Stock call. What the Capco deal means for Wipro stock

In November last year during Wipro’s first analyst call in five years, Chairman Rishad Premji confidently made a statement that one will see a ‘bolder Wipro’ that would not be afraid to upset the apple cart. The company has indicated it means business with its recent acquisition of UK-based IT consulting company Capco (announced March 4) for $1.5 billion. The value of this one acquisition matches the cumulative value of all acquisitions by Wipro in the last four years. This is also a bold acquisition by standards of the Indian IT industry where the Tier 1 companies have always been conservative when taking the inorganic route. Capco deal represents the second biggest acquisition by a tier 1 Indian IT services company and nearly 3 times more than the next biggest deal for around $500 million done by TCS (CMC merger - in which TCS already held a significant stake prior to merger) in 2014.

Changing tracks

This in many ways is a continuation of series of steps taken by the company to change tracks after being a laggard among Tier 1 Indian IT firms in the last decade. The company showed a clear intent in changing tracks when it announced appointment of Capgemini veteran and former COO, Thierry Delaporte, as its new CEO. This was the first time a foreigner was heading a major Indian IT services company.

The deal

UK-based Capco is a global management and technology consultancy, providing digital, consulting and technology services to financial institutions, primarily in North America and Europe. Capco had CY20 revenues of about $720 million. This represents nearly 9 per cent of Wipro’s estimated FY21 revenue (Bloomberg consensus). The deal was done at valuation of 2 times EV/sales (Capco CY20 revenue) and the multiple is within the range of consulting M&A deals done by Tier 1 IT services firms in the past.

This acquisition provides Wipro an opportunity to become a stronger player in the BFSI segment which remains the most important/largest vertical for Indian IT services companies (31 per cent of revenue for Wipro in Q3FY21). Capco provides Wipro access to its strong clientele and opportunity to provide Capco offerings, integrated with current Wiprorange of services to their combined clientele. There is now a better chance to win larger deals from new and existing clients while competing with peers.

The deal, however, does come with integration challenges stemming from cultural differences, aligning organisational structures, retaining talent etc. The deal is EPS dilutive and will require successful integration and driving of synergies over the next couple of years to make it a success. The background and experience of Thierry Delaporte who played a key role in the successful integration of two culturally different companies – Capgemini and iGATE (Capgemini acquired iGATE in 2015) could turn out to very beneficial.

Financials and valuation

Wipro reported strong earnings in Q3FY21, with EPS of ₹4.31 that was 16 per cent above consensus and revenue of ₹15,470 crore that was 1 per cent above. A key metric – IT services operating margins at 21.7 per cent in Q3 was at a 22 quarter high . These results followed consistent improvement in margins in recent quarters. Investors have reflected optimism with company’s performance and intent/action shown towards transforming the company – the stock is up 160 per cent from Covid lows of last year and up around 70 per cent from pre-covid levels.

It now trades at 1 year forward PE of around 20 times (Bloomberg consensus). Industry leader TCS trades at around 29 times, Infosys at 26 times and HCL Technologies at 18 times. While Wipro is trading cheaper than Infosys/TCS, this is reflective of it being a laggard over the last decade and the expectations that its growth rate is expected to be lower vs Tier 1 peers over the next 2 years; FY21-23 revenue CAGR expected at 7 per cent before considering impact of its Capco acquisition (Infy FY21-23 revenue CAGR expected at 11 per cent, 10 per cent for TCS).

Broadly, its current valuations do reflect turnaround potential and current aggressive measures bearing fruit – its current 1 year forward PE of around 20 times is well above its 10-year median PE of around 14.5 times. Hence, further appreciation might require more evidence of turnaround. On the other hand, its net cash at around 17 per cent of market cap and strong cash generation (operating cash flows/net profit well above 100 per cent in the last 10 out of 14 quarters) provide cushion on the downside from a long-term investing perspective.

Given these factors, long-term investors can hold the stock and keep tracking how its turn around initiatives are progressing. A lot can happen from the beta version stage to the release stage/ general availability. Good entry point into the stock given risk-reward would be at around 15 per cent below current levels when its net cash would represent about 20 per cent of market cap and valuation would be at forward PE of 17.

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