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Growth better than domestic peers despite tough macro; downgrade to HOLD on balanced risk-reward

Happiestminds (HM) reported 3.6% QoQ USD, 3.5% QoQ CC, revenue growth, slightly lower than our estimate of 4% QoQ CC. On a YoY basis, growth was 12.7% YoY USD (7% organic). EBIT margin came in at 19.2% (-175bps QoQ), below our estimate of 21.1% due to higher employee costs attributable to slight increase in onsite employee mix and campus joinee related costs. Margins will likely be impacted in Q2FY24E by wage hike rollout from 1st Jul’23. Forward-looking demand indicators point towards healthy demand ahead: 1) strong headcount addition (2.7% QoQ and 21% YoY), and 2) strong deal pipeline. However, management mentioned that they may revise the guidance of 25% YoY CC growth for FY24 after Q2FY24 depending on potential M&A closures. EBITDA margin guidance has been retained at 22-24%.

What to do with the stock

HM’s 3.5% QoQ growth in CC terms was largely in line with, or better than, its domestic peers like Persistent (2.9%) and Coforge (2.7%) amid the backdrop of a tough macro wherein larger-sized companies indicated drying-up of smaller deals, vendor consolidation and postponement of discretionary spend. Also, strong growth by HM in its product engineering services (PES) segment at 7% QoQ and edutech vertical at 12% QoQ – addresses two important investor concerns about HM’s business scalability: 1) PES is largely discretionary in nature and vulnerable under the current macro-environment of tech budget cuts, and 2) clients in the edutech vertical could be under threat from impact of generative AI on content creation and subscriber base. Having said that, we see two key negatives from HM’s Q1FY24 results: 1) EBITDA margin was soft at 22.9% (down 260bps YoY, though still in the HM’s guidance band of 22-24%) largely due to lower gross margin due to increase in onsite effort mix; and 2) no clarity is provided on FY24 revenue growth given lack of visibility on closure timing and size of potential M&As, and focus on shorter- term time & material based projects. As a result of these two factors, we have cut our revenue forecasts over FY24E-FY26E by 2-3% and EBIT by 6-8%. We are now forecasting 17% (13% organic) revenue growth for HM in FY24E with expectation of demand recovery in the remaining months of 9MFY24E and 5- 7% QoQ growth in each of the remaining three quarters. We also incorporate the impact of recent QIP raise of INR 5bn in our model leading to higher interest income and share count forecasts.  As a result, our FY24E / FY25E / FY26E EPS estimates change by +1.2% / -3.8% / -8.0% and our 12-month target price gets reduced to INR 929 (from prior INR 1,001) implying 1% potential upside. Hence we downgrade our rating from Add to HOLD, and see a balanced risk-reward for HM’s shares given that it is trading at 40x FY25E for FY23- FY26E EPS CAGR of 19% implying 2x PEG, higher than the average of 1.8x for our Indian IT sector coverage universe.

Key takeaways from earnings call

* Revenue growth was led by edutech (12.4% QoQ USD) and BFSI (5.5% QoQ USD) verticals, product engineering service line (7% QoQ USD) and analytics COE. Full- quarter impact of SMI acquisition was reflected in Q4FY23, hence the company’s sequential revenue growth in Q1FY24 is entirely organic.

* Revenue growth guidance of 25% YoY CC factors-in potential inorganic acquisitions. Management mentioned that the M&A pipeline is strong, but there has been no closure of any acquisition so far. Hence, depending on the timeline of potential closure of future acquisitions, company is likely to revise its guidance of FY24 revenue growth after Q2FY24.

* Demand pipeline remains strong and the company is chasing several large opportunities. HM has not seen any cancellation of contracts, but there is delay in deal signings.

* Vertical commentary: 1) In the edutech vertical, HM benefitted from vendor consolidation activity by a client – leader in the KPO business; 2) company is seeing good traction in the healthcare vertical; it won a deal on cloud-based product lifecycle solution from a global leader and innovator in biosciences industry in Q1FY24; acquisition of SMI is also adding to revenue growth in this vertical. 3) travel, media and entertainment vertical was impacted because one of the largest customers (large movie and park company) is undergoing internal restructuring, causing delay in decision-making by this client.

* A few areas where customers continue to invest: 1) modernisation converting existing applications to cloud, 2) analytics, data science and AI, 3) low code no code, 4) process automation, 5) cybersecurity, 6) optimisation of spends on cloud and multi-cloud management.

* HM is bullish about generative AI led demand opportunities. It has partnered with Microsoft for developing generative AI capabilities.

* EBIT margin came at 19.2% (-175 bps QoQ) below our estimate of 21.1% driven by higher employee costs due to slight increase in onsite employee mix and campus joinee related costs. Margins in FY24 will be impacted by wage hike rollout from 1st Jul’23. HM is focussing on improving utilisation.

* Headcount addition was strong in Q1FY24 at 2.7% QoQ and 21% YoY. Company has a target to hire ~1,300 employees in FY24 (+20% YoY), of which ~450 are expected to be freshers and rest will be laterals and employee additions as a result of M&As, as per management.

* HM opened new centres in Pune and Noida and expanded centres in Bhubaneshwar and Madurai. Management mentioned that substantial number of people are working from office.

* Company’s closing cash balance is INR 12,000mn post QIP of INR 5,000mn and NCD raise of INR 450mn.

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