Demand robust; Keep a watch on supply
Upgrading to Neutral
We met with Hexaware’s (HEXW) CEO Mr R Srikrishna. Key highlights:
* The demand environment for services remains robust. Even after closing two large deals within existing accounts last quarter, the pipeline of large deals remains very healthy.
* Demand-supply situation in the US local labor market is tight, with unemployment in the technology sector virtually zero – potentially creating a revenue and/or cost issue.
* Near-term benefits from a weaker INR will be short-lived. 70-80% will get reinvested into the business, while the remainder may have to be passed on to customers.
* HEXW is actively looking to acquire capabilities, especially in the area of customer experiences. These can add 3-4pp to organic revenue growth annually over the next few years.
* We are upgrading our price target for HEXW to INR460 (up from INR380), which discounts forward earnings by 18x, in line with peers. Key factors for upgrade in price target are: (1) Bottoming of client ramp downs, (2) Healthy large deal pipeline akin to two wins last quarter and (3) Supportive currency. As a result, we are changing our rating to Neutral from Sell.
Better win ability and a strong deal pipeline
* HEXW has been able to break into large accounts and expand its pipeline, as:  the portfolio of services has grown – HEXW has more to offer to clients,  customers are recognizing the improved capabilities, although it took some time for some old customers to acknowledge that,  sales communication around the capabilities has also improved materially and  clients signing up with HEXW have much bigger wallet shares that can be addressed.
* HEXW had shared two existing-new (EN) deals that it had won, each with a TCV of close to USD100m – one ramping up in 2HCY18 and the other in CY19. The pipeline for such deals remains very strong.
Braced to complement organic momentum with acquired capabilities
* HEXW’s growth in the four years under Mr Srikrishna has been entirely organic. The company is now actively looking to acquire niche capabilities, especially in the area of transforming customer experiences.
* Over the next few years, it may end up spending ~USD250-300m in tuck-in acquisitions, which could feed 3-4pp annual revenue growth from the inorganic route, over and above the aspiration of maintaining double-digit organic growth.
Expect benefits from INR depreciation to be reinvested into the business
* Near-term benefits to the operating margin from the depreciation of the INR will be short-lived. HEXW will reinvest the same over the medium term. 70-80% of the benefits will get reinvested into the business toward building capabilities for better growth, while the remaining will be passed on clients as the market resets to newer levels of currency.
* Operating leverage from G&A should continue for a few years, yielding 50-60bp annually. The offshore proportion of revenue is another lever, and then there is a slight room for improvement in utilization which will materialize gradually.
US labor market situation poses a key challenge
* Mr Srikrishna cited that the local labor market in the US has tightened considerably, with unemployment in the technology sector virtually non-existent. Combine that with the business compulsions to lower the usage of H-1B visas, this can potentially create pressures on revenue and/or costs. The pressure is not an outcome of Indian vendors hiring locally within the US, but more a function of overall demand-supply dynamics for technology resources.
Churn in top accounts reflective of ability to add to the pool
* While there has been a churn of 5-7 clients into and out of HEXW’s top-20 list on a YoY basis, this is more a reflection of the company’s ability to keep scaling new accounts into this list than a concern of attrition.
* This is substantiated by the client pyramid, which shows addition of five clients each in the USD1-5m and USD5- 10m brackets, three in the USD10-20m bracket, while a client-specific issue led to one client dropping out of the USD20-30m bracket.
* Over the next few years, its mining prowess should further be cemented by taking at least one client to USD100m+ and two more to USD50m+ (HEXW currently has two USD50m+ accounts and no USD100m+ account). While currency too is a tailwind currently, the labor market is a potential headwind. Expect these to set each other off, and margins to remain in a tight band.
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