Demand recovery to drive L&T Technology's FY22 show as ERD companies rise

Engineering research and development outsourcing expected to grow faster than IT services, say analysts

Software companies in the engineering, research and development (ER&D) segment have outperformed their IT services peers on expectations of a faster growth trajectory in FY22, compared to the performance of the overall software industry.

While the BSE Information Technology index has gained 11 per cent in the last three months, ER&D players such as L&T Technology Services (LTTS), Cyient, and Tata Elxsi have risen 15-60 per cent during this period.

Most ER&D firms are expected to post a low double-digit decline in FY21, after falling substantially in the first half of FY21; a recovery in the December quarter has helped them cushion the impact. This recovery is expected to pick up pace.

Vikas Ahuja and Ashish Agrawal of Antique Stock Broking believe ER&D outsourcing is expected to grow faster than IT services. They expect LTTS to register 22 per cent revenue growth in FY22.

This could be aided by record large deals, higher demand from customers looking at business transformation projects, and improved decision making.

One trend that should help the company achieve the strong top line growth is the accelerating demand for digital ER&D services.

Digital engineering spends are accelerating across verticals, and it is expected to contribute 53 per cent of ERD spending by 2025, compared to 30 per cent in 2019, according to Axis Securities.

Digital revenue contribution to overall revenues for LTTS has grown from 18 per cent four years ago, to 49 per cent at present.  

The company is witnessing strong traction in digital transformation demand, with customers demanding custom-built development on newer technology, says Omkar Tanksale of Axis Securities.

In addition to top line growth, margins — which rose 150 basis points on a sequential basis to 15.2 per cent in the December quarter — are expected to improve on the back of higher utilisation and offshoring.

Analysts expect margins to be at 17 per cent in the current quarter, on the back of better growth in high-margin segments of plant engineering, medical products, and industrial devices.

While prospects for LTTS are strong, the stock is the most expensive in the large-cap and mid-cap spaces, and is trading at 31x its FY22 estimates. Investors should await a meaningful correction bef­ore accumulating the stock.