L&T Tech IPO opens for subscription on 12 September, marking the 17^th mainboard IPO this year. The upcoming IPO, priced in the range of INR850 – 860 per share, will close on 15 September and will mobilize INR894.4 crore (INR8.94 billion). In total, 10.4 million shares will be offered by Larsen & Toubro (L&T) in the IPO which will be totally an offer for sale (OFS). Shares of the Vadodara-based company will be quoted on BSE and NSE on the listing date of 23 September. Lead managers of the IPO are Kotak Mahindra Bank, Bank of America Merrill Lynch, JM Financial, and SBI Capital Markets while Karvy Computershare is the registrar.

L&T Technology Services is a wholly owned subsidiary of capital goods giant L&T and has a relatively short operating history as it was incorporated in 2013. L&T Tech IPO is part of a value unlocking effort which also resulted in listing of another L&T subsidiary L&T Infotech. Although L&T Infotech IPO had a discounted listing and continues to trade below the issue price, investors will be keeping an eye on L&T Technology to see if the parent is leaving some money on the table this time. In this analysis, we try to find out if there is a case for retail investors to subscribe to this IPO.

L&T Tech IPO details

L&T Technology Services – L&T’s baby

As mentioned above, L&T Technology Services is fully owned by its parent L&T and has no external investors. A privileged background with a parent like L&T is a great thing to start with. Although the company was incorporated only in 2013, the business has been around for long. Prior to January 2014, the business was conducted within L&T as a division named Integrated Engineering Services (IES)) and as a sub-segment called Product Engineering Services of L&T Infotech. As part of a business restructuring exercise, both businesses were merged and the entity came to be known as L&T Technology Services.

Nevertheless, it’s a big baby

As one can imagine, having the backing of a strong brand such as L&T is offers great help. This is reflected in the impressive list of clients which includes the likes of Calsonic Kansai, Caterpillar, Danaher, Eaton, Intel, John Deere, P&G, Rockwell Automation, Scania and Shell.

L&T Tech offers engineering research and development services to clients in manufacturing, technology and process engineering industries. L&T Technology’s business operations are divided in five industry verticals – Transportation (29.9% of revenues in FY2016), Industrial products (25.2%), Telecom and Hi-tech (19.8%), Process industry (18.7%) and Medical devices (6.3%). L&T Tech employed a total of 9,419 employees as of 30 June 2016, including more than 2,000 employees outside India. The company operates through 12 global delivery centres in India and overseas, 26 sales offices in India, North America, Europe, the Middle East and Asia and 31 labs in India.

See the attached infographic for more information on the company’s capabilities and operations.

And it shows in financial performance

As we indicated above, the company is new but the business is old. Repeat business for L&T Technology contributes 98.7% and 94.6% of FY15 and FY16 revenues respectively. These are high figures at this scale and show the confidence its clients have placed in the company. At the same time, it has a diversified set of 200 global clients. Combined business of top 5 customers accounted for 22.8% of L&T Tech’s revenues in FY2016 while top 10 clients accounted for 36.2%. Business from top 20 customers accounted for 53.8% of L&T Technology’s revenues in FY2016.

In terms of revenue and earnings growth, the table below explains that L&T Tech is doing well as a business. In the latest FY, L&T Technology Services generated revenue of INR3,142.7 crore (INR31.42 billion), marking a growth of 18.9% from the previous year. During the same timeframe, net earnings surged 34% to INR416.6 crore (INR4.16 billion). Accordingly, net profit margin for FY2016 improved to 13.2%, up from 11.7% for FY2015. L&T Technology also boasts of strong balance sheet with a debt equity ratio of just 0.18 as on 31 March 2016.

Among all the positives, what we don’t like is L&T Tech’s excessive dependence on North America and Europe for business. The two regions accounted for 80.2% of L&T Tech’s revenues in FY2016 with North America alone contributed 60.4%. Nearly 19.8% of its business originated from Europe while only 8.3% revenues came from the domestic market. Dependence on a specific geography not only presents a challenge to the core business, but it can also put a dent in its profitability by playing havoc with currency headwinds. Simply put, excessive dependence on a foreign market is a red flag for a business.

Should you invest?

Subscription in an IPO is mostly a decision of valuation and how much the company is leaving on the table. History tells us that IPOs tend to be priced high during bull runs because investors’ risk appetite increases considerably. This phenomenon holds true in the current bull phase as well and we have seen several instances of IPOs at premium valuations. At the same time, investors are getting wise and the market is no longer willing to offer premium valuations to ‘me too’ stories. This learning is fresh in our minds as L&T Group’s last IPO of L&T Infotech listed on a disappointing note. Even though L&T Infotech had strong fundamentals, it continues to trade below the allotment price as there was little in terms of novelty while the IT sector’s outlook got clouded around the same time following the Brexit vote.

Given this backdrop and losing money in L&T Infotech, investors will be rightly concerned if they should subscribe to L&T Tech IPO. However, a look at its valuations is reassuring. L&T Tech IPO is priced at a PE ratio of 26.8, considering the diluted EPS of INR32.1 in FY2016. This compares with a PE ratio of 14.7X for Cyient and 37.8X for Tata Elxsi both of which have similar business operations as L&T Tech Services. Now, both of these stocks have fallen lately on concerns mentioned above, even though Indian markets have been rallying. Nevertheless, there shouldn’t be any doubt that engineering research as a business is on a much stronger footing when compared to general IT outsourcing. Indian markets are not making this distinction as of now and it is only a matter of time investors realize this difference.

Something not captured in the financial performance above is the fantastic show L&T Tech put up in the first quarter ended 30 June 2016. Its earnings jumped 52% in the latest quarter with a corresponding surge in EPS. A quick extrapolation of this, although not the finest valuation method, takes us to annualized EPS of INR48.8 and a PE ratio of 17.6 times. Once again, this is just back of the envelope calculation, intended to highlight the potential headroom for valuation.

Thanks to a deleveraged and ‘balanced’ balance sheet, L&T Technology Services has a high return on net worth (RONW) of 38.85% which compares with 17.4% for Cyient Limited and 40.1% for Tata Elxsi Limited. Overall, L&T Tech IPO comes across as a robust growth story, although there is a risk of it being offered the bearish outlook currently prevalent in IT sector. As this risk is an apparent one, investors with relatively high risk appetite can subscribe to L&T Tech IPO.