Private Equity and Edtech - what do they have in common and why they need to be built for anti-scale?
by Naveen February 7, 2023
In the post-lockdown world, R&D has become a buzzword globally, with many companies realising the necessity to innovate and adapt to supply chain disruptions and changing consumption patterns. With investments in ER&D rising, two companies that will be clear beneficiaries of this trend are L&T Technological Services (LTTS) and Tata Elxsi, two of the world’s leading providers of design and technology services across industries including Transportation, Media, Energy, Communications and Healthcare & Medical Devices, among others.
It is important for us as investors to breakdown our investee companies to continually look for the best risk-reward investments. While our portfolio company (L&T Technology Services) has done well over the last 1.5 years, the market is happy to give Tata Elxsi (one of its competitors) a much higher valuation and multiple. We aim to figure out why, through this endeavour and our interest in holding LTTS.
Fig 1: Absolute returns for LTTS and Tata Elxsi over the last 3 years
Over the last 12-18 months, there has been a noticeable divergence in returns derived from the two companies. The market has given Tata Elxsi a multiple of 1.6x premium to LTTS. In this article, we evaluate what led to this disparity and what can we expect henceforth?
Figure 2,3: Financial Growth for Tata Elxsi and LTTS
While the multiple given by the market is beyond our control, it is important to realize that the multiple is a function of consistent growth. Markets like humans, like stability and consistency. A company that grows 18% in 2 years and de-grows at 5% in the third year, is likely to get a lower multiple than a competitor that grows 12% compounded consistently.
When comparing the two companies’ performance from FY17 to FY20, it is evident that LTTS outperformed Tata Elxsi, with over twice the topline growth and a significantly higher margin profile to go alongside. Historically, Tata Elxsi had a high dependence on Jaguar Land Rover, which at peak contributed to ~30% of the company’s revenue. As JLR’s fortunes began to shift, its contribution began to wane as well.
However, the one characteristic of Tata Elxsi through this difficult period was consistency. They managed to grow at the portfolio level even during a difficult FY21 (where LTTS showed de-growth). The company (Tata Elxsi) was able to manage the slowdown through growth in healthcare, autonomous and mandates through other auto companies. In the same FY21, LTTS product portfolio growth decreased by 4%, as a result of their previous focus on the Oil & Gas industry, plant & machinery-based industry, FMCG and Chemicals, and Automotive, all of which were more tied to the recovery and capex cycle.
Figure 4: Latest Industry mix of LTTS and Tata Elxsi
The post-covid spending pattern shifted to an increase in healthcare and medical devices, as well as cutting-edge technologies such as 5G and automotive electrification, which LTTS began to scale in the latter half of FY21. The industry mix of revenues as of December 2021 indicates that the LTTS’s focus, while shifting toward concentration healthcare and automotives, is still fragmented towards industrial products and plant engineering, where they hold several legacy contracts. This is in contrast with Tata Elxsi, where Transportation and Media & Communication have consistently accounted for the bulk of their contracts. Tata Elxsi was able to capitalise on increased R&D spends and grow 35.4% in 9MFY22 over 9MFY21 with the right mix and talent (their main expense) required for expansion, while LTTS grew only 19.2% in the same period. An argument can be made, however, that diversification helps LTTS, in the long-term, from overt reliance on any industry’s cyclical nature.
Figure 5: Net profit margins (FY17 to 9MFY22)
While both firms have been able to boost margin profiles as this was achieved by optimising expenses (operational leverage), Tata Elxsi has been able to grow the margin profile significantly over the last 5 years. Their margins over a 5-year period increased from 14.2% to 21.8% while LTTS has been able to increase it only to 14.5% from 12.9% in the same period. Tata Elxsi was able to do so by improving revenue share among their top 5-10 clients. This factor, combined with Tata Elxsi’s consistency in growth (lower earnings volatility) during the lockdown periods, compared with LTTS’s degrowth during March to September 2020, provides us an understanding of the resultant valuations the market is willing to give to companies.
Why does LTTS still deserve a place in our portfolio?
We continue to believe that the product portfolio of LTTS today is significantly geared towards growth. The 5 focus areas of LTTS are garnering business as each of them are looking at technology spends as a leverage for growth.
The company has gotten repeat tenders from existing auto client to build and assemble EVs, which highlights their investments towards R&D over the last 3 years. A US-based EV battery maker has selected LTTS as its engineering services partner to support its platform and production programs as well.
While we continue to maintain that the market multiple is an external factor, the normalized growth of LTTS over the next few years has the potential to compound at a mid-high teens. As margin expansion begins to take shape, we believe that this has the ability to return a 24% IRR as shareholder returns from here.
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