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  • Stock Recommendation | Hexaware Technologies - REDUCE - Target price : 360

    Publish date: OCTOBER 25, 2018

    Unexpected challenges lead to guidance cut. Hexaware reported disappointing revenue growth of 2.1% qoq and 11.8% yoy in c/c. The revenue decline was due to twin issues of early furloughs and supply-side constraints. The company cut CY2018E revenue growth guidance by a percent following the disappointing September 2018 quarter. We cut our CY2019-20E EPS estimate by 5-6%. The stock is down 30% in the past three months. Following steep correction in the stock price, we upgrade the stock to REDUCE from SELL. We cut TP to Rs360 (from Rs455 earlier), valuing the stock at 15X September 2020E earnings.

    Revenues grew 1.7% qoq to US$171.1 mn in 3QCY18 and were 2.6% lower than our estimate. In c/c terms, revenues grew 2.1% qoq and 11.8% yoy. Revenue growth was led by IMS, which grew by 8.3% and BPO, which grew by 4.5% sequentially and contributed 88% to incremental revenues in the quarter. Growth was mainly from non-top 10 accounts, which grew 3% sequentially. EBITDA margin of 16.7% increased 110 bps aided mainly by 95 bps tailwind from rupee depreciation (58 bps in COR line and 37 bps in SG&A), 64 bps tailwind from lower visa costs and 70 bps tailwind from utilization. The gains were offset by 20 bps headwind from wage increments, 50 bps headwind from SG&A and headwinds from bill rates, calendar and other project-related costs. Strong Fx gains of Rs235 mn drove 7.1% net profit outperformance despite a 2.1% miss at the EBITDA line. Net profit grew 21.1% yoy to Rs1.72 bn.
    Hexaware reduced CY2018 revenue growth guidance to 11-12% from 12-13% earlier due to revenue miss in 3QCY18. The revenue miss was due to (1) unexpected furloughs in a couple of clients, (2) one of the large deal wins from the previous quarter being in transition phase and (3) demand fulfillment challenges in a couple of BFSI clients. Reasons for these challenges were the hot labor market in US leading to higher-than-expected attrition and inability to fulfill demand on time. Constrained availability of visa did not help either. Net new deal wins of US$25 mn in 3QCY18 and US$94 mn in 9MCY18 were lower by 42% and 13%, respectively compared to the corresponding period in the prior year. Hexaware expects blockbuster deal wins in 4QCY18.
    We cut revenue estimates by 1.6-4% following the recent disappointment. Increasing interest rates in the US make Hexaware’s portfolio of business, addressing the US mortgage market, vulnerable to volatility. We are also disappointed with frequent challenges in the top-10 clients. We cut CY2019-20E EPS by ~6%. We now value Hexaware at 15X September 2020E earnings (17X earlier). Following the steep correction in stock price, we upgrade Hexaware to REDUCE (from SELL earlier).
    New CFO. Hexaware announced appointment of Vikash Jain (ex-CFO of DXC India) as the new CFO of the company w.e.f. October 25, 2018 following resignation of Rajesh Kanani due to superannuation. Rajesh will work with the new CFO until year-end to ensure a smooth transition.
    Margin walk-through. Hexaware’s EBIT margin increased 110 bps sequentially to 16.7% due to (1) 20 bps headwind from wage increments, (2) 40 bps headwind from lower bill rates, (3) 13 bps headwind from SG&A costs and (4) 70 bps headwind from project costs and calendar, offset by, (5) 60 bps tailwind from currency, (6) 65 bps tailwind from lower visa costs, (7) 70 bps tailwind from utilization and (8) 30 bps positive impact from higher offshore mix.
    Wage increments. Hexaware expects 50 bps headwind due to onsite and offshore wage increments in the next quarter. The company reported that a material portion of onsite wage increases occurred in previous quarters during visa renewals.
    Guidance. Hexaware has guided for 11-12% revenue growth in US$ terms for CY2018, a reduction of 1% from the guidance given in the previous quarter (50 bps impact from cross-currency and 50 bps impact from furloughs in 3QCY18). The company has guided for 20% growth in EPS for the calendar year. ▶ Headcount. Employee headcount stood at 16,050, a net addition of 693 in the quarter, translating into a sequential headcount growth of 4.5%. Management reported that a large number of new hires are staffed in projects undergoing transition.
    Client metrics. Number of clients in US$50 mn, US$20 mn and US$10 mn buckets remained flat sequentially at 3, 4 and 6, respectively. Management expects to ramp up one client to US$100 mn bucket in CY2019 and 1-2 clients in the US$30-50 bucket by CY2020.
    Deal wins. Hexaware reported 3 net new deal wins with TCV of US$25 mn. Management expects TCV of deal wins for CY2018 to be higher than that of CY2017. Management was confident of high TCV of deal wins in December 2018 quarter. ▶ Attrition. Attrition increased sequentially by 130 bps to 15.7%. Management reported that spike in attrition was mainly due to high demand for talent at onsite locations. The company is taking measures to rein in attrition in the 13-14% range.
    DSO. DSO (including unbilled revenues) increased by 8 days to 83 in the quarter. The company reported that a material amount of collection occurred in the first week of 4QCY18. Management expects DSO to normalize in the next quarter.
    Capex. Management reported higher capex costs in the medium term due to expansion of office space in Chennai and new rental facility in Mumbai. ▶ Large deal ramp-ups. Management had reported two large deal wins in the previous quarter. One of the deals is in transition while the other deal contributed partially during the quarter and is expected to contribute fully from next quarter.
    BFSI commentary. BFSI revenues grew 1% sequentially in the quarter. Low growth in the vertical was due to staffing shortage for a couple of BFSI clients whose projects are predominantly onshore. Management expects revenues to pick up from the next quarter.
    Capital allocation. Hexaware board has declared an interim dividend of Rs2.5/share for the quarter.
    Onsite investments. The company plans to invest in localization to meet onsite staffing needs. Hexaware will increase hiring from local colleges and invest in brand-building and training programs onsite.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.


    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.


    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.


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