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Worries on margins to recede

We recently met with the management team of PSYS to understand the company’s strategic priorities and financial outlook for the coming years. Key takeaways: (1) PSYS is targeting a revenue of USD2b by FY27, and the management is optimistic about achieving this target despite a challenging business environment. (2) The company is implementing strict cost management strategies and has visible margin levers such as SG&A, offshoring and pyramid; it has already accounted for one-time expenses, which will no longer impact future margins. (3) PSYS is capitalizing on market opportunities, benefiting from vendor consolidation and focusing on high-demand areas like data, cloud, digital engineering, and platform engineering to strengthen its relationship with clients. (4) PSYS aims to diversify geographically to increase its European revenue share from 7-8% to 12%, while it is also exploring new sectors such as AI-driven solutions and enhancing its contact center capabilities. Since our rating upgrade to BUY on 19th Jul’24 (1QFY25 result note), the stock has outperformed both the Nifty Index and the Nifty IT index (PSYS gained 15% vs. 3% for Nifty and 7% for NSE IT). We estimate an 18% USD revenue CAGR for PSYS over FY24-27, which, combined with margin expansion, could result in a ~21%+ EPS CAGR. This positions PSYS in a league of its own as a diversified product engineering and IT services player, justifying a premium valuation multiple.

Industry best revenue growth to sustain

* Revenue and growth targets: PSYS aims to reach a revenue milestone of USD2b by FY27. The management is confident of achieving this goal through strategic market expansion and wallet share gains despite a challenging environment.

* Opportunities from large firms: PSYS is capitalizing on increased opportunities arising from fatigue among larger firms, positioning itself to fill the gaps and capture additional market share.

* Key strength areas: The company will continue to focus on key strength areas such as data, cloud, digital engineering and platform engineering, allowing it to have a differentiated position among peers as well.

Multiple margin levers support our view on margins

* Reduction in SG&A expenses: A key lever for improving margins is the expected reduction in SG&A expenses going forward (as % of revenues). PSYS has invested ahead of time in SG&A and does not expect a significant rampup in these costs.

* One-off costs/benefits: The management has addressed all significant oneoff costs/benefits to margins in FY25 and does not expect these items to impact margins in the future, barring employee and ESOP costs rationalization. For context, one-off benefits in 1Q include the reversal of earn-out credit pertaining to past acquisitions (60bp contribution), a change in the useful life of computer and networking assets (40bp) and employee benefit rationalization net of increased ESOP costs (10bp).

* Utilization level: While the management indicated that this could serve as a margin lever going forward, its current utilization level of 82.1% is already elevated and we believe it would be difficult to take this up further.

* Offshoring and lower subcontractor costs: Additionally, the company expects increased offshoring in the recent large deal ramp-up in healthcare, which will help reduce subcontracting costs and further bolster margins.

* We expect margins to be flat in FY25, in line with management estimates. We expect 2H margin performance to be better than that in 1H. We expect ~100bp YoY margin expansion in FY26.

Cautious on demand - does not rule out a mild recession

* PSYS management indicated a cautiously optimistic outlook on overall demand, noting that while the business environment remains challenging and somewhat tepid, the company would continue to find growth opportunities through vendor consolidation, wallet share gains and benefits from fatigue among largecap vendors. There is strong interest in their core offerings such as data, cloud, digital engineering, and platform engineering, which are key growth areas. The management also mentioned that it is not observing any material changes in client conversations. It expects hi-tech to be weaker for longer, whereas healthcare demand remains robust and would continue to lead the charge.

Valuation and View – Maintain BUY

* Since our rating upgrade to BUY on 19th Jul’24, the stock has outperformed both the benchmark Nifty Index and the Nifty IT index (PSYS gained 15% vs. 3% for Nifty and 7% for NSE IT).

* We estimate an 18% USD revenue CAGR for PSYS over FY24-FY27, which, combined with margin expansion, could result in a ~21%+ EPS CAGR. This positions PSYS in a league of its own as a diversified product engineering and IT services player, justifying a premium valuation multiple. That said, owing to its superior earnings growth trajectory, on PEG basis, we believe the valuation still has room for upside. We introduce FY27 estimates and roll over to Sep’26E EPS. Reiterate BUY with a TP of INR6,300, based on 50x Sep’26E EPS.

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