LTTS: Recent acquisition of SWC overhang dents investor sentiment

Near-term growth concerns, too, weighed on the stock

The stock of the country’s largest engineering research and development (ER&D) services player, L&T Technology Services (LTTS), has declined 15 per cent over the past month. In addition to growth concerns for the ER&D space, a key overhang for the stock was the recent acquisition of Smart World and Communication (SWC), a business unit of Larsen and Toubro (L&T).

SWC offers solutions in areas of end-to-end communications, city surveillance, and intelligent traffic management systems for the government and enterprises. The rationale for the acquisition was enhancing LTTS’s capabilities in the 5G network architecture and conceptualisation.

While the valuation of the acquisition at 0.7 times its sales and eight times its operating profit is not demanding, brokerages believe that its inferior client profile, low margins, and high working capital are negatives. At 8-10 per cent, SWC’s margins are much lower than LTTS’s 21.5 per cent and, thus, will dilute the latter’s profitability profile. Further, as government contracts are its primary source of revenue, the working capital is also high with days sales outstanding or DSO at 400+. Axis Capital downgraded the LTTS stock from ‘buy’ to ‘add’ and cut its target price by 11 per cent.

Akshay Ramnani and Manik Taneja of the brokerage cut their target price-to-earnings (P/E) valuation multiple from 33 times to 30 times as they expect the new acquisition to impact LTTS’s growth momentum, margin profile, and balance sheet position.
 

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Nuvama Research, too, had a negative stance on the acquisition. Say Vibhor Singhal and Nikhil Choudhary of the brokerage, “While SWC addresses some of the white spaces in LTTS’s portfolio and has a large opportunity, we believe a company with existing client base in LTTS’s target geographies would have been a better bet (even if it would have come at expensive valuations). That the to-be-acquired entity is an L&T group company creates an additional negative overhang.” They remain cautious on the entire sector in the near term due to the likely impact of a slowdown or recession in the US and EU on the discretionary spend-based ER&D business.

Though there are near-term headwinds, some brokerages are positive on LTTS’s prospects. Macquarie Capital Securities (India) has an ‘outperform’ rating and believes the company is a long-term compounder as engineering services growth is less volatile now with the digital transformation trend supporting growth across industries.

Ravi Menon of the brokerage says the company’s scale is superior to most of its global peers in engineering services, which allows it to invest in many new areas. LTTS is able to cross-pollinate its capabilities across industry verticals and this creates more cross-selling opportunities and higher differentiation compared with peers. It is also present in a broader set of verticals as compared to Indian engineering services peers like Cyient, KPIT Technologies, and Tata Elxsi, he adds.

At the current price, the stock is trading at 27 times its FY24 earnings. Given near-term growth issues, investors should watch the December quarter earnings, due Thursday, and management outlook before considering the stock.