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.
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