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Absence of near-term growth levers to limit upside

Exceptional margin run now coming to an end  The Zensar stock has witnessed a substantial surge (a 78% increase over the past six months v/s a 1.5% decline in NIFTY IT index), on the back of a new leadership (Manish Tandon was appointed as CEO in mid-December) and a sharp margin recovery over the last two quarters (up 600bp from a low of 8.5% in 2QFY23). Despite the increased optimism on medium-term growth, following the leadership change, the growth prospects for FY24 are limited due to the prevailing weak macro environment. Given the elevated sensitivity to macro headwinds in a large part of its industry mix (Retail, Hi-Tech, and manufacturing sectors contribute 56% of revenues), we expect Zensar to deliver a modest 3.4% YoY CC revenue growth in FY24. Moreover, with the management’s focus on growth investments and limited headroom on operating metrics (peak utilization, recordhigh offshoring, and low subcontracting expenses), the EBITDA margin is expected to stabilize. The stock is currently trading at 16x our FY25E EPS (in-line v/s its peers at 17x). The near-term catalysts are already priced into the stock, while the medium-term growth recovery (management’s aspiration to achieve top quartile growth within three years) remains a work in progress. Hence, we are downgrading the stock to “Neutral” from Buy.

Adverse macros blurring near-term growth visibility

* ZENT has faced significant growth challenges over the last six years. Over FY17- 23, it reported a CAGR of 4.8%, far below the global industry CAGR of ~6.5%.

* Despite a modest FY23 revenue growth (4.9% YoY USD organic growth), we expect ongoing challenges for FY24 growth (3.4% YoY CC USD), due to macro headwinds and difficulties in managing the top account. Even with an expected improvement in FY25, this would result in a modest USD revenue CAGR of 8.0% over FY23-25E. This growth rate is among the lowest in our coverage of IT services.

* The management’s comments suggest a gradual normalization of growth. Its aspiration of aligning the company’s topline growth with that of top quartile peers is projected to be realized by FY26/27.

Margins have peaked at the current level

* Zensar was one of the most impacted companies in our coverage due to the constrained supply-side environment in FY22/23. The company registered a loss of c600bp due to rightsizing its hiring engine and fulfilling demand at high cost.

* The company has done a commendable job of recovering the margin over last two quarters, and is now near its guided margin level of mid-teens.

* We expect the profitability to stabilize at its current levels (peak EBITDA margin estimate of 15.0%), which limit near term earnings drivers and should result in earnings growth to mirror the weak topline performance going forward.

Focus on long-term horizon - Analyst Meet

* We attended Zensar’s analyst meet during the RPG day. Overall, there was a general sense of weak demand, primarily driven by a macroeconomic slowdown, especially in the Consumer, Hi-Tech and Manufacturing sectors.

* Owing to the previous investments in organizational restructuring and the establishment of the sales and delivery team, the management believes that all its ingredients are in place. However, it acknowledges that achieving topquartile performance and matching the growth of its peers will require a longer time horizon.

* It aspires to achieve mid-teen margin and any thing over and above would be reinvested to drive further growth.

* Management expects the growth recovery to be a gradual process, with company improving its revenue performance to third quadrant of peer group in FY24, second quadrant in FY25, and aims to reach the top quadrant by FY26.

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