It’s been a volatile ride for the IT sector over the last year with post-pandemic exuberance fading. Since the start of FY23, it has been more of payback time for the stocks for excess returns made in FY21 and 22. In the last one year, the Nifty IT index and many of the large and mid-cap IT stocks have delivered flattish to negative returns. For example, Nifty IT index has delivered 1 per cent returns as against the Nifty 50’s 15 per cent returns. Blue chip TCS has delivered the same 1 per cent returns while Infosys is down 13 per cent. Amidst this pandemonium one amongst the very few stocks that have bucked this trend and delivered solid returns is Zensar Technologies (Zensar).
Zensar is up 98 per cent in the last one year, and up 110 per cent since bl.portfolio gave a buy recommendation on the stock when it was trading at ₹233 on August 28, 2022. The positive view on the stock amidst our cautious view on the IT sector, and many IT stocks, was driven by the skewed positive long-term risk-reward in Zensar at that time. The stock had already corrected 60 per cent from its peak with much of the pandemic digitisation and low interest rates driven-froth already squeezed out.
Further, a few company-specific factors that had resulted in out-sized margin compression as compared to peers had also contributed to correction in stock. Trading at one-year forward PE of 13.5 times, EV/FCF of 12.5 times and also importantly net cash at over 25 per cent of market cap, the risk was worth taking despite expectations of slowdown in the IT sector.
We had noted in our article that historically, for well-established IT services companies (Zensar being one amongst them), strong net cash balance when it had reached levels of 20-30 per cent of market cap always provided strong downside support. From those levels, the stocks had significantly outperformed peers and the sector index. This had nicely played out with companies like Hexaware Technologies and Polaris Financial Technologies in the previous decade.
Fast forward to today, post the 110 per cent return, Zensar trades at a one-year forward PE of 20.7 times as against five-year historical average of 15 times, EV/EBIT of 16.2 times as against historical average of 10.7 times. While some premium is warranted against historical averages, given the rerating seen in mid- and small-cap IT stocks in recent years, the current premium appears excessive amidst significant slowdown in client spending, as indicated by results of all large-cap IT companies.
If the slowdown gets more broadbased, which is a decent possibility as global central banks continue their fight against inflation, mid- and small-cap companies like Zensar too will get impacted. Further downside support is diminished to some extent with net cash at around 15 per cent of market cap now.
Hence, we recommend investors to book profits in Zensar and pocket the gains. We would, however, like to note that this is entirely a valuation call, and not a call on the long-term prospects of the company. The recent performance of the company has been good, reflecting a nice turnaround (which also underlied our thesis) and fixing of company-specific issues. At current levels, the turnaround is captured and decent long-term prospects are also factored. The risk reward is not favourable amidst current global macro uncertainties.
Recent performance and turnaround
While revenue growth was trending well for Zensar last year, its EBITDA margins contracted from 18.5 per cent in Q1 FY22 to as low as 11.2 per cent in Q1FY23. While across industry higher attrition rates and reversal of pandemic-related savings (travel, sales and promotion) had impacted margins, it was more outsized in the case of Zensar and worse than analyst expectations. This was driven by higher cost of delivery (salaries and subcontracting costs) and lower utilisation.
The company, by then, had also initiated steps to fix the margin issues by focusing on improving utilisation, increasing deployment of freshers (as higher lateral hiring had increased delivery costs) and negotiating better billing terms with customers.
A year down the line, these initiatives have paid off and issues appear fixed. In Q4 FY23, EBITDA margin had improved to 14.5 per cent, and in recently reported Q1FY24 results it had rebounded to 18.75 per cent and back at the levels seen in Q1 of FY22. Revenues, though, in recently reported quarter were a bit weak with constant currency revenue growth down 1.6 per cent, reflective of broader industry pressures.
The company’ s major verticals are split into Hi-tech and emerging (33 per cent of revenue), BFSI (37 per cent) and Manufacturing and consumer services (30 per cent). In terms of geographic segments, the US accounts for 69.4 per cent of revenue, Europe 19.2 per cent and South Africa 11.4 per cent. The management is a bit cautious on the demand environment. High exposure to the US and BFSI are risks to watch out for in the current environment.
