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Good long-term prospects, despite near-term pain

Margin has bottomed out, valuations attractive

* ZENT’s 2QFY23 performance of 1.6% QoQ constant currency (CC) revenue growth (up 180bp v/s our estimate of a decline) was encouraging, given the weakness in Consumer and Hi-Tech verticals. EBITDA margin dipped 270bp QoQ on higher than usual wage hikes and was 30bp below our estimate. ZENT maintained its mid-teen margin aspiration by 2QFY24.

* ZENT’s performance over the last six quarters under Mr. Ajay Bhutoria’s (CEO and MD) leadership is reassuring, given it is a unique industry (Hi-Tech, Retail) and the supply-side challenges. While the management has guided at moderation in growth over the next one-to-two quarters due to a weakness in its Consumer, Hi-Tech, and Manufacturing verticals (~60% of revenue), we view these macro-led drags as temporary and expect growth to normalize over FY24, resulting in a USD revenue CAGR of 7.7% over FY22-24, despite forex-related headwinds of ~430bp.

* We see a moderation in quarterly attrition (-180bp) and sub-contractor expenses (-220bp) as a positive indication of easing supply-side issues. The significant ramp-up in fresher intake is another positive on both revenue as well as margin.

* With a wage hike behind it, we feel that margin has bottomed out at current levels and expect it to recover from here on. Utilization, lower subcontractor expenses, and better commercials will drive margin. We expect EBITDA margin at 10.4% (down 510bp YoY) in FY23, which makes it unlikely for ZENT to hit its mid-teen margin guidance in 2QFY24. Factoring in a 210bp YoY margin pickup in FY24, it should recoup the decline in earnings in FY23.

* The company’s relatively low valuation (at 13x 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 view the significant discount to its peers as excessive and more near-term focused. We expect this to narrow as growth recovers in FY24.

* We largely maintain our FY23/FY24 earnings estimate. Our TP implies 14.5x FY24E EPS. We maintain our Buy rating.

Revenue above our estimate, good deal TCV in 2QFY23???????

* Revenue grew 14.4% YoY in CC terms, EBIT/PAT fell 51%/40%.

* In 1HFY23, revenue in USD terms grew 16% YoY, while EBIT/PAT in INR terms fell 41%/32%.

* Revenue grew 1.6% QoQ in CC terms to USD155m (up 180bp as against our estimate of a decline). Reported USD revenue fell 60bp QoQ. Deal TCV was stronger than expected at USD142m, up 13% QoQ, although it fell 24% from 2QFY22 levels due to a high base. The book-to-bill ratio stood at 0.9x.

* EBITDA margin fell 270bp QoQ to 8.5% in 2QFY23, 30bp below our estimate, led by wage hikes (up 320bp), but was partly offset by lower employee count and higher offshore revenue share.

* PAT fell 24% QoQ to INR568m (above our estimate) due to higher other income.

Key highlights from the management commentary

* BFS continues to do well and M3bi is also firing well. It has seen significant wins in Insurance. Larger clients, post transformation support, and diversification will reduce lumpiness in Insurance.

* It closed good logos with large customers in emerging verticals. The management sees good opportunities there.

* In anticipation of a slowdown in Consumer and Hi-Tech and Manufacturing, ZENT has strengthened its GTM strategy to counter the slowdown.

* The management is seeing segments of softness, which is hitting on two fronts: 1) HTM and Consumer, and 2) Reduction of discretionary spends (experience and design). It indicated that the weak macro will continue to impact growth, especially in the Consumer and Hi-Tech verticals.

* It indicated that margin has bottomed out, and is well on track to achieve midteen margin by 2QFY24.

Valuation and view

* ZENT’s current valuation (13x FY24E EPS) is one of the lowest in our midcap IT Coverage Universe.

* The new CEO-led leadership team is in place, and its growth strategy has delivered results. The management expects to revert to mid-teen margin over the medium term. With good long-term growth prospects 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 14.5x FY24E EPS. We maintain our Buy rating on the stock.

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