Big margin improvement, but awaiting growth recovery
Expect some reinvestment of margin gain in business
* While Zensar’s (ZENT) 2QFY21 revenue performance – impacted by restructuring at its top client – was in line with our expectation, it was meaningfully below growth seen at its mid-cap peers. With the drag in top clients continuing in 3Q-4QFY21, we expect ZENT to come near industry growth only in FY22E.
* On the other hand, 2QFY21 EBITDA margin for core business (19.4%) was much ahead of our expectation and the company’s target of 15%. We expect the company to reinvest some of the gains from aggressive cost rationalization into growth and expect EBITDA margins of 17% in FY22E.
* ZENT continued to report healthy deal wins with 2QFY21 TCV of USD175m, suggesting a book-to-bill of 1.3x. Deal pipeline also remained strong at USD1.5b, which we see as encouraging.
* We upgrade our EPS estimate for FY21/FY22E by 3%/5% as we adjust our revenue growth and margin assumptions post the 2QFY21 beat. In our view, growth revival would be necessary for any stock rerating, despite the inexpensive valuations. Our TP implies 12x FY22E EPS. Maintain Neutral
In-line revenues; Better-than-expected margin performance
* ZENT reported revenue (USD/ EBIT/ PAT growth of -14%/26%/12% YoY (v/s est. -13%/-10%/-3% YoY). For 1HFY21, the company reported revenue (USD)/ EBIT/ PAT growth of -14%/6%/2%.
* Revenue decline of 0.6% QoQ (CC) was in line with our expectations.
* Unlike 1QFY21, Hi-tech declined (4.7% QoQ CC) along with Manufacturing (3.8% QoQ CC) and Emerging (10.8% QoQ CC). This was offset by strong growth in Consumer Services (11.3% QoQ CC), Banking (6.6% QoQ CC) and Insurance (2.3% QoQ CC).
* Europe/ Africa reported strong growth of ~8%/6% QoQ (USD) while America declined (1.5% QoQ USD).
* Top-5 clients reported sequential decline in revenue (7.2% QoQ USD) while Top 6-10/11-20 reported robust growth of ~6%/4% QoQ (USD).
* Margin expansion of the company is a big positive surprise. Optimization of direct costs (+370bp impact) and volume/utilization (+130bp impact) were the key margin tailwinds. Overall, core EBIT margin expanded 450bp QoQ (v/s est. 30bp).
* Utilizations increased to 83.3% (v/s 82.2% in 1QFY21) while attrition also improved by 220bp and stood at 11.7% (all-time low).
* DSO remained largely stable. The company’s debt further reduced by ~USD17m.
* Total Contract Value of deals signed during the quarter was ~USD175m. Management indicated that the current deal pipeline is USD1.5b+.
Key highlights from management commentary
* The company got back on growth trajectory in 2QFY21 and management believes they are strongly positioned to continue on this path. This is on the back of robust pipeline and continued traction in cloud and digitization services.
* Hi-Tech vertical and top-5 client growth was soft due to business challenges in their largest customer in the vertical. Softness is expected to continue for the coming 1-2 quarters.
* EBITDA margins surpassed the 15% target during the quarter. There is continued focus on cost conservation and management is optimistic to be in a narrow band despite return in travel/discretionary spends and wage hikes in 4QFY21.
* Sustained margins are expected on the back of cost optimization levers and divestment of its non-core business, which was margin dilutive.
* It is actively looking at M&A opportunities in the digital engineering and cloud space.
Valuation and view – Multiples should remain stable
* Barring FY19, when Zensar’s overall revenue growth (including inorganic) had come close to that of its mid-cap peers (mostly organic), the stock has always traded at a steep discount to the sector.
* This was largely driven by its inferior growth (organic revenue CAGR of 4% over FY15-20 v/s 12%+ for mid-cap peers), payout ratio (20%, v/s average payout of 40%), and return profile (RoE of 18% v/s 30%+ for most peers).
* We value the stock at ~12x FY22E EPS, , at its 5-year median P/E band.. We expect the company to see improvement in its revenue and PAT growth in FY22, but would wait for any recovery before turning more constructive on the stock.
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