Tata Elxsi To Persistent: Why JPMorgan Finds Valuations Of Engineering, R&D Firms 'Super Rich'

The spending slowdown in the engineering, research, and development market over the last six months is structural and not cyclical, according to JPMorgan Chase and Co.

Though ER&D services-based firms rose over the last three years on increased spends in the digital sector, they can expect strong headwinds soon, the financial services firm said in a note.

As the global market reopened, it lowered the need for connected and smart products, and as such, enterprises were no longer keen to spend on these areas, JP Morgan said.

The biggest impact of this slowdown will be on the shares of Persistent Systems Ltd., Tata Elxsi Ltd., and L&T Technology Services Ltd., it said, making their current valuations "super rich".

The onset of Covid, led to an urgency among clients to accelerate their digital engineering spends on areas like factory automation, OTTs, and connected health, according to JP Morgan.

ER&D stocks rallied to rise three to eight times over the last three years against a two-time growth in the NSE Nifty IT on assumptions that these spends would continue for the next decade due to under-penetration of digital services and offshoring, the investment firm said. This had driven growth for ER&D services firms at a 23% compound annual growth rate over two years, outperforming the 18% growth seen in midcap IT stocks, it said.

However, the investment firm described the spending slowdown over the last six months as structural and not cyclical as the reopening of global economies reduced the urgency for connected and smart products, slowing the pace of ER&D spending, JP Morgan said.

Manufacturing and medical sectors are seeing a lesser need for smart and connected products, while hi-tech clients are cutting back on spending on large-scale ER&D ideas, it said. The OTTs are reducing spending too due to slowing advertisement revenues, it said.

This slowdown has impacted Persistent Systems, Tata Elxsi and L&T Technology the most, JP Morgan said, while maintaining auto ER&D as the only vertical that might persist.

Shares of Persistent Systems declined 1.44% intra-day to Rs 4,680 apiece, while those of Tata Elxsi and L&T Technology slipped 2.37% to Rs 7,310 and 2.19% to Rs 3,833, respectively.

There is a 'real urgency' in the auto ER&D vertical from original equipment manufacturers to launch electric, connected, and autonomous vehicles, which is driven by competition to improve market-share, JP Morgan said.

The investment firm cut its estimates for ER&D global and offshore spends and India revenue growth over the medium term by 4% and over the long term by up to 3%. Revenue growth was lowered to 11% CAGR over FY23 to FY33, down from their earlier assumption of 14%.

Its price targets and multiples imply mid-teen growth, ranging from 13–18% over the next decade, against earlier assumptions of 18–25% growth.