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Growth momentum to continue, valuations attractive

Margin to rebound in FY23E

* ZENT reported a strong 2QFY22 with a USD CC revenue growth of 12.3% QoQ and organic CC growth of 6.4% QoQ, ahead of our estimate. EBIT margin declined by 300bp QoQ to 10.9% due to a salary hike and other supply-related factors. Deal TCV witnessed a strong recovery to USD188.5m (v/s USD97mn in 1QFY22), implying a book-to-bill ratio of 1.3x.

* ZENT’s solid 2QFY22 performance reinforces our view that its new sales led strategy should help the company return to the high-teen organic growth path in FY23E. We estimate organic CC growth of low double-digits in FY22E and ~19% in FY23E. A good exit to FY22E, in addition to a recovery at key accounts and an improving deal momentum, should aid growth in FY23E.

* The management has highlighted that its leadership and sales team is largely in place. We expect the company to continue to benefit from its growth strategy, which is already visible in both revenue acceleration and deal win momentum. As the demand environment continues to remain conducive, ZENT’s growth should remain strong in the medium term.

* While ZENT has seen a 500bp dip in EBIT margin over the last four quarters, due to supply constraints and sales-related investments, we expect the same to start improving going forward on operating leverage and peaking of salesrelated investments. The management continues to expect EBITDA margin to revert to high teens in FY23, although supply side hurdles remain a challenge on the timeframe for the same. We expect ZENT to deliver 25% PAT CAGR over FY21-23E.

* We also see high downside protection in the share price at current levels, as ~11% of ZENT’s market capitalization is in cash. A strong cash balance also offers incremental growth from tuck in acquisitions in coming years.

* The company’s relatively low valuation (20x FY23 P/E) is primarily due to its weak topline performance over the last two years. While valuations have inched up in the past six months, it is meaningfully lower when compared to the midcap IT universe. It remains at a steep discount to its peer group median of 37x FY23E EPS. We continue to expect this to narrow with a pickup in growth over the next few quarters.

* We have increased our FY22E/FY23E earnings estimate by 8%/6% on better than expected performance and strong growth expectations in FY23E. Our TP implies 25x FY23E EPS. We maintain our Buy rating.

Impressive performance on topline and deal wins

* Revenue grew 13% YoY to USD142m (est. +11%), EBIT declined by 18% to INR1,144m (est. -22%), and PAT rose 7.5% to INR944m (est. -8%).

* Revenue rose 11.6% QoQ to USD141.9m, above our expectation of 10.1%. In CC terms, revenue grew 12.3% QoQ. Organic revenue grew 5.3%/6.4% QoQ in USD/CC terms in 2QFY22.

* Growth in revenue was broad based and was led by Banking (+39.2% QoQ CC, aided by the M3Bi impact), Consumer Services (+18.9%), Insurance (+13.4%), Manufacturing (7.2%), and Hi-Tech (+4.2%).

* DAS/DFS grew 10.8%/16.1% QoQ.

* Revenue from the US/Europe/Africa increased by 11.9%/11.6%/9.7% QoQ.

* Revenue growth was led by a 7% QoQ increase in the top 10 accounts. Growth in the beyond top 20 stood at 17.1% QoQ.

* EBIT margin fell 300bp QoQ to 10.9%, 40bp above our estimate.

* A sequential decline in margin was due to a 530bp impact from a salary hike, but was partially offset by higher volumes and utilization (+200bp) and a SG&A impact (+50bp).

* PAT grew 7.5% YoY to INR944m, a 16% beat to our estimate due to higher operating income and other income.

* Deal TCV grew 7% YoY to USD187.5m, with a book-to-bill ratio of 1.3x.

* Accounts over USD20m were stable QoQ, while those over USD10m increased to 10 (v/s eight in 1QFY22). Over USD10 accounts include an account from the M3bi acquisition.

* Net headcount addition grew a strong 9% QoQ to 863 employees (including M3bi). Organic net additions rose 4.3% QoQ. Despite strong net additions, utilization increased by 290bp QoQ.

* Attrition inched up to 23.2% (+510bp QoQ).  DSO (including unbilled) increased to 82 days (v/s 80 days in 1QFY22).

* Net cash fell USD22.3m to USD160.8m due to the pay out for the M3bi acquisition and annual performance bonuses.

Key highlights from the management commentary

* Deal wins stood at USD188m in 2Q (v/s USD97m in 1QFY22). It includes a deal worth ~USD61.1m from the City of San Diego. The management has used a conservative methodology for reporting deal TCV and hence YoY comparison is not meaningful.

* Growth was broad based across verticals. Its largest vertical – Hi-Tech and Manufacturing – has three sub-verticals of Hi-Tech, Manufacturing, and Emerging. The management has re-designed the vertical in terms of strategy and new offerings. The new operating structure is ready, and there will be an additional leadership team onboarding in 3QFY22.

* With the leadership and sales team in place, the management expects the pace of addition to the sales team to normalize from hereon.

* While the top five accounts have been flattish, the company has witnessed strong growth in the top 6-20 accounts. The management expects continued volatility in the top five clients and continued strength in the top 6-20 clients.

* The management expects the growth momentum to continue. However, 3QFY22 would have a seasonal impact from furloughs. The City of San Diego deal has been partially ramped up in 2Q and will witness a full ramp up in 3QFY22.

* ZENT continues to invest in its sales engine and has been working towards pyramid rationalization, higher focus on offshoring, better pricing, optimizing fixed price productivity, and cost optimization.

* The management expects EBITDA margin to revert to high teens over the medium to long term. However, supply-side hurdles have placed a challenge on the time frame to achieve the same.

Valuation and view

* ZENT’s current valuation of 20x FY23E EPS is one of the lowest in our midcap coverage and is at a discount of ~45% to its peer median valuation.

* We expect the revenue growth momentum to continue in 2HFY22 and FY23. The new CEO led leadership team is in place and its growth strategy has delivered results. We expect sustained traction, despite margin falling to midteen levels. The management expects margin to revert to high teens in the medium term. With a likely return to high-teens organic growth in FY23E (we estimate 19% YoY) on a good FY22 exit and a recovery in key accounts, we see potential for a significant stock re-rating as valuations catch up with its peer group.

* We also see higher downside protection in its share price at current levels as ~11% of ZENT’s m-cap is in cash. Our TP implies 25x FY23E EPS. We maintain our Buy rating.

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