Saurabh Mukherjea's 'The Rising Giants portfolio' has lost 19.4% & underperformed the Benchmark

Saurabh Mukherjea's 'Rising Giants' portfolio of mid-cap stocks has underperformed the Benchmark (-19.4% vs -2.8%). He has pointed out that two stocks are responsible for this. He has explained why the concerns of the market are misplaced

The Rising Giants portfolio’s NAV has declined by 19.4% since inception until May 31, 2022. In the same period, the Benchmark BSE 500 lost only 2.8%. The underperformance has continued even over three and six months ending May 31, 2022.



As can be seen from the image below, the two stocks which have seen above average corrections in their share price in the last 6 months are Dr Lal Pathlabs and L&T Technology Services. Team Marcellus has opined that the concerns around both of these stocks are overdone.



Dr Lal Pathlabs

Concern #1 – weak 2HFY22 earnings: After recording 27% YoY PBT growth in FY21 and 100% YoY in 1HFY22, Dr Lal Pathlabs witnessed significant decline in PBT (down 31% YoY) in 2HFY22.

Marcellus take: Dr. Lal has reported healthy numbers for FY22 with PBT up 20%. The fall in PBT in 2HFY22 is primarily on account of tapering down of Covid-19 testing related revenues in 2HFY22 (decline of 50% YoY) as Covid-19 cases dropped significantly in India. Covid-19 related revenues were never expected to be sustainable and hence tapering down was expected.

The more sustainable non-Covid revenues have grown by 35% YoY in FY22 (30% YoY even after excluding Suburban Diagnostics acquired in October 2021). Non-covid revenue growth of 30% YoY ex-Suburban is despite increase in Covid cases affecting normal business for around ~4 months during FY22. In Q4FY22, non-Covid sales have grown at 12% YoY. However, ex-Suburban growth is only 4% YoY which is a muted number. Moderation in non-Covid growth in 4QFY22 is due to: (a) Non communicable and chronic disease were largely not tested during covid; and (b) The short spike in the Omicron variant of Covid during Jan/ Feb affected non-Covid testing. In past too we have seen non-Covid moderate whenever there is increase in Covid cases. As Omicron reduced by mid-Feb, non-Covid sales grew in double digits in the month of March as per management commentary.

Leaving aside the near-term results, three-year CAGR (FY20-22) in operating profits is 24% and in operating cash Flows is 21% (FCF is impacted due to Suburban acquisition as discussed in a preceding section).

Concern #2 – New entrants and disruptive pricing thereof: The Indian diagnostics space has seen some new entrants like Tata 1mg. Furthermore, these new entrants have announced aggressive prices in certain metro cities.

Marcellus take: Although not enough to build a loyal consumer base of customers, these discounted offers are common to gain new customers and has been going on for many years. Even Dr. Lal has similar offers in micro clusters in new geographies it is entering. Pharmeasy had similar offers when it entered diagnostics (these offers were subsequently rolled back).

What gives additional confidence about Dr Lal’s ability is to deal with the competition are: (i) Swasthfit (bundled tests/ health packages) contribution to Dr Lal’s revenues has increased to ~18% of sales v/s ~15-16% pre-Covid. This is a good sign because this is where price competition is the hardest from competitors (competitors would offer full body check-up at Rs 500 vs Rs 1,500 for Dr Lal Pathlabs); (ii) Home sample collection share in revenues for Dr Lal has increased from 5% to 12% of sales. (iii) Aggressive expansion of physical collection centres by 23% YoY from (ex-Suburban) during FY22.

Marcellus has stated that they neither expect meaningful market share loss, nor do they expect any weakness in margins in core non-Covid business. Further, management has set an aggressive target of doubling of non-Covid revenues from Suburban in two-three years with a sharp focus on Mumbai & Pune which should also improve Suburban’s non-Covid EBITDA margins from current levels of 7-8%. Evolution of the firm on various aspects over the last 2-3 years has been encouraging and they remain convinced on the fundamentals despite the recent share price correction.

L&T Technology Services

LTTS reported strong set of results for 4QFY22 (INR revenues up 21.9%, EBITDA up 30% YoY). All segments reported strong revenue growth led by transportation (up 30%), plant engineering (21%) and industrial products (22%). However, despite this seemingly strong 4QFY22, the firm’s share price has witnessed significant correction in the recent months due to the following concerns.

Concern #1 – potential impact of US recession on LTTS’ growth: Given that LTTS derives 60-65% of its revenues from US, a US recession has the potential to significantly impact its growth prospects.

Marcellus take: In the results call, LTTS management indicated that the overall demand outlook remains robust and there has been no indication of any change in budgets from the clients. From a structural standpoint India is likely to be a big gainer due to the cost optimization drive across the globe in a rising inflation or a slowing global growth scenario. While engineering services is a relatively younger industry, data from the Indian IT sector shows that slower growth in US/Europe has a limited impact on outsourcing. Moreover, with a lag of a year, Indian IT companies have actually seen a sharp acceleration in the rate of their revenue growth. Further, LTTS continues to benefit from the cross-pollination advantage by being present across multiple industries. Moreover, the company has been taking active steps over the last two years to sign up larger deals, which provide longer-term revenue visibility. On the back these steps, LTTS has signed two back-to-back $100 million plus deals in the last two years. In FY21, it signed a $100 million plus deal with an Oil & Gas company based out of North America. In Q4FY22, the company signed a large deal the with Jaunt Air Mobility (electric aircraft manufacturer) to provide engineering services for the electric Vertical Takeoff and Landing air taxi.

Concern #2 – lack of availability of talent and impact thereof on execution and margins: Given high demand for talent in the industry and labour supply issues in USA.

Marcellus take: While LTTS did witness an attrition of 20.4% in 4QFY22 due to widespread supply issues in the industry, the attrition rate was the lowest amongst the pure play Indian ER&D players. The reason for people moving out from LTTS or broader IT services companies was the high salaries being offered by start-ups and the product companies. However, in the last one month, things have changed - increasing lay-offs by start-ups have led to easing of supply of the talent in the industry. LTTS also continues to focus on employee learning and development which can help retain talent. LTTS has recently carved out a new business unit and Centre of Excellence for Metaverse and visual reality products. The company hired around 3,000 freshers in FY22 and would largely benefit from deploying them for the projects. Working in LTTS provides the exposure of core engineering and allows passionate engineers to work for innovative products.

Overall, Marcellus consider LTTS is well-positioned to benefit from increasing ER&D spend and offshoring by the customers across the globe.