'Inflated valuations': Sell Tata Elxsi shares despite excellent biz, says Kotak

Tata Elxsi Ltd at 61 times one-year forward earnings is more than adequately factoring in all positives, said Kotak Institutional Equities. Calling Tata Elxsi an excellent company but with inflated valuations, the domestic brokerage in its latest note said near-term headwinds for Tata Elxsi have been ignored by investors so far, leading to steep valuation premium. This is despite a growth deceleration in the past two years and continued challenges due to high client concentration.

The stock is up 26 per cent in the past two days. “The stock was expensive even before the rally. We believe that Tata Elxsi's revenue growth would improve through the rest of FY2025E, as large OEM engagements ramp up. However, challenges in the rest of the portfolio persist: (1) weak spending in the media and communications vertical and (2) middling presence in healthcare, along with deferrals by large clients," Kotak said.

The brokerage said valuations are stretched and are baking in over 20 per cent dollar revenue growth compounded annually over FY2024-34E. It retained 'Sell' on the stock with a fair value of Rs 5,500. 

Tata Elxsi has benefited from aggressive R&D spending by JLR in FY2024, with the account contributing 75 per cent of the incremental revenues or 18.1 per cent of overall revenues. 

"We believe growth in FY2025E would be more concentrated, with JLR contributing entirely to incremental revenues (Exhibit 1). Apart from JLR, the company needs to deepen relationships with other OEMs. There has been some progress on this aspect, with wins in SDV from a global top 5 OEM. Tata Elxsi has 34 per cent of revenues from the impacted tier-1 suppliers, which remain under pressure and would partly offset revenue growth," Kotak said.

Kotak feels that challenges in the rest of the Tata Elxsi's portfolio are likely to continue at least over the foreseeable future. 

For example, the media and communications segment’s performance has remained muted in the past eight quarters without any signs of significant improvement in clients’ appetite to spend on new programs. 

The healthcare and medical devices vertical has remained volatile. Tata Elxsi works with a few marquee logos and has been impacted by client-specific challenges and insourcing. 

"Overall, we build in a 4.3 per cent CQGR over 2Q-4QFY25, adequately factoring in the strength in the transportation vertical. We expect 11.3 per cent c/c revenue growth in FY2025E," it said.

Kotak said Tata Elxsi runs a tight ship, optimising cost structure with industry-leading profitability. Investments in sales and strengthening global delivery capabilities should limit margin expansion in the medium term, it said while expecting EBIT margins to remain in the 27 per cent range over FY2025-27.

Kotak said Tata Elxsi achieving a revenue scale of $2.6 billion is a daunting task. Tata Elxsi is a high-quality business, but Kotak disagrees with the magnitude of the valuation premium, and thus maintained its 'Sell' rating.