L&T Technology Services IPO The Make in India Firm

Transcription

1 A quality report by JainMatrix Investments L&T Technology Services IPO The Make in India Firm Mid Cap: Rs 8,700 crore Mkt cap Industry Engineering R&D services Date: 11 th Sept 2016 IPO Period: th Sept and Price range: Rs Advice: Investors may BUY with a 2 year perspective. Overview: LTTS is a global pure-play engineering R&D services firm, a part of L&T group. LTTS had revenues and profits of Rs 3,143 crores and Rs 416 cr. resp. in FY16. Its revenue, EBITDA and PAT have grown 18.9%, 40.7% and 34.0% this year. The contract R&D services help firms develop and deliver products to end customers. After the IT services sector growth over the last 2 decades, the ER&D sector appears to be the next generation opportunity for more advanced, sector specific product development services. The govt. has set up a Make in India program to encourage mfg. However ER&D services seem a more likely candidate for local success as it accelerates mfg. and innovation. LTTS key customers include BMW, Calsonic Kansai, Caterpillar, Danaher, Eaton, Intel, John Deere, P&G, Rockwell Automation, Scania, Shell and UTC. The primary risks are: 1) highly dependent on customers in North America and Europe 2) Forex fluctuation risks 3) Uncertainty around M&A and growth potential. As an investment, the LTTS IPO is rated a medium risk, medium return type of offering. Outlook: Investors may Buy LTTS with a 2 year perspective. Here is a note on L&T Technology Services Ltd (LTTS). IPO highlights IPO opens: Monday th Sept 2016 with Issue Price band: Rs per share. Shares offered to public: 1.04 crore of Face Value: Rs. 2 per share, Market Lot is multiples of 16. Shares offered are 10.2% of equity. The IPO is of Rs 894 cr. (upper end of band) which is a sale by promoter L&T; there is no fresh issue of shares. L&T holds 100% stake in LTTS pre-ipo. In the IPO shares are available to institutional, non-institutional and retail in ratio of 50:15:35. Post IPO shareholding will be L&T promoter 89.8%, QIB 5.1%, NIB 1.5% and retail 3.6%. The IPO will unlock value for promoter L&T. The grey market premium is Rs 95 96, a positive. Introduction LTTS is a global pure-play engineering R&D services firm, a 100% subsidiary of L&T Ltd. LTTS had revenues and profits of Rs 3,143 crores and Rs 416 cr. resp. in FY16. Its revenue, EBITDA and PAT have grown 18.9%, 40.7% and 34.0% in one year. There are only 2 years of data on LTTS. LTTS has 26 sales and 12 delivery offices globally. It has 31 labs in India. It has 9,400 employees.

2 In a business restructuring exercise, LTTS was put together by a merger in 2014 of 1) the Integrated Engineering Services division of L&T and 2) Product Engineering Services division of L&T Infotech. LTTS has verticals such as transportation, industrial products, telecom etc. Fig 2. They provide a set of services to mfg. technology and process engineering firms, to help develop and build products, and deliver these to their end customers. LTTS offers design & development solutions to the product development chain for solutions in the areas of manufacturing engineering, embedded systems, software and process engineering. For new technologies, LTTS provide services and solutions in the areas of product lifecycle management, engineering analytics, power electronics, M2M connectivity and IoT. They focus on innovation and tech. leadership and have set up labs specific to industry verticals to replicate customers environment, enabling them to work closely with their R&D teams on innovations. Fig 1 Geographic revenue/ Fig 2 Revenues by Vertical Fig 3 LTTS s segment revenue and operating margins LTTS s key customers include BMW, Calsonic Kansai, Caterpillar, Danaher, Eaton, Intel, John Deere, P&G, Rockwell Automation, Scania, Shell and UTC. Revenue geography is in Fig 1. LTTS s revenues are generated from services provided on either a time-and-materials (T&M) or a fixed-price (FP) basis. For contracts on a T&M basis, they charge their customers on the basis of the hourly billable rates of employees. 31.9% of LTTS s revenue were from FP contracts and the remaining 68.1% of the contractual revenue was T&M based for FY16. Report by JainMatrix Investments Page 2/7

3 Repeat business from existing accounts was 98.7% of customers in FY15 and 94.6% in FY16. The top 5, top 10 and top 20 customers constituted for 22.8%, 36.2% and 53.8% resp. of FY16 revenues. LTTS had 3 $20m+ clients and 8 $10-20m clients in FY16. LTTS added 36 new customers in FY16. As of June 2016, LTTS had over 200 clients out of which 50 were among the fortune 500 companies. LTTS has been recognized by Zinnov in the leadership zone in 8 industry verticals (industrial automation, construction and heavy machinery, medical devices, aerospace, auto, rail and marine, telecom, energy and utilities) and 2 horizontal service offerings (embedded systems and mechanical) in Zinnov's GSPR Ratings Leadership: A.M. Naik is non-exec. Chairman; Keshav Panda is MD-CEO and P. Ramakrishnan is CFO. Promoter Larsen and Toubro (L&T) - Snapshot and Financials L&T is a diversified engineering, construction, mfg., technology and financial services company. Income and PAT has grown at 12.4% and 4.3% CAGR respectively over 5 years. In the same duration EPS witnessed a fall of -8.03% CAGR. P/E ratio has however risen to 27.5 times today. See Fig 4. Fig 4 L&T financials L&T has low net profit margin of 5.21%. The dividend yield for L&T is 1.24%. The RoCE stands at 10.6% and RoE at 11.33%. This is average performance. This is the third listing from the group after L&T Ltd, L&T Finance and L&T Infotech. L&T has struggled in the last 3 years. Profitability in segments such as power, material handling and metallurgy were flat. In West Asia, there is uncertainty due to falling crude prices. There was slow revenue recognition in Indian projects due to weak project execution and delay in client payments. L&T s share price has appreciated only 12% CAGR over the last 5 years with CMP Rs 1,518. However we are positive that the investment cycle and infra focus has started as the economy picks up. Sectors like defense, railways, roads and construction are recovering. L&T is best placed to benefit from this, given its exposure to diverse sectors, its strong balance sheet and good cash flow. News and Updates for LTTS LTTS plans to double revenues in 3-4 years, as per L&T Chairman AM Naik, partly from acquisitions. LTTS is collaborating with startups to either take or jointly built solutions in the IoT space to its global customers. They believe there is a level playing field for startups with large companies. Report by JainMatrix Investments Page 3/7

4 LTTS is a sponsor of the Nasscom's centre of excellence for IoT in Bengaluru. LTTS is looking at buying start-ups valued at $50 m or less with revenues around $20 m which had lesser financial muscle to grow further. These may be on IoT, and cloud & automation technologies. The Indo-American Chamber of Commerce (IACC) had conferred LTTS with the exclusive Company of the Year award in June This is the highest distinction conferred by the IACC to any company. LTTS in Aug 2016 opened a new engineering center in Dublin. LTTS collaborated with Redknee Solutions in June 2016, to together offer a complete architecture for enterprises to enable connectivity, analytics and monetization for the IoT. Attrition rates at LTTS in Q1FY17, FY16 and FY15 were 13.2%, 12.1% and 14.3% resp., quite low compared to the IT services industry. The company has filed 34 patents and co-authored 134 patents with clients and others. The INR/USD rate is We expect a range of Rs/$, over the next 6 months, a flat outlook. The unofficial/ grey market premium for this IPO is in the range of Rs L&T Tech Services mops up Rs 268 cr. via anchor investors on 9 th Sept. ER&D Services Industry Outlook India s ER&D environment is a healthy mix of service providers, captive centers and start-ups. Currently, there are over 350 captives, with around 60% focused on hi-tech verticals, and the infrastructure and industrial automation realms. Firms spent a total of $ 1,007 billion on R&D and engineering activities such as product & process development, manufacturing engineering and other allied engineering in India is a market of key activity for the R&D industry with regard to the setup of R&D centers. There is a resurgence in the setup of new R&D centers in India. A total of 44 new offshore technology centers were set up globally in 2015 and nearly 70% of these centers were set up in India. India and China are markets of key activity for offshore in-house R&D centers. Prior to 2010, the India-based ER&D service industry was providing low-end services at lower cost and augmenting resources for customers' R&D. The providers have since moved up the value chain, taking over complex product development tasks, improving quality and decreasing time to market. The ER&D services industry is currently at a stage of capability augmentation, where players in the industry have direct access to emerging markets, leverage the local talent pool and leverage the growing Indian technology sector and start-up companies to promote local innovation. According to NASSCOM, the current phase will lead to increasing home-grown innovation, resulting in higher margins and an increase in value added services. In FY15, in-house ER&D centers contributed $ bn to India's ER&D industry whereas third-party ER&D service providers contributed $ 7.76 bn. We estimate that LTTS commanded a 5.7% market share in the Indian ER&D market in FY2015. The new trends which have a direct impact on the ER&D services industry include emerging technologies like IoT, robotics, wearable devices and 3D printing. The India-based ER&D services industry grew faster than the global industry. FY15 over FY14 growth rates in the global ER&D industry for in-house R&D centers and third-party ER&D service providers were 7.6% and 8.7%, respectively. In FY15 over FY14, India-based in-house R&D centers grew by 8.3%, and India-based third-party ER&D services providers grew by 12.7%. Report by JainMatrix Investments Page 4/7

5 India-based R&D centers are projected to grow at a 13.3% CAGR and India-based third-party global ER&D service providers projected to grow at a 14.0% CAGR from FY15 to FY20. Source: LTTS RHP. Financials of LTTS Fig 5 LTTS financials LTTS s revenue, EBITDA and PAT grew 18.9%, 40.7% and 34.0% in FY16. The FY17 data is a simple projection of the Q1 FY17 results. The dividend rate has been rising. LTTS paid a dividend of Rs 14.2 in FY16, a dividend yield of 1.64%. Revenue growth is moderate, but margin growth is impressive for a mid-size company. See Fig 5. The EPS growth is a positive. LTTS has generated Free Cash Flows since inception, a positive, Fig 6. Fig 6 LTTS cash flows LTTS has a ROE of 38.8% (FY16) making it amongst the best in the industry. The cash per share including Reserves & Surplus plus Cash in Balance sheet is Rs 118/share. This indicates that the current operations of LTTS are available in IPO at ( ) = Rs 742/share. Benchmarking We benchmark LTTS against peer companies like Cyient, Tata Elxsi, Mphasis etc. See Fig 7. LTTS appears to be available at moderate valuations in terms of PE and P/B. High ROE, ROCE and dividend yield is good. Strong balance sheet can be leveraged for acquisitions. Report by JainMatrix Investments Page 5/7

6 Utilization rate is the lowest at 71.4% (FY16). But in Q1FY17 it improved to 76.2%, and there is room for improvement. Margins are average, however they are growing fast. Particulars L&T Tech L&T Cyient Tata Elxsi Mphasis Services Infotech Mindtree Syngene Revenues (FY16) 3,143 2,736 1,075 5,795 6,143 4,690 1,107 EBITDA (FY16) Profits (FY16) Market Cap 8,745 5,419 4,884 11,839 12,059 11,124 9,796 PE (x) Price to Book Value (x) Yr CAGR Sales (%) Yr CAGR Profit (%) Debt to Equity Ratio (x) EBITDA Margin (%) Net Profit Margin (%) Return on Equity (%) Return on Capital Employed (%) No of Employees Utilisation Rate (FY16 - In %) 71.4% 72.7% 75.0% 79.0% 75.7% 70.6% na Dividend Yield (FY 16 - In %) Exhibit 7 Benchmarking Positives for LTTS and the IPO ER&D services are a very stable business linked to firm s product launches and is often a critical activity for companies. Thus outsourced ER&D is a predictable, solid business. India offers a number of competitive advantages for ER&D, including technical talent pool, low costs, managerial talent, stable business environment and an open economy. LTTS is part of the L&T group, which gives it a access to 1) specialized knowledge and talent in many sectors 2) a good customer base in India & Middle East. 3) synergies with L&T Infotech for cross selling and common prospects. They are already working together. The IPO pricing is fair. At the upper band of Rs 860/share, LTTS s asking P/E is 25.4 times. LTTS has a good balance sheet. It has high ROE and ROCE numbers with good margins. It has a diversified client base with a majority giving repeat business. This makes LTTS attractive. With revenues > Rs 3,000 crore and employees > 9,000, LTTS is well placed to pitch for and win large size $10-20 million ( crores) and new business in ER&D. With a good geographic spread and employee strength, LTTS has the potential to grow rapidly. Attrition rates are low. Per management it will double revenues in 3-4 years with M&A and organic growth. L&T used to own Preference shares in LTTS, but they were redeemed by May 2016, so there are no outstanding Preference Shares. This will boost profits of LTTS compared to previous years. Internal Risks LTTS might engage in acquisitions that may not be successful or meet expectations. LTTS s business could be adversely affected if they fail to develop new services and solutions or enhance existing services and solutions or if they fail to keep up with customer expectations. Inflation and urban costs increase affects the resource oriented business such as LTTS. It will have to ensure that costs and attrition remain in control. Report by JainMatrix Investments Page 6/7

7 Exchange rate fluctuations could impact financials. Revenues in USD and in Euro amounted to 76.2% and 11.3% of revenues in FY16. LTTS does not hedge against all forex risks. As of now, they have outstanding unhedged forex receivables of Rs 733 cr. and unhedged forex payables of Rs 17.6 cr. The sister company, L&T Infotech operates in the IT services space and has global clients. While these 2 firms have well defined spaces, there will be many areas of overlap or where coordination among them is required and sales conflict. External Risks The changes in technology can be rapid, and if LTTS does not move fast enough, the firm can be rendered obsolete within a few years. Europe and Middle Eastern regions seem to be facing a slow growth or even recession. A reduction in the R&D budgets of their existing and prospective customers could affect LTTS pricing and volume of work. Similarly customers may stop or reduce the scope of outsourced ER&D work or may set up captive R&D centers, which may result in a reduction in their volumes of work. 94.6% of revenue in FY16 came from existing clients whereas revenue from new customers was only 5.4%. This could be a sign of weak new business and sales pipeline. LTTS has mentioned that it wishes to take up acquisitions in future. However the firm has a limited history of acquisitions and the task of M&A integration is complex and risky. Overall Opinion After the IT services sector growth over the last 2 decades, the ER&D sector appears to be the next generation opportunity for more advanced, sector specific product R&D services delivery. There are big opportunities for India in the global ER&D market. India is already a hub for global small car design, innovation and mfg. It is possible that the ER&D can extend this success to other auto sub sectors, telecom, industrial products, etc. The govt. has set up a Make in India program to grow mfg. However ER&D services seems a more likely candidate for success as it speeds global mfg. and innovation. LTTS has excellent group credentials in the ER&D space with access to L&T knowledge and skill base, and customer networks from L&T and L&T Infotech. So far, the 2 year old company has shown good signs of business solidity. It is the leader in the Indian ER&D space. The larger peers are software + ER&D players. At a FY16 PE of 25.4 times, the valuations just seem to be fair. However the projected FY17 forward PE of 17.7 times based on the current run rate, looks attractive. The LTTS IPO is rated a medium risk, medium return type of offering. Investors may BUY with a 2 year perspective. Disclaimer This document has been prepared by JainMatrix Investments Bangalore (JM), and is meant for use by the recipient only as infor mation and is not for circulation. This document is not to be reported or copied or made available to others without prior permission of JM. It should not be considered or taken as an offer to sell or a solicitation to buy or sell any security. The information contained in this report has been obtained from sources that are considered to be reliable. However, JM has not independently verified the accuracy or completeness of the same. Punit Jain has a small equity ownership < Rs 2 lakhs in L&T, where he is a shareholder since Other than this JM has no known financial interests in L&T Technology Services Ltd. or any group company. Neither JM nor any of its affiliates, its directors or its employees accepts any responsibility of whatsoever nature for the information, statements and opinion given, made available or expressed herein or for any omission therein. Recipients of this report should be aware that past performance is not necessarily a guide to future performance and value of investments can go down as well. The suitability or otherwise of any investments will depend upon the recipient s particular circumstances and, in case of doubt, advice should be sought from an Investment Advisor. Punit Jain is a registered Research Analyst under SEBI (Research Analysts) Regulations, JM has been publishing equity research reports since Nov Any questions should be directed to the director of JainMatrix Investments at punit.jain@jainmatrix.com. Report by JainMatrix Investments Page 7/7