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Near-term growth challenges persist, albeit recovery in sight

FSOL’s Q2FY23 revenue was broadly in line with our expectations, while EBITM missed our estimates. Mortgage revenue declined ~25% QoQ to ~USD24mn in Q2; Management expects it to see further decline in Q3 and likely bottom-out in Q4. FSOL has lowered its FY23 CC revenue growth guidance to -2 to 0% and 12-15% excluding mortgage & acquisitions (earlier 2-4% and 16-19%, respectively), to factor-in the continued decline in mortgage, slower recovery in collections, delay in deal closures in HPHS and the slower pace of deal ramp-up amid a tight labor market in the UK. The guidance builds-in flattish growth in Q3/Q4 at the lower-end and decent growth in Q4 at the upper-end. FSOL has also lowered EBITM guidance to 9-9.5% for FY23 (earlier 10-10.5%), given weak revenue growth and fixed-cost impact on the mortgage business. It targets normalized EBITM of 11.5-12% by Q4FY23. We cut FY23-25E EPS by 3.3-3.9%, factoring in the weak Q2 and the revised FY23 guidance, which will weigh on near-term stock performance. We expect the stock to gradually recover as investors gain confidence on a sustainable recovery in sequential revenue growth and margin. We retain BUY with TP of Rs125 (earlier Rs130) at 13x Sep-24E EPS, considering the anticipated recovery in performance and ~4% dividend/~9% FY24 FCF yield.

Result summary: Revenue declined 2.1% QoQ to USD187mn (0.2% CC), broadly in line with our expectations. Organic revenue excluding the mortgage business grew by 12.8% CC YoY. EBITM expanded by ~50bps QoQ to 8.4%, coming in below our estimates. Net profit stood at Rs1.29bn, beating our estimates due to a one-off item that relates to the fair value of the liability for contingent considerations pertaining to the ARSI/TSG acquisitions which are expected to be settled in Q3/Q4FY23. Management indicated that the macro environment has further deteriorated in Q2, dragging down volumes in new home sales and the refinance business. Mortgage revenue declined ~25% QoQ to ~USD24mn in Q2, with contribution from origination:servicing at a 35:65 ratio. The mortgage business is expected to remain under pressure in the near term due to increase in mortgage rates (30-year fixed mortgage rates jumped to ~7% from ~3% at the start of CY22 which is a 20-year high). FSOL added 25 clients in Q2, led by (a) BFSI, which saw 22 additions spread across Mortgage (8), Collections (11), and Europe BFS (3); (b) CMT, which saw 1 addition - Edtech client; and (c) Healthcare, which saw 2 additions. Recovery in the collections business is slower than earlier expectations, as delinquency rates remain unusually low amid low unemployment and strong household balance sheets. What we liked: Steady growth in the HPHS business, healthy cash conversion (>100% OCF/EBITDA). What we did not like: FY23 guidance cut, slow recovery in both, collections and the provider business.

Earnings-call KTAs: 1) Weakness in Mortgage is likely to negate the growth from other segments, resulting in a flat Q3; while continued traction in HPHS, the possibility of stability in mortgage, collection-business seasonality and better fulfilment rate in the UK are expected to drive sequential growth in Q4. 2) Collections business Q2 revenue run-rate is ~USD33mn, of which organic revenue is ~USD16mn (vs USD14.5mn in Q2FY22), with the rest contributed by ARSI. 3) Management highlighted that impact of macro is transitory in its view, and that it is confident of sustaining growth momentum in medium term, as it strategically diversifies its portfolio to combat the cyclical nature of the mortgage business. 4) Europe BFS saw steady growth, while Collections remained sluggish. 5) Healthcare is expected to lead the growth in FY23 because of growth momentum in HPHS and the anticipated recovery in the provider business at FY23-end. 6) CMT grew ~7% YoY CC and is expected to maintain its steady growth momentum. The top client in CMT continues to demonstrate healthy growth. 7) Company expects ETR to remain within the 17-19% range for FY23.

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