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Topline growth recovery needed for stock re-rating

Expect some reinvestment of margin gains in business

* Zensar (ZENT)’s 3QFY21 revenue performance (decline of 3.7% QoQ CC) – impacted by restructuring at its top client – was below our already muted expectation. With the company guiding for a weak 4Q on continued drag from the top client, we expect double-digit decline (-12.1% YoY) for FY21E.

* On the other hand, the 3Q EBIT margin (15.9%) was ahead of our expectation as it continued to benefit from the offshore revenue shift (+300bp QoQ; +910bp YoY). We expect the company to reinvest some of the gains from aggressive cost rationalization into growth and expect an EBIT margin of 14.8% in FY22E.

* ZENT continued to report healthy deal wins with 3QFY21 TCV of USD200m, suggesting a book-to-bill of 1.6x. The deal pipeline also remained strong at USD1.7b, which is encouraging. However, we remain cautious on a leaking bucket and pockets of weakness in the ZENT portfolio. On account of these factors, we expect only a 9.0% revenue CAGR for FY21–23E (the lowest among peers).

* While we trim our revenue growth estimates on a weaker-than-expected 2H FY21 performance, we remain positive on the company’s margin performance.

* Despite required investments, we expect margins to inch up gradually from FY21E to FY23E. In our view, growth revival would be needed for a stock rerating despite inexpensive valuations. Our TP implies 13x FY23E EPS. Maintain Neutral.

Margin-led beat

* ZENT’s revenue de-growth of 3.7% CC was weaker than our expectation of 0.7% QoQ CC decline.

* Excluding the impact of decline in Hi-Tech (due to the top account), CC growth would have been 0.9% QoQ.

* Insurance (-8.7% QoQ) and Hi-Tech (-10.6% QoQ) declined, while Consumer grew 6.2% QoQ and Manufacturing was flat.

* Digital now constitutes 65% of total revenue.

* EBITDA margins expanded 120bp QoQ to 20.6% and EBIT margins 110bps to 15.9%. Expansion was seen despite lower utilization (-320bps QoQ) and on the back of a better offshore mix (+300bps QoQ) and sales cost optimization.

* PAT stood at INR 987m, an increase of 12.3% sequentially and a 4% beat to our estimates, majorly led by higher operating income.

* Deal TCV for the quarter stood at USD200m+ (+18% YoY).

* Zensar is now a zero-debt company with the highest ever net cash position of USD160.2m.

* DSO for 3Q is 73 days, implying an improvement of 20 days on a YoY basis.

Key highlights from management commentary

* Management alluded that 4Q would remain impacted on account of continued weakness in the top account.

* The business continues to gather steam, with several deals on the verge of closing, and a solid pipeline. Going forward, the company strategy would be to focus on delivering consistent profitable growth with a higher focus on deal closures. The topline is the clear priority.

* EBITDA is at decade highs, cash is at an all-time high, and Zensar is a zero-debt company. The management intends to use this ammunition to drive growth.

* Within verticals, Hi-Tech was impacted due to a client-specific issue, while other verticals have been fairly good.

* This quarter was good for the Insurance vertical – a couple of deals were closed. Legacy to cloud is becoming a big theme in this space, and Zensar’s capability in digital foundation is helping with this. It would lead to growth revival in this vertical.

* The company started with 100 associates for the ‘Work from Anywhere’ program, which has now increased to 550. This has had a massive positive impact on margins.

* The company intends to make certain investments; with wage hikes, margins are likely to be pressured. However, they would remain in the narrow range.

* The management alluded that the current margin profile is not sustainable going forward.

Valuation and view – multiples should remain stable

* Barring FY19 – when Zensar’s overall revenue growth (including inorganic) had come close to that of mid-cap peers (mostly organic) – the stock has always traded at a steep discount to the sector.

* This is largely attributable to its a) inferior growth (organic revenue CAGR of 4% over FY15–20 v/s 12%+ for mid-cap peers), b) payout ratio (20% v/s an average payout of 40%), and c) return profile (RoE of 18% v/s 30%+ for most peers).

* We value the stock at ~13x FY23E EPS. We expect the company's revenue to improve and PAT to grow in FY22, but would wait for any recovery before turning more constructive on the stock.