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On the Mend

While there is increasing concern on macro challenges for Indian techs due to slowing Global Economy (and a potential US recession), we find the improvement in internals for Zensar encouraging as is reflected in (1) much stronger exit for FY22 (and thereby should aid FY23 revenue growth , (2) Investments in sales and delivery leadership across key verticals like Financial Services and Retail (which is showing up in terms of improving client metrics performance) and (3) improving order booking and focus on fresher hiring. We also find the current EBITDA margin profile of 14-15% far more defendable as compared to the elevated levels in 2HFY21 which should cushion the risks of further earnings downgrades. Valuations are back to 5 year mean after ~45% pullback in CY22YTD. We upgrade ZENT to BUY(V/s HOLD earlier) with a revised TP of INR 400( based on 20x FY24E EPS). Key risks: Weakness in global macro impairing near term IT spending.

* Increasing concerns on global macro albeit internals continue to reflect improvement: While increasing macro concerns are driving sector wide correction in CY22YTD, we find Zensar well placed heading into FY23; driven by the actions undertaken by the new CEO who took charge 12 months back. This has involved a mix of senior level hiring across both sales and delivery and is beginning to reflect in (1) improving revenue growth trajectory (Zensar is beginning to see consistent sequential revenue growth through FY22) and (2) improving client metrics (no of USD 20 mn+ clients has increased from 2 to 4 over the past 12 months, no of USD 10 mn+ clients up by 4 over the same time frame). While Zensar has continued to underperform Tier II peers on growth in FY22, we note that Zensar is exiting FY22 with a stronger exit which should help the company reduce the growth differential in FY23.

* Margins in a far more defendable zone at current levels: Zensar had seen a significant improvement in EBITDA/EBIT margins through FY21 aided by natural cost savings due to Covid in addition to aggressive cost containment measures undertaken by the company which included even headcount rationalisation (note that Zensar had been cutting headcount prior to Covid in 2HFY20 as well and had cut headcount by ~16% over a 12 month period until 2QFY21). While this drove margins to artificially high levels during FY21(Zensar saw EBIT margins improve by 520 bps YoY in FY21), it impacted company’s ability to fulfil demand as client spending picked up sharply in 2HFY21. Zensar has made course correction on this front with significant pick up in hiring through FY22. This has driven normalisation in Zensar’s operating margins in recent quarters with Company’s EBIT margins at 10.1% in 2HFY22. We believe that the current margin profile is more defensible for the company and thereby see limited risks of margin reset led earnings downgrades

* Recent correction makes valuations quite reasonable given the ‘mend’: Zensar has corrected by ~45% in CY22YTD in-line with the weakness in the overall sector/market due to concerns on potential impairment on IT spending due to global macro concerns. We continue to be backers of a ‘resilient and accelerated IT spend with increasing offshore intensity’ thesis and believe that the revenue growth for the sector will see limited impact in FY23. In addition, if recent INR weakness were to sustain, it may limit margin headwinds from supply side pressures and resumption in travel/facility expenses for the sector as a whole. We moderate our revenue assumptions slightly as well as lower margin assumptions (build in EBIT margins at 10.6%/10.9% for FY23/24 V/s 11.1% in FY22) thereby cutting FY22-24E EPS by 5-6%. Valuations at ~1.1x FY23 EV/Sales, <17x FY23 PER are quite reasonable on a relative basis. We upgrade to BUY (V/s HOLD earlier) with a revised TP of INR 400(V/s INR 470 earlier).

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