Why buy Zensar Technologies stock now

It has been a difficult journey for IT stocks. The Nifty IT Index is down 16 percent in the past year and has underperformed the Nifty 50 by more than 20 percent. The Nifty IT index is also deep in bear market territory now, having fallen 27 percent from all-time highs in January. The correction in the sector was driven by three factors – one of them, that valuations are far ahead of fundamentals; second, margin pressures driven by high supply/attrition side constraints; Third, demand side concerns as the threat of recession looms in advanced economies.

While at BL Portfolio, we have been cautious about the sector since mid-2021, the sharp correction in the sector has gradually created pockets of opportunity for long-term investors. One such stock is Zensar Technologies (Zensar) which investors can consider adding to their portfolio now. After correcting 60 percent of its peak, the stock provides a sufficient margin of safety for the headwinds the industry/company is facing. Trading on a one-year forward PE price of only 13.5 times, EV/FCF 12.5 times, and net cash on the balance sheet at about 25 percent of the current market value, the risk-reward ratio becomes favorable for the stock. While the headwinds from more margin pressures and the potential impact on business from the slowdown in developed markets remain, if one has a multi-year perspective, buying at current levels may well pay off.

Historically, for well-established IT companies in India, a strong net cash balance provided support, and when they reached levels of 20-30 percent of market capitalization and valuations were cheap, stock returns often performed well in the long run. Few examples where it has played well are Hexaware and Polaris Financial Technologies, in the last decade. Apart from this, high net cash/market capitalization has also proven to be a decent support for many other Tier 1 and 2 IT service companies over the past two decades during difficult times. However, investors need to note that patience will be required, as catalysts will be needed in terms of unlocking value by tapping into excess cash or overcoming current business headwinds to realize value in the stock. The timing of both cannot be predicted.

work and performance

Headquartered in Pune, Zensar is a well-established mid-level IT services company and part of the $4 billion RPG Enterprises Group. Its operations are spread across geographies with more than 30 locations around the world. It derives its revenue from six internally defined segments; Hi-Tech (27.4% of revenue), Consumer Services (18.8%), Banking (16.7%), Insurance (16.5%), Manufacturing (13.2%) and Emerging (7.5%). In terms of geographical revenue, it derives 71 percent from North America, 18 percent from Europe and 11 percent from Africa.

Similar to its peers, Zinsar has also benefited from the digital trend caused by the pandemic and has seen a significant increase in business momentum. Combined with investor excitement about technology stocks, Zensar’s stock has surged 8 times from its March 2020 lows. But since hitting peak levels in September 2021, the stock has been on the decline driven by broader market pressures/headwinds and a few specific companies. . Issues.

In the first quarter of fiscal year 23, the company recorded solid year-over-year constant currency revenue growth of 26.3 percent. This was much better than what was reported by some of the Tier 1 peers, and somewhat lower than what was reported by some of the Tier 2 peers. While revenue growth has been good, there are two factors that are cause for concern in the near term. The first is margin contraction. The company’s EBITDA margins declined to 11.2 percent for the quarter from 18.5 percent in the first quarter of fiscal year 22 and 14.1 percent in the fourth quarter of fiscal year 22. While margins were on a downward trend throughout Industry driven by rising wage and attrition costs and a reversal of pandemic-related savings (travel, sales and merchandising), the downturn was most severe for Zensar and the performance was well below market/analyst expectations.

Margins compressed almost entirely on a sequential basis this time around, driven by higher delivery cost (primarily salaries and subcontracting costs) which increased 10 percent sequentially, and lower utilization. Year-over-year, the cost of delivery was up 41 percent and far outpaced revenue growth. Overall, while revenue in rupee terms increased by 29 per cent, net profit decreased by 26 per cent. Management has now deferred its EBITDA margin targets to the second quarter of fiscal year 24, versus the previous goal of achieving it in fiscal year 23.

The second factor causing concern from the recent results is that while most verticals posted solid growth, management noted seeing the impact in the high-tech and consumer services sectors due to the impact of weak macroeconomic conditions globally. While this ideally shouldn’t come as a surprise given the global growth slowdown, the concern stems from the fact that Zensar appears to be seeing this trend earlier than most of its peers whose results have not indicated any effect of the slowdown thus far.

After first-quarter results, analysts (Bloomberg Consensus) now estimate Zensar’s earnings per share will fall 14.5 percent in fiscal year 23 and rebound by 30.5 percent in fiscal year 24.

Why buy in spite of headwinds?

There are three reasons why investors are considering buying stocks despite the current headwinds. The first is that margin pressures are expected to ease over the next few quarters as companies across the industry including Zensar work to improve usage, increase newer deployments, negotiate better billing terms and so on. The second reason is that the current global enterprise technology cycle with the focus on digital transformation is expected to continue for a longer period although there may be an impact in the meantime as advanced economies progress through current macroeconomic issues. The third reason is that many of the historically well-established companies in the IT sector have created market-beating fortunes for investors from the levels that Zensar now trades in in terms of earnings multiples and net cash as a percentage of market capitalization. The company has positive free cash flow (fiscal year 23 FCF yield of 6 percent) and the cash balance is likely to continue to strengthen (unless the company engages in any mergers and acquisitions). While there is no certainty that Zensar will give returns like some of its peers in the past, the risk is well worth the risk.

Why

The allure of risk and reward

Adverse factors at current levels

Net cash balance provides negative support

Posted in

August 27 2022

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