-term median PE discount to TCS. Improved visibility should help bridge this, hence the upgrade. CLSA’s new price target is at 21x 12-month forward EPS from 19x earlier.