Kotak cautious on midcap IT stocks amid stretched valuations; prefers Cyient

Indian ESPs (Engineering Service Providers) have shown robust revenue growth despite facing a traditionally slower quarter, said brokerage house Kotak Institutional Equities in a recent report.

The automotive sector experienced a slowdown in growth across various companies, attributed partly to furloughs and observed weaknesses among Tier-1 suppliers. However, Kotak anticipated that automotive Original Equipment Manufacturers (OEMs) will maintain high spending levels throughout CY2024E (Calendar Year 2024 Estimated). Moreover, Earnings Before Interest and Taxes (EBIT) margins also remained steady compared to the previous quarter for most companies, noted the brokerage.

Concerns linger due to stretched valuations, particularly impacting the outlook for L&T Tech, KPIT Technologies, Tata Elxsi, and Tata Technologies, said the brokerage but prefers Cyient as it stands out due to its improved business portfolio and relatively more reasonable valuations.

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The brokerage analysed the December quarter (Q3FY24) earnings for these mid-cap IT stocks. Let's take a look at its findings:

Healthy revenue growth in a seasonally weak quarter: According to the brokerage report, pure-play service providers in the Engineering Research and Development (ERD) sector sustained a steady growth momentum during the third quarter of FY24, aligning well with market expectations. KPIT emerged as the leader in this regard, achieving a quarter-on-quarter (QoQ) growth of 4.3 percent in constant currency (c/c), followed closely by Tata Elxsi and Cyient (DET) with growth rates of 3.0 percent and 1.1 percent respectively. However, L&T Tech experienced a more modest growth at 0.9 percent, while Tata Tech's services revenue saw a decline of 0.5 percent QoQ. However, revenue growth was partly impacted due to furloughs and delays in deal ramp-ups, it added.

Some dichotomy in automotive spending: The brokerage also pointed out that automotive vertical growth on a sequential basis moderated across companies, impacted by (1) higher-than-expected furloughs and (2) some moderation in spending by tier-1 suppliers. Tata Elxsi indicated a delay in deal ramp-ups and tier-1 suppliers moving a part of spending inhouse leading to some pressure on outsourced spending. On the other hand, OEMs continue to spend on technology transition as part of a strategy to launch electric and connected vehicles on dedicated platforms by CY2026E, it noted. ESPs such as KPIT, which have stronger relationships with OEMs, have benefitted from healthy spending. Tata Tech's revenue growth was impacted due to the accelerated ramp-down of the Vinfast account. Sequential revenue growth was the lowest post-Covid ($ terms), added the report.

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Improved CY2024E outlook in a few industries: As per Kotak, the growth outlook for FY2024E has been influenced by challenges in certain industries, notably telecom, media, hi-tech, and medical devices. However, there are signs of potential improvement, particularly in the hi-tech sector. Budget constraints are expected to persist for clients operating in medical devices and media verticals, although any negative impact from reduced spending is anticipated to be limited. Sustainability continues to be a key priority for clients, which could serve as a significant growth driver for companies like L&T Tech and Cyient, given their focus on providing sustainable solutions.

EBIT margins remain range-bound: The brokerage also stated that cost optimisation efforts have delivered notable outcomes across Engineering Service Providers (ESPs). With alleviating pressures on the supply side, companies have directed their efforts toward optimising their employee structures and refining cost frameworks. Tata Elxsi and Cyient (DET) experienced a margin decline of 30-50 basis points (bps). Meanwhile, Tata Elxsi's profitability was affected by costs related to travel, visas, and long-term investments, whereas Cyient (DET) attributed its margin decline to wage increases for senior employees. Conversely, Tata Tech witnessed a significant improvement in margins, up by 140 bps quarter-on-quarter (QoQ), primarily due to the absence of wage hike impacts. Meanwhile, LTTS and KPIT saw their EBIT margins increase by 10-60 bps, it added.

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Cyient is the preferred pick; Kotak remains cautious on others given stretched valuations

Kotak forecasted that Indian ERD service providers are well-positioned to benefit from the technology transition underway across multiple industries. The companies have strengthened their digital offerings and have access to large skilled talent pools at significantly lower cost as compared to onsite-centric or near-shore players, it said.

Further, strategic relationships forged with clients would enable them to play a greater role in clients’ technology transformation. However, valuations are expensive at most factoring in most positives. Hence, it prefers Cyient (BUY) given reasonable valuations and retained SELL on L&T Tech, KPIT Tech, Tata Elxsi, and Tata Tech.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decision.