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Tepid quarter due to hi-tech weakness

Adjusted margin now at more sustainable level

* ZENT reported a weak performance in 3QFY24 as revenue declined 3.2% QoQ in CC due to continued pressure in hi-tech vertical and higher furloughs. However, it was above our estimate of 4.4% QoQ decline. Deal TCV rose 28% YoY to USD168m but fell 14% sequentially from its peak in 3QFY24. Adjusted EBITDA margin was in line with our estimate of 16.2%, with reported EBITDA margin down 140bp QoQ due to the reversal of bad debt provisions.

* ZENT management expressed optimism on growth in most of its verticals, but it sees constraints in hi-tech (26% of revenues) segment, including extended furloughs. The weakness in hi-tech has impacted the overall growth of the company, leading to YoY decline in revenue for the last five quarters. We continue to see muted growth in 4Q as well, resulting in a weak exit and in turn impacting FY25 revenue growth. Given the challenging near-term macro outlook, especially in key verticals like Hi-Tech and Manufacturing (52% of 3Q revenues), we expect FY25 revenue growth to be 7.1%, before picking up in FY26. We factor in a modest USD revenue CAGR of 5.5% over FY23-26E.

* ZENT reported a write-back on a cost for the third straight quarter, with 3Q benefitting by 110bp. Adjusting that, the company has now returned to our comfortable margin range of around 16% (guidance of 14-16%), although this will act as a drag in the near-term YoY comparison given the high base. The management continues to target mid-teen EBITDA margin and reinvest above that level for growth. We expect ZENT to deliver 17.7% EBITDA margin in FY24 (including one-off benefits), but normalize to 15.9%/15.6% in FY25/FY26. This will result in an INR PAT CAGR of 26% over FY23-26E (partially on low FY23 base).

* We remain on the sidelines for the stock, especially given the headwinds on growth. Considering near-term challenges in a significant portion of its portfolio and limited upside on margins, we see current valuations at 20xFY26E EPS as fair. Our TP of INR570 implies 20x FY26E EPS. Retain Neutral.

Beat on revenues, in line margin performance

* USD revenue stood at USD144.7m, down 3.2% QoQ CC vs. our estimates of a 4.4% QoQ decline. Reported USD revenue declined 3.0 % QoQ.

* Hi-Tech (-8.0% QoQ CC), Healthcare (-5.6% QoQ CC) and Manufacturing (- 1.9% QoQ CC) reported weak growth, while BFS was muted at 0.1% QoQ CC.

* EBITDA margin stood at 17.2% (down 140bp QoQ) vs. our estimates of 16.1%. The decline in margin was offset by reversal of PDD (+100bp QoQ), hence adjusted EBITDA margin was 16.2% (in line with our estimate).

* Net headcount was again down (-105 QoQ), LTM attrition was at 12.0% (down 110bps QoQ), utilization declined 240bp QoQ to 80.7%, and offshore revenue share rose 50bp QoQ.

* PAT of INR1,616m (-7.0% QoQ) beat our estimates of INR1,237m, led by a margin beat and forex gains.

Key highlights from the management commentary

* The furlough impact was deeper and wider in 3Q, which led to a significant decline in the performance of the hi-tech and healthcare verticals. ZENT expects the furlough impact to reverse for other verticals (except for hi-tech) in 4Q.

* The management believes that the verticals (except hi-tech) have bottomed out and should start contributing to revenue growth. Apart from furloughs, 3Q saw multiple deal closures, which affected the verticals.

* The company has announced a new vertical, Healthcare. It has started exploring the med-tech and life science segments that have a broader scope for innovations compared to the payer segment, which is highly saturated. The company’s provider segment is large and focuses on selective deals

* The management reiterated its aspiration to keep the margin guidance band of 14-16%, while anything over and above would be re-invested to drive future growth. The company was working around few large deals, which had an impact on margins in 3Q.

Valuation and view

* The weakening global environment and worsening economic conditions in key economies are making the growth recovery difficult for the company in the near to medium term.

* The stock is trading at 20x (FY26E), in line with its small-cap peers. We believe ZENT’s growth story is already factored into the price and it is trading at full valuation, leaving limited upside potential from its current level. Maintain Neutral.

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