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IT Midcap Picks: Zensar, a better bet at CMP, Mindtree good on dips

HDFC Sec | 12 Jul, 2012  | Follow Author | Add to my Favourites 

Zensar Technologies' (ZTL) valuations look attractive - Buy at CMP and on dips in the price band of Rs233-244 for price target of Rs297
HDFC Securities expects ZTL’s revenues & PAT to grow by 16.0% each in FY13. IM, BFSI, Manufacturing / Retail / Distribution and Government / Healthcare / Utilities are likely to be key focus areas and major growth catalysts. Akibia is expected to do well. The consolidated service offerings along with Akibia are getting increased acceptance from company's clients. ZTL has an opportunity to scale up its Remote Infrastructure Management Services business using Akibia's large datacenter customer base. Cross selling opportunities of own and Akibia products across globe is likely to increase the client mining going forward. Vendor rationalization exercise by CISCO is likely to benefit ZTL in generating additional revenues from CISCO. The company is confident of strong growth from CISCO going ahead

HDFC Securities has assumed FY13 revenue growth to be purely organic. ZTL is also pursuing inorganic opportunities in US & Europe over the next 12-18 months in the infrastructure management (in compliance space) & manufacturing (in SAP), which it considers big areas of growth going forward. If these acquisitions materialize, then it could boost the consolidated revenues of ZTL significantly going forward.

HDFC Securities expects ZTL’s operating margins to improve in FY13 on the back of rationalization of low-margin business, cost optimization and expected turnaround in Akibia’s profitability. The company has benefited due to vendor consolidation by 2 of the Top 10 clients. ZTL stated that it is likely to rationalize some more accounts, which are yielding low margins. This is likely to improve the company’s margins. Further, despite the lower other income expected in FY13 (assuming there would be no forex gains in FY13), PAT margins are likely to remain stable at FY12 levels mainly on the back of expected increase in revenues from SEZs.

At CMP, ZTL is trading at 6.1xFY13E EPS, which is at a discount to Mindtree (MTL). In terms of financial parameters like Revenue & PAT per employee, return ratios like ROCE & RONW, P / BV and dividend payouts (19.1% in FY12 vs 7.4% in case of MTL), ZTL is better placed compared to MTL. Despite this, ZTL trades at a discount, largely due higher onsite revenue proportion (70.7% compared to MTL’s 33.6%), higher dependence on IMS (commoditised services), client concentration risk (Top client Cisco accounts for 22% of the total turnover) and higher dependence on US (71% of total revenues). However, if ZTL is able to steadily improve its margins, revenue growth profile remains stable, acquisitions that it plans are successfully integrated, then it could get much better valuations going forward. HDFC Securities feels ZTL deserves to trade at 7xFY13E EPS, which gives a price target of Rs297. They feel investors can buy this stock at current levels in small quantities and add on dips in the price band of Rs233-244 (5.5-5.75xFY13E EPS) for the mentioned price target over the next one to two quarters.

MTL’s valuations look slightly stretched - buy on dips in the price band of Rs590-619 for a price target of Rs708
HDFC Securities expects MTL’s revenue & PAT to grow by 14.5% & 9.3% respectively in FY13. The revenue growth is likely to be driven by ITS business. The company expects growth ahead of industry growth of 11-14% projected by Nasscom for FY13. The growth is likely to be largely back ended. Early exit of failed smartphone business is viewed as a positive and the focus now is back on core IT services business. The company has made investment in building client facing team in IT services. This could start yielding benefits in the coming quarters and enable the company to grow its revenues above the industry rates. However, due to underperformance expected for a few more quarters in PES, HDFC Securities doesn’t expect a significant outperformance from MTL in terms of overall revenue growth. Any turnaround in the PES space could result in better than estimated revenue growth.

Among the verticals, BFSI and Manufacturing are likely to remain key focus areas for MTL. Maintenance, IMTS and Testing services are likely to provide MTL immense opportunities going forward. MTL has already started to yield benefits in terms of improvement in the client metrics from its strategy of focusing on select verticals and leveraging domain expertise. Going forward, MTL is likely to continue with this strategy, which could further improve client mining and drive the company’s revenues and profits going forward.

Rationalization of employee pyramid & improvement in utilization rate could result in OPM expansion. HDFC Securities expects MTL’s OPM to improve by 90 bps to 16.2% in FY13. While wage inflation could continue to put pressure on the margins, this is likely to be more than offset by tailwinds from factors such as continuation of rationalization of the employee pyramid, improving utilization level, effort to shift offshore and lowering SG&A from current levels. The company has given offers to ~3,000 campus graduates for FY13. The joining ratio is expected to be 70-75% and most of these are expected to join in H1FY13. This would help MTL rationalize its employee pyramid and cushion its margins. However, the company is likely to witness pressure on the absolute PAT and PAT margins due to higher effective tax rate expected in FY13 (as two of the company’s SEZ facilities complete their 100% tax holiday period & get into the 50% tax bracket in FY13) and lower other income expected over FY12.

At CMP, MTL trades at 11.1xFY13E EPS, which is at a premium to ZTL, despite ZTL being better placed in terms of most of the financial parameters like return ratios (ROCE & RONW), Revenue & PAT per employee, P / BV and higher dividend payouts. HDFC Securities feels this premium could be because of MTL’s more reputed management, higher operating & PAT margins, low client concentration (MTL’s top client accounts for 7.5% of total turnover, while ZTL’s top client share stands at 22%), no presence in IMS (commoditised service), focus on niche areas like travel & transportation and services like product engineering, which are better than low margin IMS (where ZTL has a strong presence). Moreover MTL’s well-diversified revenue stream geographically, high offshore presence (66.4% of total revenues, compared to 29.3% in case of ZTL), larger institutional holding compared to ZTL and higher number of Fortune 500 clients also supports the stock’s premium valuations.

MTL has historically traded at 13x+ 1 year forward EPS (except during the 2008-09 global crisis and later after the exit of Mr. Ashok Soota, the key promoter/co-founder of MTL). However, its valuation has started to claw back upwards as the street is more confident that Mr. Soota’s exit may not have any major impact on the future of the company. Further, the concerns relating to the smart phone business have ended since the company has already exited the business. MTL could also keep witnessing buying from the secondary markets by V G Siddhartha (Coffee Day Group's chairman) whose stake has reached 21.87%. One expects that he could raise the stake to close to 25% i.e. the threshold of making open offer.

HDFC Securities feels MTL is capable of trading at 12xFY13E EPS, which gives a price target of Rs708. For better returns and margin of safety, they recommend investors to buy this stock only on dips in the price band of Rs590-619 (10-10.5xFY13E EPS) for the mentioned price target over the next one to two quarters.

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Disclaimer: The author has taken due care and caution to compile and analyse the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. Neither the author nor accept any liability whatsoever arising from the use of any of the above contents.

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