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Structural growth levers intact

Growth outlook continues to improve across segments

* Quess Corp (QUESS)’s 2QFY22 revenue growth (8% QoQ / +23% YoY) was in line with our estimates. However, the adjusted EBITDA margin at 4.8% (+40bp QoQ) was ahead of our estimates.

* Adj PAT grew 81% YoY to INR766m, while reported PAT declined 17% YoY to INR412m (expectation of INR702m). RPAT was impacted by 1) ECL provisions of INR440m (government training and other government business), 2) the reversal of ineligible GST credit (INR480m), and 3) receivables write-offs (INR200m). This was partially offset by the reversal of impairment charges in the IFM business (INR766m).

* We continue to see Quess as a key beneficiary of the revival of normal operation across industries, especially in its Workforce Management and Operating Asset Management verticals. With the addition of new clients and the pickup in associate headcount, we expect Quess to deliver a strong operational performance. It should also continue to benefit from strong demand for IT staffing and deliver 25% revenue growth in FY22E, after a flat FY21, partially aided by a low base.

* Moreover, the adjusted EBITDA margin was strong; we expect continued margin strength on better operating leverage. We expect a 30bps YoY increase in the FY22 EBIT margin to 3.5%. With the full impact of business normalization in FY23E, Quess should deliver a 4.3% EBIT margin, leading to an adj. PAT CAGR of 80% over FY21–23E. The company should return to the net cash status over the next two quarters.

* Over the medium term, we expect QUESS to be a big beneficiary of the recent labor law reforms. Moreover, the management is seeing strong trends of formalization and hiring. Our TP of INR1,100 per share implies a multiple of 23x FY23E EPS. Reiterate Buy.

In-line revenue; operating profits strong albeit PAT miss

* Revenue was up 23.4% YoY to INR32.3b (in-line); adj. EBITDA rose 12% YoY to INR1.56b (exp. of 1% YoY growth). Rep PAT stood at -17% YoY to INR412m (v/s the expectation of +41% YoY).

* 1HFY22 revenue/EBITDA/RPAT came in at +24%/+7%/-1% YoY.

* Revenue grew 8% QoQ and 23.4% YoY. Workforce Management grew 6.9% QoQ. Operating Asset Management grew 5.4% QoQ and GTS 15% QoQ.

* The adj EBITDA margin stood at 4.8%, +40bp QoQ and -50bp YoY (v/s the expectation of 4.3%). This excludes the ECL provision impact of INR440m. Including this impact, the reported EBITDA margin stood at 3.5%.

* The sequential margin expansion was attributable to operating leverage. Conversely, YoY margin erosion was seen due to the service mix change.

* Adj PAT grew 81% YoY to INR766m, while reported PAT declined 17% YoY to INR412m (v/s the expectation of INR702m).

* RPAT was impacted by 1) ECL provisions of INR440m (government training and other government businesses), 2) the reversal of ineligible GST credit (INR480m), and 3) write-offs in receivables (INR200m). This was partially offset by the reversal of impairment charges in the IFM business (INR766m).

* General Staffing revenue was up 27% YoY.

* Headcount was up 9.8% QoQ and 30% YoY. The Core-to-Associate ratio for General Staffing stood at 379 (+1.6% QoQ / 16% YoY)

* IFM revenue increased 13% YoY, with 24 client wins. The margin shrank 1.6% QoQ on a slowdown in the Food business, partly offset by improved efficiency.

* Terrier Security revenue was up 8% on a QoQ basis.

* Industrial business revenue was up 10% QoQ, with five new client wins during the quarter.

* OCF/EBITDA stood at 80% vis-à-vis 60% in 1QFY22.

* The net debt position improved to INR680m v/s INR1.5b in 1QFY22.

* DSO was stable at 58 days v/s 57 days in 1QFY22.

* The company declared interim dividend of INR4/sh.

Key highlights from management commentary

* The company is seeing very strong momentum in formalization, hiring, and upskilling. Hiring and attrition have picked up across sectors.

* All industry verticals have recovered to pre-pandemic levels, including Retail, which was soft until 1Q.

* The company has been investing in sales, and the management is confident that these investments would accelerate client additions.

* The company continues to target a 20% CAGR in all of its businesses.

* Within IT Staffing, the company has exited low-margin businesses. Moreover, it has a separate high-margin stream of Digital, and its share in the business has expanded. The management expects to see further improvement in IT Staffing margins.

* The margin decline in Workforce Management is largely attributable to the Training and Skill Development business. The company is not likely to sign any further contracts in the Training business and would only fulfill existing contracts. However, the pandemic has delayed this process by a couple of years. The management does not expect the business to significantly contribute to margins going forward.

Valuation and view – company-level improvement to drive re-rating

* Strong hiring trends have led to robust demand recovery. We noticed similar trends in the immediate aftermath of the GFC/demonetization – when staffing companies benefitted from positive hiring trends in certain verticals. Such a trend would likely play out over the near term, benefitting business services firms such as QUESS.

* Over the medium term, as both the center and state governments look to liberalize and formalize the labor markets, QUESS should be among the biggest direct beneficiaries.

* We welcome the corrective steps taken by the new management to address some of the investor concerns. The improvement in cash conversion / RoE should drive a re-rating. Our TP implies 23x FY23E EPS.

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