Coforge’s 3QFY24 revenue was a tad better than our estimate while EBIT margin was higher as ESOP cost came in lower. It held on to its initial FY24 guidance of revenue growth of 13-16% CC (will come in at the lower end) and ~18.3% adjusted EBITDA margin (same as in FY23). This will be the first year that Coforge will be coming at the lower end of the guidance unlike in the past when it used to generally surpass the upper end of the initial guidance.
The demand commentary for 2024 was quite subdued with budgets indicated to flat versus 2023 and no indication of a turnaround in spend by its customers in the next couple of quarters. But it indicated its resolve to grow in the coming year through execution led share gain.
We have been negative on the IT Services sector since April 2022 and continue to be cautious as we believe that the worst on the macro front is ahead of us. We believe that our base case of a shallow US recession in 2024 could pose a risk to both our as well as consensus earnings & PE multiples. We believe that we are in a ‘slower for longer’ kind of environment.
While Coforge could be among the top quartile performers in the industry in FY25 in terms of revenue and earnings growth, we believe that the current valuation of 36x FY25E our EPS is high (though not as egregious as that of Persistent systems which is at 47x). We reiterate ‘SELL’ with a slightly lower target price (TP) of Rs3,818 based on a target PE multiple of 18x Dec. 2025E EPS, 10% discount to benchmark TCS. This is among the highest target PE multiples for Tier-2 companies as we expect faster-than-peer growth and ROICs. But we believe that it is as vulnerable as its Tier-2 peers due to cohort related weaknesses.
While Coforge under CEO, Sudhir Singh, has done a good job in the last six years to grow to US$1bn (from a revenue of ~US$420mn), we believe that as the company grows larger, it will be up against competition from the behemoths in the BFSI space (a very competitive vertical which embraced outsourcing/offshoring decades back). It will also require significant skills in the ‘run the business’ side and in cost optimization which we believe Coforge is not the best at. While it will grow faster than the Tier-1 IT set over the next five years, we are not in the camp that believes it will go back to growing at 20% plus in the medium term.
Depressed demand environment: The management indicated that the demand environment has remained depressed in 3QFY24 and that is leading to strong competitive intensity and pricing pressure. This has been the scenario in the past 4-5 quarters, and it is expecting this to continue for the next 2-4 quarters.
SG&A to remain elevated: Coforge indicated that the SG&A expenses will continue to remain elevated at ~15% mark. It has been heavily investing in sales and marketing to scale up, win larger deals, expand in newer geographies, sub-geographies, and verticals so it can reach the US$2bn revenue mark by FY27/FY28.
Expects strong deal ramp-ups in 4QFY24: The management is confident that it will be able to initiate strong deal ramp-ups in 4QFY24 and has also hired to support this growth. It also clarified that leakages in conversion from TCV to revenue (which has been the problem in the industry) are not material due to strong execution.