Wednesday, January 3, 2024

Information Technology: ER&D: Well Poised For Growth Acceleration

We expect pure play engineering research & development (ER&D) companies to benefit from the likely acceleration in ER&D spend, growing digitization, and rising share of sourcing. ER&D spend has a high correlation with industry cycles and is thus prone to macro factors in the short term. But many industries like Auto are undergoing significant technology transition/disruptions that are driving higher spends on ER&D—this would negate any near-term weakness in other segments due to macro factors. Developed economies are expected to face shortage of skilled talent which will drive sustainable opportunities and sourcing from the engineering talent-rich Indian market. Nifty IT index inched up ~8%/11% in the last 1M/3M, on hopes of higher rate cuts in USA in CY24. ER&D stocks also saw a similar/better upmove which may cap any near-term upside; however, improving medium-term growth outlook would support higher valuations, in our view. We initiate coverage on Cyient with a BUY recommendation and TP of Rs2,700/share, and on LTTS with a REDUCE and TP of Rs5,050/share.

ER&D Services market well poised for growth

The ER&D Services market is set to see acceleration in growth momentum, on the back of: i) anticipated spurt in global ER&D spending, which is expected to register 8-9% CAGR over 2023-30 compared with 7-8% CAGR over 2020-23; ii) rising share of fast-growing, digital-engineering spends that are expected to clock 12-13% CAGR over 2023-30, with share inching up to ~65% of spend in 2030; iii) higher ER&D sourcing, which is likely to log ~16% CAGR over 2023-30, driven by sourcing decisions of global corporates focusing on resilience and agility post the aftermath of the pandemic, market expansion, evolving manufacturing footprint, cost dynamics, and access to new-age, digital-ready talent.

Indian ERD Service providers likely to benefit from growing sourcing trends

ER&D sourcing (captives or third-party providers) is likely to see ~16% CAGR over 2023-30, almost 2x of the global ER&D spend growth. As per the Bain report on ER&D, the sector sees far less outsourcing than the IT Services sector, which underwent a similar transformation in the 2000s. As the innovation pace hastens, enterprises are likely to see rise in sourcing, for managing skills requirement and cost & time-to-market constraints. Share of ER&D sourcing is expected to rise to 24% of the global ER&D spend by 2030 from 15% in 2023. India’s share of global ER&D sourcing is estimated to grow to 22% in 2030 from 17% in 2023, assisted by a skilled talent pool, favorable demographics, installed ER&D capacity, thriving start-up ecosystem, and talent competitiveness (upskilling/reskilling). Automotive, Software, and Healthcare & Medical Devices segments are expected to drive ~50% of the incremental ER&D spend by 2030, and players with higher exposure to such verticals are likely to benefit from this trend.

We initiate coverage on ER&D players Cyient (BUY) and LTTS (REDUCE)

ER&D players would benefit from industry growth tailwinds in the medium term, but valuations already factor this in to some extent, in our view. ER&D services stocks moved up in the last 1M/3M, on hopes of higher rate cuts in USA in CY24 which may cap any upside in the near term. However, improving medium-term growth outlook would support higher valuations. We initiate coverage on Cyient with BUY and TP of Rs2,700/sh, given relatively reasonable valuations, anticipated double-digit revenue growth trajectory, progress on margin trajectory, and steps to improve performance consistency. LTTS benefits from its strong engineering parentage and well-diversified portfolio, but given its rich valuations, we initiate coverage on the stock with REDUCE and TP of Rs5,050/sh.

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