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Strategy refresh and investment in sales to aid growth

Risk reward attractive, upgrade to BUY

* While ZENT’s revenue performance in FY21 (down 12% YoY in CC terms) was among the weakest in our IT Services coverage due to hit from both COVID19 and restructuring in its top account (over 20% of revenue), it reported an impressive PAT growth (33% YoY), led by 6pp EBITDA margin improvement.

* The company’s low valuation (13x FY23E P/E) is on account of its weak topline performance over the last two years. With a new leadership (Mr. Ajay Bhutoria took over in Jan’21), refreshed strategy (Exhibit 1), and reinvestment of margin gains in sales, we expect it to return to sustainable growth from 2HFY22.

* A good exit to FY22E, in addition to recovery in key accounts, should help ZENT deliver double-digit (15% YoY) growth in FY23E. This could lead to a significant re-rating in the stock as valuations catch up with its peer group.

* We upgrade the stock to BUY on improving growth potential and attractive risk reward ratio as current valuations are the lowest in our midcap coverage and at a 43% discount to the median valuation of peers on a FY23E EPS basis.

* We see higher downside protection in the share price at current levels, as 21% of ZENT’s market capitalization is in cash v/s only 8% for its midcap IT Services peers. A large cash balance also offers the possibility of a share buyback at attractive levels.

* Higher investment in sales and a return to normal wage cycle will cause a 70bp YoY decline in FY22E EBITDA margin (down 190bp from 4QFY21 levels). This, coupled with weak revenue growth, would result in low single-digit FY22E PAT growth before picking up in FY23E. We estimate ZENT to deliver 20% PAT growth over FY20-23E, with a recovery in FY23E compensating for a weak FY22E.

* We trim our revenue growth estimates (12%/5% for FY22E/FY23E) on weaker than expected 4QFY21 performance, but upgrade the stock on attractive valuations. Our TP implies 16x FY23E EPS. Upgrade to Buy.

Weaker topline but in line margin performance in 4QFY21

* Revenue fell 3.4% QoQ to USD120m in CC terms, below our expectation of a 1.8% decline. In reported terms, revenue decreased 2.1% QoQ CC.

* Decline in revenue was led by a 1.9% fall due to revenue mix and volume and 1.5% dip in the Hi-Tech segment (top client weakness). This was offset by a 1.3% forex gain.

* The decline was consistent across DAS and DFS, both of which fell 2% QoQ.

* EBITDA margin fell 70bp QoQ to 19.9%, 30bp above our estimate.

* The decline was majorly led by the wage hike impact and increase in SGA.

* PAT stood at INR905m (down 8.3% QoQ), 5% lower than our estimate due to lesser operational income. 

* The management sees five strategic growth opportunities (SGO) in experience services, advanced engineering services, data engineering and Analytics, application services, and foundation services.

* The management intends to overlay these SGOs on their existing three industries (BFSI, Consumer, and Hi-Tech and Manufacturing) and the three regions (US, Europe, and South Africa) that it is present it.

* TCV stood at USD100m/USD623m in 4Q/FY21 (book-to-bill ratio of 1.3x).

* ZENT saw a gross headcount addition of 1,332 QoQ, despite a 120bp increase in utilization.

* Attrition inched up to 14.8% (up 200bp QoQ).

* Revenue from the US/Africa declined 3.1%/6.2% QoQ. This was partially offset by a 4.6% QoQ increase in Europe.

* The decline in revenue was majorly contributed by a 4.3% QoQ dip in the top five accounts. Top 5-20 accounts grew 5.9% QoQ.

* OCF stood at INR8,580m (up 25% YoY) in FY21, indicating an OCF/EBITDA ratio of 125%, while FCF stood at INR8,185m (up 35%), indicating an FCF/EBITDA ratio of 199%.

Key highlights from the management commentary

* Bookings for 4QFY21 stood at USD100m, including renewals and new deals. Two significant deals for ZENT in the BFS segment were deferred to 1QFY22. The management said the decline in the BFS segment was due to project completion in a large BFS account and that the pipeline remains strong.

* The five strategic growth opportunities are: 1) experience services, 2) advanced engineering services, 3) data engineering and Analytics, 4) application services, and 5) foundation services. These would act as primary tools for go-to-market strategies.

* Going forward, the management will continue focusing on driving operational efficiencies, including offshoring, which has been one of ZENT’s key growth levers. This will be partly offset by an increase in S&M expenses as it makes further investments in the business.

Valuation and view – Upgrade to Buy

* ZENT’s current valuation at 13x FY23E EPS is the lowest in our midcap coverage and is at a 43% discount to median valuations of peers.

* We expect revenue growth to rebound from 2HFY22E as the new leadership (Mr. Ajay Bhutoria took over in Jan’21), refreshed strategy, and reinvestment of margin gains in sales start paying off. With a likely return to double-digit growth in FY23E (we estimate 15% YoY) on a good FY22E exit and recovery in key accounts, we see potential for a significant stock re-rating as valuations catch up with its peer group.

* We see higher downside protection in the share price at current levels as 21% of ZENT’s m-cap is in cash v/s only 8% for its midcap IT Services peers.

* We upgrade the stock to BUY on likelihood of a recovery in growth and attractive valuation. Our TP implies 16x FY23E EPS.

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