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Margin pressure to erase FY23 earnings growth

The impact of macro on Consulting remains a concern

* WPRO reported a 1QFY23 IT Services revenue of USD2.74b (up 2.1% QoQ CC), in line with our estimate and its guidance, although it saw a 60bp gain from an early Rizing integration. Communications/Consumer (up 9.2%/5% QoQ CC) did well, while Manufacturing/ENU/Health were weak (-1.5%/- 1%/+0.5%). In IT Services, EBIT margin fell 200bp QoQ to 15% in 1QFY23, 80bp below our estimate, due to lower utilization and heightened people investments. The management guided at a 2QFY23 USD CC revenue growth of 3-5% QoQ and double-digit USD revenue growth for FY23.

* Adjusting for the Rizing impact (120bp), WPRO’s 2QFY23 revenue guidance was 100bp ahead of our estimates at the mid-point. Strong deal booking (large deal TCV at USD1.1b), highest ever pipeline, and elevated hiring indicates good near-term revenue growth visibility, although it will continue to trail peers in organic growth in FY23 (MOSLe at 10.1% YoY CC).

* The drop in EBIT margin in 1QFY23 surprised us, given the absence of any one-time factor. While WPRO should see a margin improvement in 2Q as it shifts the full impact of the wage hike to 3QFY23. It is likely to stay meaningfully behind its 17-17.5% medium-term EBIT margin guidance for IT Services over the next two years. We estimate a FY23 EBIT margin of 15.7% (-190bp YoY) in IT Services, which should result in a 2% drop in INR PAT, despite ~5% gain from a depreciation in the INR v/s the USD. Our estimates suggest a FY22-24 INR PAT CAGR of 5%, one of the lowest in our IT Services coverage.

* With continued concerns on the macroeconomic environment, we see WPRO’s Consulting exposure (over 10% of revenue added in the last one year) as a potential risk to both growth and profitability. While it is not seeing any impact currently, we expect the impact of a slowdown on client spend on the industry in 2HFY23, which should have a more pronounced drag on its recent acquisitions (Capco and Rizing) in the Consulting space. This remains the key concern on the stock price.

* We lower our FY23/FY24 EPS estimate by 7%/6% to factor in a miss on lower margin. We maintain our Neutral stance as we view the current valuation as fair. Our TP implies 16x FY24E EPS.

Margin miss in 1Q, in line guidance for 2QFY23

* In CC terms, revenue from IT Services grew 2.1% QoQ in 1QFY23. INR EBIT/PAT fell 2.1%/20% YoY.

* EBIT margin in IT Services fell 200bp QoQ to 15%. It missed our estimate by 80bp.

* WPRO guided at a revenue growth at 3-5% QoQ in CC terms in 2QFY23.

* Attrition (LTM) fell 50bp QoQ to 23.3%.

* PAT fell 21% YoY to INR25.6b, 12% below our estimate.

Key highlights from the management commentary

* The pipeline remains at a record high and the management is confident about growth, given the demand environment, strong pipeline, and order book. It is seeing a good win rate and increased amount of transformational deals.

* Despite the weak macro environment, the management suggested that it is not seeing any slowdown in demand and clients are not signaling any spending cuts.

* It suggested that margin has bottomed out at 15%.

Valuation factoring in muted growth

* Though WPRO had a strong 1QFY23, with strong bookings and pipeline, it expects its FY23 organic growth to be one of the lowest in Tier I IT Services, along with margin below the medium-term guided range of 17-17.5%. Moreover, its capital allocation has started suffering due to elevated investment in its Consulting capability. This should impact its FY23 payout as well.

* We lower our FY23/FY24 EPS by 7%/6% to factor in the margin miss. We maintain our Neutral stance as we await: a) further evidence of the execution of WPRO’s refreshed strategy, and b) a successful turnaround from its growth struggles over the last decade before turning more constructive on the stock. Our TP implies 16x FY24E EPS.

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