Engineered for Success

These are turbulent times for the Indian IT sector. Apart from the uncertainty on the US regulatory front and an appreciating rupee, the Indian IT industry itself is seeing a structural change with newer technologies like cloud and automation that is cannibalising traditional IT services. With clients shifting their tech spend to newer areas like digital and IoT, there is a need for newer skill sets that existing employees don’t always have. Amidst all the turmoil with slower growth and unprecedented lay-offs in the industry, having a differentiated business model with a strategic relationship with clients does put a company in an enviable position. Finding itself in that position is Hyderabad based mid-cap company, Cyient. 

What makes Cyient so different? For one, the company provides engineering services, coupled with niche offerings in the communication and the GIS segment, which are relatively immune from the problems plaguing the IT industry. “Structural changes are impacting services, like Application Development and Maintenance (ADM), infrastructure management and testing, where Cyient does not have presence. So it is least impacted by these structural changes,” says Amit Chandra, research analyst, HDFC Securities.

Engineering services encompass the entire product development cycle, including design, development, testing, rollout and maintenance. India’s engineering services market is expected to grow at an average of around 14% every year till 2020 to reach $38 billion — faster than the traditional Indian IT and BPO services driven by shortening product life cycles — according to technology research firm Zinnov. Cyient is among the few Indian companies with such a huge exposure to engineering services (61% revenue). 

The company has made several strategic changes over the past three years including expansion of its service offerings through acquisitions, aligning services to industry verticals for better focus and venturing into design-led manufacturing. Its business is divided into seven verticals — the top three being aerospace & defence, communications and utilities & geospatial. (See: Balancing act)

Krishna Bodanapu, who took over as the CEO of Cyient three years ago, led much of the transformation. The company broadened its service offerings from ideation to design, prototype development testing and maintenance through its S3 (services, systems and solutions) strategy, thereby getting a large share of the customer wallet. “S3 is based on our aspiration to move from being a service provider to a solution provider. It focuses on building capabilities and providing end-to-end solutions to our clients by leveraging unique, distinctive capabilities of engineering design, manufacturing, aftermarket and asset management services,” he explains. 

Over the past years, Cyient has been on an acquisition spree, shelling out $80-90 million to augment its capabilities. “As a company we have a well laid out M&A strategy. Our acquisitions are closely aligned with our S3 strategy. We will acquire to fill strategic capability gaps in our portfolio in terms of competency, business segments, geographical reach and client access. Focusing on inorganic as well as organic growth to fill in the gaps has helped us realise our strategy,” Bodanapu explains.   

Its foray into design-led manufacturing (DLM) was driven by its Rangsons acquisition in FY15. The company picked up 74% stake for Rs.360 crore in Rangsons Electronics in an all-cash transaction. The Mysore-based electronics system design and manufacturing (ESDM) services firm helped Cyient foray into design-led manufacturing to address opportunities across the seven verticals it is present in. According to Urmil Shah, analyst at IDBI Capital, “The drive to differentiate is generally not visible in mid-cap companies and that is one of the reasons we expect Cyient to do well in the long run.” Strengthening its DLM business might prove to be a smart and bold move as most firms in this category have pre-dominantly focused on designing handset and not on high-end manufacturing. “By FY19, its investment in DLM will start delivering,” adds Shah. Rangsons also provided access to certain certifications that are a must to work with some of the larger aerospace and defence manufacturers.

As is the case with most acquisitions, the synergies have taken some time to play out. According to Ajay Aggarwal, CFO, Cyient, in terms of fructification of synergy benefits, it was taking longer than what the management had anticipated. “First you get the customers then it takes about two years to certify the facility. It takes another one to two years to get the prototypes certified,” Aggarwal explains. FY16 was the first year of full consolidation where DLM contributed 8.6% to overall revenue. In FY17, revenue from DLM grew by 36% to Rs.365 crore, making up to 10% of total revenue. In the first quarter of FY18, the DLM business grew 17% YoY but declined 27% on sequential quarter basis. According to the management, growth in the DLM business has always been back-ended and they expect the business to grow by 20% in FY18 supported by a better order inflow ($26 million in Q1FY18 versus $12 million in Q1FY17) after weeding out low-margin projects. They expect the DLM business to start generating cash from the next quarter, which will improve the overall margins for the company.

In FY17, Cyient acquired two other firms in the US and the UK — Certon Software and BlomAerofilms. While from a revenue perspective these might be minor acquisitions, it augments Cyient’s existing capabilities. Aggarwal explains, “For instance, Blom is a company which can do a lot of aerial surveys for highways. One of our largest customers in utilities and GIS is TomTom, which is a Dutch firm that sells live traffic services for internet-connected devices and smartphone apps. We do a lot of data analysis for them, which is mostly back-end work. We are building the capability for field work, and this is one of the companies which will aid the process.” Similarly Cetron’s testing and automation capabilities along with Cyient’s strong global delivery capabilities will reduce the time to market for its clients in the aerospace and defense segment. 

Spreading its wings
Cyient’s ability to develop deep strategic relationships with its top clients has worked well to its advantage. For instance, its first customer in the aerospace and defence vertical was Pratt and Whitney — one of the leading global manufacturers of aircraft engines. It is now Cyient’s largest client and a strategic investor in the company with 13.59% stake. Similarly, it has developed strong ties with leading aerospace and transportation global major, Bombardier. “Our focus will be on nurturing these strategic relationships and mining them well for growth,” says Bodanapu. The contribution from its top five clients increased to 41% of total revenue compared with 35.7% of total revenue two years ago. “Cyient derives its competitive advantage from its strategic relationships. It has been in a better position to navigate the transition that the IT industry is going through in comparison to its peers,” says Deepak Purswani, analyst at ICICI Securities. 

The company’s portfolio approach of building a significant presence in its key verticals other than aerospace and defence such as communication and transportation has helped the company manage volatility in the aerospace business. For instance, during Q1FY18 when aerospace and defense saw a moderate growth of 1.7%, communications and transportation came to the company’s rescue. Transportation, which makes 10.5% of overall revenue, grew by 11.7% QoQ with better traction in its rail transportation business. The communications business riding on fibre rollouts across Australia, New Zealand and the US, thanks to the adoption of small cells in a bid to enhance 4G networks, grew by 9.9% during Q1FY18. This was on the back of posting a 32.6% growth in FY17. The management expects the communications, medical, semiconductor and utilities verticals to post a double-digit growth in FY18, while aerospace grows in high single digits. The management expects the aerospace business to bounce back in the next quarter as the business is much more diversified now, with over 50% of revenue from non-design business versus 30% of revenue coming from non-design business, a few years back. This works well for the company since the design work is also more cyclical in nature.

Getting back on track
The company’s revenue has seen an average growth of 14%, over the past five years (FY13-FY17) with profit growing at a slower pace (9.86%) during the same period. The slower growth in profit is mainly due to a drop in margins from 18.2% in FY13 to 13.4% in FY17. There have been two key reasons for this — first, higher contribution of onsite revenue over the years (from 45.9% in FY13 to 60% in FY17). Second, the Rangsons and Sofitential acquisitions had a negative impact of about 150-200 basis points on margins. Rangsons’ margins have been under pressure due to Cyient’s strategic investments and Sofitential’s margins suffered due to revenue volatility.

Analysts expect margins to improve in the next two-three years due to better operating leverage, lower employee costs and improved performance of the acquired companies (See: Steady gains). “We are also focusing on non-linear growth which will improve our margins. Going forward, we expect profit to grow faster than revenue,” says Aggarwal. Analysts expect the company’s revenue to grow by 26% and profit to grow by 33% over the next two years. As profitability improves thanks to better margins and improved synergy between Cyient and acquired companies, analysts expect the RoE, which declined from 19.57% in FY15 to 17.4% in FY17, to improve back to 19.5% by FY19. 

Cyient derives over 60% of its revenue from the US and according to the management for every 1% appreciation in the rupee, it has a 30-35 bp impact on operating margins. At any point in time, the firm takes a 12-month forward position on 70% of its net inflows. The realised gain from forward contracts pegged at Rs.71 crore for FY18, a steep rise from Rs.44.1 crore in FY17 will cushion any adverse impact of the rupee appreciation on the company’s profitability. If the rupee continues to appreciate, then Aggarwal says they will resort to some price increases to protect its profitability. The company expects the services business to see a similar growth like the previous year driven by a strong order pipeline. In FY17 the services business grew by 14.27%. The firm is currently trading at a one-year forward price to earnings multiple of 14x. Given its differentiated business model with its DLM offering, projected revenue growth better than some of its larger peers, Cyient is definitely worth a look.