We initiate coverage on Zensar (ZENT) with a Buy rating for a 20% upside. We believe the business refocusing underway since the CEO change in Q3FY16 is nearing completion. ZENT is positioning itself as a challenger to the scale players in clients with significant IT spend (7/15 of the Top 20/Top 40 clients are Fortune500 companies). While this may constrain margins and/or DSOs in the near term, the potential revenue upside could be significant. ZENT also appears attractively placed in Digital with selective but scale presence in areas such as Oracle and Guidewire implementation services. Momentum is also picking up in the Cloud-centric large deals with $400 mn TCV won over 1HFY19 and a 25% y-o-y jump in the deal pipeline in Q3FY19.
We estimate these could drive 12% USD revenue and 16% EPS CAGR over FY19-21 on stable margin assumptions; EPS CAGR could be higher if the planned divestment of the MVS business comes through by Q4FY19. Return ratios/cash-conversion that weakened due to acquisitions should also get aligned to industry average by FY20. Thus, at 0.8x PEG and 20% average discount to peers, we find risk-reward attractive. Client concentration (47% from Top10) + high exposure to Retail vertical (23% revenues) are key risks.
Lead indicators are turning positive
There has been a visible pick-up in large deal wins over the last 6 quarters – with $400 mn TCV won in 1HFY19 alone. Importantly, the wins are also in new logos, indicating the refreshed management/ large deal perusal teams are becoming productive. We estimate large deals won over Q1FY18-Q2FY19 to give $55 mn incremental revenues in FY20.
Digital is concentrated but strong
ZENT’s Digital revenues – 44% of total revenues in Q2FY19 – compare well with relatively larger peers such as MTCL (48%) and LTI (37%). Within Digital, ZENT has scale presence in the Oracle Commerce and Cloud applications (c.25% of total Digital revenues), Cloud infrastructure services (c.10%), and Cloud software implementation (c.4%). We believe this ties well with ZENT’s focus on large clients.
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Planned divestment of non-core business is an upside risk
We expect 16% EPS CAGR over FY19-FY21 on improved revenue growth (12% USD revenue CAGR) from ramp-ups in large deals won over 1HFY19 + a strong pipeline ($950 mn in Dec-18) and stable margins. This lifts up to 17% if the proposed divestiture of MVS business (that has Ebitda margin in -5% to +5% band) comes through by Q4FY19.
Risk-reward attractive; BUY
ZENT currently trades at 15x 12-month forward EPS; our Dec-19 TP of Rs 290 is also at 15x target PER (and at 6% discount to market-cap weighted PER of mid-cap IT services players (MTCL/ NITEC/ HEXW/LTI). We see a 20% potential upside in the stock over the next 12-18 months. Sale of the MVS business could be a potential near-term trigger.
