Why you should book profit in Persistent Systems stock

It has been an excellent year for India's IT industry. The tier one and top tier two companies have deftly maneuvered through the initial Covid impact and subsequently capitalised on the enhanced digitisation spends in the western world, more specifically the US. Persistent Systems too is one such company that has had a stellar year.

On the back of good growth, the stock has returned 271 per cent in the last one year and around a significant 475 per cent from its pre-Covid highs in February 2020. Following this run up, it now trades at a rich valuation of 41.9 times its next twelve-month (ntm) EPS, which is now at a significant 140 per cent premium to its 5 year average and 81 per cent premium to its 2 year average. While growth has also accelerated in recent quarters and outlook is solid for current and next fiscal year based on recent trends, given heightened valuation, investors are better off booking the profits and cashing in on the gains. CY22 is looking to be a year of macro uncertainty. Inflationary pressures and pull back of monetary stimulus are an overhang on macroeconomic drivers for next two years. Impact of stimulus unwinding on stock market valuations is also an important factor to consider. At current levels, the stock offers no margin of safety for the risks that may play out, making the risk-reward unfavourable.

Business and prospects

The company’s business encompasses – one, IT services segment (83 per cent of FY21 revenue) - product engineering services and platform based solutions; and two, IP based software products segment (17 per cent of business). Its product segment is a differentiator versus some of its peers – revenue can be lumpy but comes with better margins. In terms of business verticals, BFSI accounts for 31 per cent of revenue, Tech and Emerging Verticals (50 per cent) and Healthcare (19 per cent). It is heavily levered to US with 79 per cent of revenue coming from North America.

In FY21, the company reported revenue of ₹4,188 crore - USD revenue growth of 13 per cent and INR revenue growth of 17 per cent over FY20. EBIT margins improved nearly 300 basis points from 9.2 per cent to 12.1 per cent. This was primarily driven by reduction in sales and marketing expenses, a trend seen across many IT companies in Covid impacted year. Driven by revenue growth and margin expansion, profit grew by a nice 32 per cent for the year to ₹451 crore.

Momentum has continued into FY22 as well with 1H FY22 revenue of ₹2,581 crore – USD growth of 30.7 per cent and INR growth of 29.1 per cent. EBIT margin was at 13.7 per cent and PAT grew 63 per cent Y-o-Y to ₹313 crore. For full FY22 consensus (Bloomberg) expectations are for revenue and PAT to grow by 33 and 55 per cent respectively. While business is expected to remain good driven by strong deal wins won by the company in recent quarters, the momentum is however expected to taper with consensus expecting revenue and PAT growth of 22 and 23 per cent respectively in FY23.

Given acceleration in business momentum relative to historical trends, a premium to historical valuation is warranted. However this is more than adequately factored at 140 per cent premium valuation to its 5 year average and with stock trading at ntm PE of 41.9 times and FY23 PE of 39 times. While growth is expected to remain good there is not much clarity on how growth rates will trend beyond FY23 given macro uncertainties.

No margin of safety

Its five year revenue CAGR between FY15-20 was at 14 per cent. FY20-23 revenue CAGR is expected at 24 per cent. According to a NASSCOM report, Indian IT services sector can reach $300-350 billion in annual revenue by FY25. This implies a 13 per cent CAGR for the industry during this period. In this backdrop, it would be challenging for the FY20-23 CAGR growth of Persistent to sustain beyond FY23 given that industry growth is expected at around 13 per cent. Current valuation can be justified only if growth will trend above 20 per cent for few more years beyond FY23 and margins will continue to improve. Both appear less likely.

Another potential factor to note is that while the company has improved EBIT margins recently to around 13 per cent, it is substantially lower versus that of Tier 1 players like TCS (26 per cent), Infosys (22 per cent) and HCL Tech (20 per cent). Companies with lower margins are at higher risk in case of any economic slowdown, currency volatility or intensifying competition. For example, the growth of Tier1 IT services companies mentioned above is much lower than that of Persistent. But given their margins are superior, in case of intensifying competition they are better equipped to sacrifice margins for growth and gain market share.

Its current dividend yield is also low at around 0.5 per cent. Its free cash flow yield is expected at just 1 per cent for FY22 and 2 per cent for FY23. Capital returns to investors, which are usually based on free cash flows, are thus going to be sub par. This also fares poorly when compared with Tier 1 IT companies like which are returning significant portion of their free cash flows to investors annually in the form of dividends and buy backs.

Given risks due to lower margins and lower capital returns, the current valuation of Persistent which is at premium to Tier 1 IT services companies (NTM PE in range of 25-35) is also unsustainable and gives another reason to become cautious on the stock.