Wipro (NYSE:WIT), a leading Bangalore-based IT consulting and system integration services company, posted yet another strong earnings result, impressively beating on the top-line for the fourth consecutive quarter. Importantly, the solid report validates the case for a medium to longer-term organic growth acceleration under new CEO Thierry Delaporte through a reorganization that looks set to return Wipro to competitiveness going forward. However, the company still faces several downside risks, especially on margins, from the upcoming Capco integration and potential dilution risk, along with forthcoming wage hikes. Furthermore, shares have already re-rated to a lofty c. 26x P/E multiple, likely pricing in a structural recovery ahead. As such, I remain neutral.
Top-Line Growth Outperforms, But Signs of Moderation Ahead
For its latest quarter, Wipro posted revenue growth of c. 12.0% Q/Q in constant currency terms - notably, this is well above the 8-10% growth guidance previously provided by management (including c. two months of Capco contribution). More importantly, c. 5% of the growth contribution was organic - one of the highest Wipro has seen in recent years and the fourth successive quarter of strong growth under the new CEO. Looking ahead, the growth guidance for FQ2 '22 also looks strong at 5-7%, implying an organic growth contribution of c. 2.5% Q/Q and including three months of consolidated Capco financials.
Source: Wipro FQ1 '22 Presentation Slides
However, the lack of broad-based strength is a key issue and raises questions about the sustainability of the current growth trajectory. In stark contrast to Tata Consultancy Services (TCS) and Infosys (INFY), both of which saw broad-based growth during the period, Wipro has seen a relatively more skewed growth profile. Notably, the BFSI ("banking, financial services, and Insurance") segment (ex-Capco), healthcare, tech, and manufacturing businesses delivered significantly below par organic growth for the quarter. And while Energy & Utilities performed strongly, much of the outperformance seems to have been driven by the execution of a large order during the quarter. As such, even though the deal pipeline is solid, growth from here will likely be lumpy and uneven, resulting in moderation from the FQ1 '22 level going forward.
Margin Strength to Normalize in the Upcoming Quarters
In FQ1 '22, Wipro delivered EBIT margins well above the prior guidance range at 18.8%, after consolidating two months of Capco contribution and significantly investing in its talent supply chain. Recall that at the time of the Capco acquisition announcement, Wipro had disclosed its longer-term sustainable operating margin band (post Capco dilution) in the 17-17.5% range. Wipro had also stated at the time of its Analyst Day event that it would keep operating margins in the 19-19.2% range, so the margin performance was impressive in this regard. However, I do not see the FQ1 '22 result as sustainable - Wipro could still see significant margin contraction in the upcoming quarters from wage hikes, rising attrition, moderating utilization, and returning G&A costs, as well as Capco-related margin dilution.
Source: Wipro FQ1 '22 Presentation Slides
Over the medium term, it also remains unclear if Capco will prove to be a major driver of BFSI growth beyond fiscal 2022. Instead, I see plenty of margin pressure over the fiscal 2022-2024 period largely due to the Capco acquisition, but also from a secular inflation in talent costs, and normalization of discretionary costs amid the economic re-opening. Another key point to note is the one-off gains from the exit of its investments in Ensono and Denim (booked as operational other income), which has helped offset any headwinds from the Capco acquisition and compensation-related expenses. With these gains set to normalize over time, I see downside to the margin trajectory ahead.
Turnaround Plan Trending in the Right Direction
New CEO Thierry Delaporte has implemented some radical changes to Wipro's operating structure, with the objective to narrow the growth gap relative to larger peers like TCS and Infosys. At the same time, the plan also aims to deliver sustained margin performance over the medium to longer term. Considering the rise in large and mega deals wins, the uptrend in organic revenue growth, and the swift closure of the Capco acquisition, Wipro's turnaround effort appears to be on the right track
And in line with Thierry's call for revenue acceleration in the first year, catch-up with industry growth in the second, and industry-leading growth in later years, many of these objectives appear to have been achieved well in advance - a commendable feat. For context, Wipro expects its IT Services revenue to be in the range of $2,535-2,583 million in FQ2 '22, implying a growth of 5-7% Q/Q in constant currency terms. Even at the lower end of the guidance range, Wipro is set to cross its $10 billion annual revenue run-rate, which is a positive step.
Source: Wipro FQ1 '22 Presentation Slides
Final Take
While the growth thus far has been positive after almost a decade of underperformance, the sustainability of its recent top-line and margin performance looks uncertain beyond fiscal 2022. Nonetheless, the sharp rally in Wipro shares over the last year indicates that the market has largely priced in a sustained turn for the better in earnings growth, which could prove optimistic. With valuations at historic highs, further re-rating will likely only be possible if organic growth continues to narrow relative to industry peers. As such, I am remaining on the sidelines at these levels.