Not All of IT is Going Down ??

Greetings!

While tension regarding the US debt ceiling persists, Germany has fallen into recession and Mumbai Indians lost - we know which one ya’ll care about most. Hence, quickly skim through the newsletter and head over to watch the world’s second most valued sports league (US$ 8.4 billion) and pick a side!

NIFTY 50: 18,500 (1.6%)

NIFTY 10Y Benchmark G-Sec Index: 2,172 (0%)

Founder’s Recap

5 Month High ??

The Nifty hit a five month high this week. But why? After all, there’s not much good coming out of the world lately.

• The US is struggling to reach a consensus on the debt ceiling. With the government battling it out through negotiations, the country is running short on time. If the debt ceiling is raised, there will be some deal reached in the government that entails spending cuts to ensure more prudence. And, if the deal isn’t reached in time, anyway the government will have to partially shutdown and/or cut spending. In any case, fiscal pressure seems highly probable, which may fast track the US into a recession
• Inflation in the UK is still high at 8.7%. It did drop off a little after being in double-digits for eight months. But, 8.7% is still far higher than BoE’s 2% target. This means the central bank won’t go easy on rates, and just send one more country faster into the trenches of a recession
• Germany flopped into a recession as the economy shrank by 0.5% in the last quarter of 2022, and by another 0.3% in 1Q 2023. By definition, two straight quarters of decline = recession. And with the biggest kid in the eurozone falling, there is a high risk that others could be dragged down as well
• China’s comeback has been meh. Since April there has been a series of disappointments - industrial production and retail sales were both below estimates, youth unemployment surpassed 20% for the first time, and corporate sales are yet to reach pre-pandemic levels

And while global economic stability goes down the drain, the Nifty is up 1% in the last week, 3% in the last month, and 14% in the last year. Why even?

1. Relative outperformance - Relative to other countries, India seems to be doing extremely well on the macro front. Inflation seems to be cooling off, the RBI took a pause to assess the impact of hikes on the economy, GDP estimates by everyone peg India as the fastest growing large economy. What more do you need?
2. Liquidity - With this foreign investors poured in over US$ 5 billion in equities since April 2023. Increased liquidity has been creating the necessary support ecosystem for the markets to rise
3. Earnings - Corporate earnings for 4QFY23 were decent. Large companies announcing a satisfactory set of numbers kept the sentiment buoyant
4. Normal monsoon - The IMD suggested India would receive a normal rainfall, at 96% of the long-term average, which essentially means a good crop, easy prices and no major headwinds for inflation

There are enough reasons for the Indian markets to be in a cheerful zone. But, but, but, with so much going wrong globally, there are risks too. And when things go south, it doesn’t take too long for the Indian markets to join global peers in bleeding red. While the recent rally has brought in some green, it’s important to be cognisant of risks, and factor them in as well.

Market Stories

Not All of IT is Going Down ??

What do BMW, Honda, Jaguar, Rolls Royce, Boeing, and Airbus have in common? They all outsource part of their work to India. And no, not the boring old-school IT services work of ERP systems, payroll management, and BPO services.

There’s a breed of Indian technology companies that has been doing the sexy stuff for global engineering giants. We’re talking about the development of driving systems in autonomous cars, powertrains for EVs, infotainment software in cars, navigation systems for airplanes, and much more.

This sub-sect of the US$ 245 billion Indian IT services industry is called engineering services. And because engineering service providers are part of such critical design and development work, they have been rather unaffected by the massive deterioration in the global economic outlook, which the Indian IT companies have been bogged down by.

While the top 5 Indian IT services companies grew by 14% in FY23, the three listed engineering service companies collectively grew by 30% in the same year.

The difference can also be seen in stock returns. The Nifty IT index has appreciated by a mere 4% in the last one year. Against this, LTTS is up 15%, Cyient 74% and KPIT Tech 122%. But will this party continue?

Engineering Services FTW

There are several reasons for engineering services to grow faster than traditional IT services:

• Global Engineering and R&D (ER&D) spending has been increasing and is all set to cross the US$ 2.6 trillion mark by 2026, from the current US$ 1.5 trillion
• Outsourcing of ER&D is fairly under-penetrated at a mere 0.6% of the total spend, compared to 25% in IT services
• Within the outsourced pie, India’s relevance has been increasingly growing. It has the potential of addressing nearly half of the US$ 130 billion ER&D outsourcing opportunity

The combination of the above factors is likely to result in a structural tailwind for Indian engineering services companies that has the potential of translating into sustained multi-year revenue growth. The underlying factors for this potential success are pretty straightforward:

• More money is being spent on engineering as the technological evolution forces multiple industries to transform (EVs in transportation, med-tech in surgical equipment, 5G in telecom, autonomous driving in automobiles, and so on)
• Given the fact that disruptive technology is a threat to incumbents, ER&D expenditure is almost mandatory; a bad economy gives no excuse for companies to spend less on technologies that will wipe their existence out

According to Zinnov and Nasscom, within ER&D spending, while legacy engineering spend is expected to grow at a 2% CAGR over 2020-26, digital engineering spend is expected to exhibit a 19% CAGR over the same period.

What Are the Options Within Engineering Services Though?

The listed Indian space is quite diverse, with everyone trying to participate in the hot engineering market:

IT players - top IT giants like TCS, Infosys, Wipro, and HCL Tech all have engineering services divisions, cutting across several industries. However, engineering comprises of 10-30% of their total revenue, and hence these become more diversified plays

Broad-based engineering companies - Cyient, L&T Technology Services (LTTS), and Tata Elxsi are hardcore engineering players, but with a presence across multiple industries. Cyient is spread across Aerospace, Railway, Telecom, Energy, Semiconductors, and Medical. LTTS has revenue diversified across Automotive, Telecom, Industrial Products, Plant Engineering, and Medical Devices. Tata Elxsi’s revenue is divided across automotive, media, and healthcare.

Niche engineering companies - KPIT Technologies is fully focused on the automotive engineering space. Similarly, Persistent Systems has been focused on tapping the ER&D spending by software companies like Microsoft, Salesforce, and IBM.

Which Companies Are Doing Well?

Companies that perform well over the long run in the engineering space tend to exhibit the following traits:

Expertise - Engineering is a highly specialized domain, and requires not just higher-skilled talent, but also domain expertise at a company level built through pedigree, experience, in-house R&D, culture, scale, and clientele

Offerings - Offerings in high-growth areas, which are also those that are high-value-add, are core to customers and can lead to potentially higher wallet share and co-dependence over time

USP - Sharp selling point that makes for a commendable and credible proposition for clients

Concentration - While high industry concentration can be a sign of deep expertise unless the industry is in a high-growth phase, it can be problematic. For example - while automotive is seeing a structural growth trend, aerospace usually goes through massive cyclicality. Additionally, higher client concentration also exposes the company to sharp deviations as seen in the past for Cyient (Pratt & Whitney), KPIT Tech (Cummins), and Tata Elxsi (Jaguar Land Rover)

Where’s the Value?

On a one-year forward basis, the median PE for engineering services company is at 37x, which is materially higher than the valuations for pure-play IT services companies. And that is justified given the industry tailwinds, and higher growth.

However, despite being in the same space there is a large divergence in the valuations of engineering services companies. While Cyient trades at 18x FY25E earnings, Elxsi trades at 60x. This divergence becomes even more perplexing because the PAT growth expectation for all the companies is in a similar range of a 20-28% CAGR over FY23-25E.

How should one then determine which stocks to back and which to avoid because of valuations?

And the Winner Is…

The average one-year forward PE multiples that these companies have traded at over the last 5 years highlight how Cyient trades at a deep discount and Elxsi at a steep premium.

Track record: Other than Cyient, everyone has exhibited a strong track record of delivering double digit revenue growth over the last 5 years. Elxsi has been particularly strong in delivering industry-leading revenue and PAT growth

Value add: The margin profile of an engineering services company is a good indicator of the quality and criticality of its services, and how much customers are willing to pay. While all companies have seen margin improvement, Elxsi’s margins have been materially higher compared to peers. This is also reflected in Elxsi’s ROE, which is in the mid 30s compared to 18-26% for peers. Cyient has lagged here as well, with the lowest EBITDA margin in FY23

Other than these points, higher valuations are also determined by parentage, growth of underlying industries, client concentration and corporate governance - all of which one company particularly stands out in - LTTS.

LTTS checks the list on multiple factors - strong parentage, exceptional track record, diversified industry presence, strong sales capabilities, low client concentration, better-than-average margin profile, and forecasted growth in line with peers. However, it trades at 26x forward PE, which is at the lower end of the spectrum, and has the potential to re-rate higher.

We discussed all this and more on the latest episode of the Common Cents podcast so check it out below!

Rupeeting Bulletin

ESG Investing - The Next Big Thing?

We wrote a little piece for YourStory on ESG investing. Our views have been a little different compared to the traditional approach.

Conventionally, ESG investing would avoid sectors like chemicals. But nah, we think differently.

We are okay investing in chemicals as long as they are moving towards a more sustainable way of operating, reducing emissions, treating effluents efficiently, and even perhaps doing the environment some good (compared to the past).

Read on to get a better understanding of this. We’ve got a brilliant example in fluorine chemicals of how companies are reducing global emissions and even giving shareholders mad returns!

https://yourstory.com/2023/05/esg-investing-next-big-thing

US Debt Ceiling, Inflation, and More

There’s a lot happening economically. We shared our views with Trinkerr - just de-cluttering some of the hot topics.

A bit on the clean-chit to Adani, a little on the US debt ceiling drama, and some on the inflation situation. More importantly, with so much happening, what direction will the Indian markets take on now?

Watch to get some dope on how we’re looking at recent events, their impact on the markets, and the strategy to handle the volatility.

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