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Valuation comfort to help tide over near-term hiccups

Supply-side pressures to further delay a margin recovery

* ZENT’s 1QFY23 performance of 3.1% QoQ constant currency (CC) revenue growth (120bp ahead of our estimate) was encouraging, given the weakness in Consumer and Hi-Tech verticals. While the 290bp QoQ EBITDA margin drop was broadly expected (on account of elevated supply-side pressures), it should dampen the company’s earnings performance in FY23

* ZENT’s performance over the last five quarters under Mr. Ajay Bhutoria’s (CEO and MD) leadership (organic CQGR of 4% QoQ) is reassuring, given its unique client and supply-side challenges. While the management has guided at a moderation in growth over the next two-to-three quarters on a slowdown in its Consumer, Hi-Tech, and Manufacturing verticals (~60% of revenue), we see these macro-led drags as temporary and continue to expect growth to normalize over FY24, resulting in an USD revenue CAGR of 11.3% over FY22-24, despite an over 250bp FX headwind.

* We see the moderation in quarterly attrition and the significant ramp up in fresher intake as positive on both revenue as well as margin. ZENT plans to further ramp up its fresher hiring, which should help it reduce its reliance on industry high sub-contractor cost (16.5% of revenue in 1QFY23).

* We remain cautious on margin in the near-term, with supply-side headwinds, return of travel costs, and a higher wage hike in 2QFY23. We expect EBIT margin to be at 11.5% (down 400bp YoY) in FY23, which makes it unlikely for ZENT to hit its mid-teen margin guidance in 2QFY24. Factoring in a 200bp YoY margin pickup in FY24, it should recoup the decline in earnings in FY23 next fiscal.

* The company’s relatively low valuation (at 12x FY24E P/E) is attributable to its weak revenue performance over the last two years, along with a correction in expensive Tier II IT Services companies. We continue to see the significant discount to its peers as excessive and more near-term focused, and expect this to narrow as growth recovers in FY24.

* We cut our FY23/FY24 earnings estimate by 3%/8%, due to our lower margin expectation this fiscal. Our TP implies 14x FY24E EPS. We maintain our Buy rating.

Good revenue growth, but higher delivery cost hit margin.

* ZENT’s 3.1% CC revenue growth was 120bp above our estimate. Reported revenue grew 1.8% QoQ in USD terms. It won a deal TCV of USD125m (down 25% QoQ, but up 29% YoY, with a book-to-bill ratio of 0.8x).

* EBITDA margin fell 290bp QoQ to 11.3% in 1QFY23, 30bp below our estimate.

* PAT grew 42% QoQ to INR751m (est. INR716m) on higher other income.

Key highlights from the management commentary

* Consumer and Hi-Tech and Manufacturing were impacted due to softness in tech spending. The management is seeing a deferment, slowdown, and a cut in discretionary spends in these verticals. The key areas impacted include experience, designing, and in some cases large Digital transformation deals.

* The management said the recovery in margin was delayed by two quarters, and now expects margin to be in the mid-teens by 2QFY24, v/s 4QFY23 earlier, on account of continued headwinds to margin.

Valuation and view

* ZENT’s current valuation of 12x FY24E EPS is one of the lowest in our midcap coverage.

* We expect the revenue growth momentum to continue in FY23. The new CEOled leadership team is in place, and its growth strategy has delivered results. The management expects margin to revert to the high teens over the medium term. With strong organic growth in FY23E and a recovery in key accounts, we see potential for a significant stock re-rating as valuations catch up with its peer group. Our TP implies 14x FY24E EPS. We maintain our Buy rating on the stock.

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