Tata Elxsi : Premium performance < Super premium valuations

Tata Elxsi (TELX) reported strong revenue growth of 7.3% QoQ US$ (7.4% QoQ CC) in 4QFY22, representing a beat to our estimate of +6.0% US$ QoQ. Growth was broad-based across verticals: transportation (+8.3% QoQ CC) led the pack, followed by media (+7.2% QoQ CC) and healthcare (+6.8% QoQ CC). Margin performance was resilient at 32.5% (-70bps QoQ) vs Isec estimate of 31.9%; the slight beat was largely on account of lower employee expenses at 51% of revenue – lowest-ever – which led to gross margin of 44.5% in Q4FY22. Margin is unlikely to expand further given the supply-side challenges due to high attrition, reversal of elevated offshore mix (75.2% in Q4FY22 vs 55-57% pre-covid), peaked-out utilisation and return of travel and facility costs post the normalisation of global economy.

However, we expect margin to stabilise above pre-covid levels (~24%) due to greater acceptability of clients toward offshoring and supported by levers of revenue growth leverage and pyramid optimisation. We build in EBITDA margin of 28.3%/27.5% for FY23E/FY24E.

TELX has emerged the fastest-growing company among Indian ER&D peers, growing at 9% YoY in FY21 and 34% YoY in FY22. We expect revenue growth leadership of TELX to continue over FY23E-24E driven by 1) higher offshore R&D spends on digital, 2) strong client mining capabilities (top 1 / top 5 clients grew 57%/40% YoY in FY22), 3) focus on winning longer-duration larger sized deals by becoming strategic partners for clients (e.g. Aesculap and Schaeffler deal wins), and 4) expansion in fast-growing healthcare sector and diversification in auto to de- risk growth. We expect TELX to continue its growth momentum and forecast revenue growth of 26%/23% in FY23/FY24.

TELX has superior operating metrics compared to its peers: 1) lowest cost of delivery; 2) highest offshore mix; 3) reducing client concentration and, at the same
time, superior client mining capabilities. We like the company for its robust growth profile and maintenance of margin way above pre-covid levels. We are above
consensus earnings estimates by 10% for FY24. However, its super premium valuations of 74.5x/61.3x on EPS of Rs106/129 drive our SELL rating. We value TELX on 38x target multiple of FY24E earnings to arrive at a fair value of Rs4,902 (prior: Rs4,875). Key upside risk to our rating includes better than expected margin
performance.

Revenue above estimates. Revenue for the quarter came in at Rs6,817mn, +7.3%  QoQ US$, 7.4% QoQ CC, above our estimates (Isec: 6.7% US$). In CC terms,  revenue grew 7.4% QoQ. Growth across verticals was broad based. Transportation  (+8.3% QoQ CC) led the pack, while media (+7.2% QoQ CC) and healthcare (+6.8%  QoQ CC) were marginally below company average. 

Embedded Product Design (EPD – 89% of revenue) reported robust growth of 7.6%  QoQ (CC). This was despite strong performance (avg. growth of ~10.1%) in prior 2  quarters. Industrial Design & Visualization (IDV) reported robust growth of 8.7%  QoQ (CC). System Integration & Support (SIS) lagged with decline in growth of 3.8%  QoQ (CC). 

In terms of geography, Europe (+10.5% QoQ) led growth. Growth in the USA  remained tepid at 3.8% QoQ while India / RoW grew 5.3%/7.9% QoQ, respectively.  After 2 consecutive quarters of 16%+ growth, top client growth moderated to 8.1%  QoQ for the quarter but top 2-5 clients reported robust growth of 7% QoQ while  growth declined in top 6-10 accounts by 3.2% QoQ. 

Segmental commentary
EPD continues to gain traction and showcases strong growth, while increasing  traction for TELX’s design offerings has led to strong sequential growth in IDV.  

Growth in transportation was led by increased engagements in autonomous, electric  powertrain and connected vehicles. Management is seeing good traction and multi year deals in areas of EV, AD/ADAS and connected infotainment. 

TELX is winning increased number of transformation and platform led deals which  is driving growth in media while healthcare is being driven by digital and connect  health engagements. Within media, expansion into newer geographies like the  Middle East, Africa, India and Latin America has aided growth tremendously. 

Management stated that deal pipeline is robust and it is seeing a lot of traction in  large deal discussions. Newer geographies, good deal wins, large multi-year deals  and strong orderbook give confidence to management as the company enters FY23. 

Resilient margin performance: EBITDA margin contracted 70bps to 32.5% (vs  Isec: 31.9%). Beat was largely on account of higher than expected gross margin  (44.5% vs our estimate of 42.5%). Offshore mix remained stable for the quarter at  75.2% which helped margin during the quarter. 

Attrition increased sharply by 260bps QoQ to 20.8%. Attrition is higher at junior level  while mid to senior levels are largely stable. Management hopes to manage the  demand and supply mismatch in the next 2-3 quarters through increased hiring. 

Margin was impacted (-150bps) due to wage hikes given to junior level employees (65-70% of workforce in January, 2022) which was offset by operational levers like  utilisation, pyramid rationalisation, better realisation from fixed price projects. For  senior level, wage hikes would be rolled out in April, 2022 and impact of the same  should neutralise by operational efficiencies and increase in volumes. 

Further, management also stated it has seen price increases in a few pockets where  it has value engagements. However, we believe benefits from these would be back ended.

Strong hiring continues: On workforce front, net addition for the quarter stood at  343. Supply-side challenges persist and the company is aggressively investing in  accelerated hiring of freshers and laterals. TELX hired ~1.1k freshers in FY22 and  intends to add ~2.5-3k freshers of the total gross hiring of ~3-3.5k in FY23. 

Impact of Russia-Ukraine conflict: There has been no impact on account of the  conflict as TELX does not have exposure to the affected areas. Given the company’s  customers are largely in the western region, management is not seeing any slowdown yet. Management is seeing few enquiries from clients in Europe (those of  EPAM) but it is not a very large number. 

Other highlights: As part of its innovation efforts, company globally launched T Engage at the end of March (2022). It has had brilliant response in the US and is  having conversation with multiple customers. It announced a dividend of Rs42.5 per  share.  ICICI Securities