Case for L&T IPO: Do valuations trump plain-vanilla biz model?

The Rs 1,243-crore initial public offer (IPO) of L&T Infotech was oversubscribed nearly 6 times.In CNBC-TV18's show Bull vs Bear, Urmil Shah of IDBI Capital, who had a subscribe call on the issue, put down the enthusiastic response to domain expertise, renewed aggression at expanding business geographically as well as in digital space and relatively reasonable valuations. Shah expects the company to post annual earnings growth of roughly 12-14 percent in the next few years.Vibhor Singhal of PhillipCapital, however, has a contradictory view. He agrees valuations are fair though not cheap but expects the company's growth to lag peers in the near term as there seems to be nothing unique in its business model. Among other mid cap information technology companies, Shah likes Cyient and Mindtree.Below is the verbatim transcript of Urmil Shah and Vibhor Singhal's interview to Reema Tendulkar and Nigel D’Souza on CNBC-TV18.Nigel: You seem to be in the camp that believes it’s a subscribe and the subscriptions detail tells us that it already been subscribed by more than 5.5-6x tell us why?Shah: We have recommended a subscribe to the initial public offer (IPO). We believe that L&T Infotech does have some positives, the most important of that is the domain expertise that the group brings across various sectors, which in the past we know they have not been aggressive in utilising it, but I think going forward they are very determined to leverage that.Secondly, they also have a very strong presence in the US and they are targeting to grow aggressively in the Europe. They have very less presence in the UK just 2 percent of their revenue, so overall the geographic presence has also quite strong and they have focussed on the new technologies and digital as well, which is just 11 percent of their revenue right now which they are targeting to grow at aggressively is quite positive. If we also look at the valuation it is at 13 times on FY16 earnings on reported numbers and even on adjusted for the forex gain it is at 16 times. It is still at a discount to what Mindtree which is at 18 times on FY16 numbers. So think that the valuation is also reasonable and keep in mind the positives, we have recommended subscribe to the IPO.Reema: What could be the expected listing gains as well as what would be your fair value in the next say 12 months?Shah: Because of compliance things we have not put out the fair value on the same, but think that in the last two years the company has underperformed the sector grown by 9 percent in USD terms that can improve going forward. They are also targeting to be aggressive on the mergers and acquisitions (M&A), so I think that the earnings could grow at 12-14 percent and you could expect that much upside.Reema: You have a very different view while Urmil’s point about valuations at 13 times trailing that’s FY16 PE or even if you take forward for FY17 its PE would be at 12 times which is lower than what the large caps are trading at. You still believe that there is no valuation headroom or comfort.Singhal: With the L&T Infotech I think the valuation is the only point which is probably positive, so I wouldn’t say nearly a big positive, I mean if you look at the earnings for FY16 around 30 percent of the PAT was forex gain, so if you adjust for that and even if you basically draw forward around 10 percent kind of a top line growth, we are still looking at 12-13 times FY18 valuations at the upper price band. Now at a time when HCL Tech is available at 11.5-12 times FY18 earnings, I don’t see these valuations excessively inexpensive, in fact, if it trading at a discount to Mindtree and eClerx that because we believe that the business model itself is inferior to those companies.If you look at the business model, their 47 percent revenue comes from banking, financial services and insurance (BFSI), 44 percent revenue comes from application development management (ADM), they do not have any revenues from engineering research and development (ER&D) because L&T has a separate arm for that. The digital revenue was around 11 percent in which the management itself concluded that they are a little behind the other players, so we believe it will be very difficult for the company to actually outperform their peers on the growth numbers itself, so we see the company lagging behind the peers as they have been doing for the past 2-3 years in terms of growth overall.Fundamentally, we do not find the business model anything exciting in the business model at all and the only argument for a stock to be invested is in the valuation parameters. I don’t think that makes for a strong enough argument for the stock to be held as a portfolio stock.Nigel: You believe it’s an avoid then would you advise investors to rather go with an HCL Tech as you mentioned that it may be 5 times its size and its trading at around 12 times or thereabouts its forward earnings.Singhal: There are multiple stocks which are there in that between large cap and midcap space which look attractive. Mindtree though at expensive valuations has a very strong revenue growth profile, so believe Mindtree would actually be a better pick than L&T Infotech as well.Reema: In the pecking order once L&T Infotech is listed and there is a fresh investor who wants to buy then in the midcap space, I am not talking about the large the top 5 IT companies, but in the midcap space which one do you think will be most attractive given the upside potential, given the valuations as well as the growth potential.Shah: We like Cyient in the midcap space and I would agree with Vibhor that even Mindtree despite its expensive valuation given the growth which they are expected to deliver looks attractive.