Zalaris — Tenth consecutive quarter of revenue growth

Zalaris delivered record quarterly revenue in Q224, successfully continuing its momentum as it delivered a 10th consecutive quarter of year-on-year revenue growth. Revenue increased 15.3% (constant currency) to NOK323.2m (Q223: NOK280.5m) in Q2, as strong progress made in Managed Services (+18.8%) offset a 3.7% year-on-year decline in the Professional Services business. The higher-margin Managed Services business now accounts for 75.0% of group revenue, up from 72.7% in Q223. With a high degree of recurring revenues, continued growth in the Managed Services business will be key to Zalaris achieving management’s mid-term revenue target of NOK1.5bn by FY26.

The Managed Services business recorded a number of new client wins and renewed services with existing customers, upselling existing services and moving clients from legacy technology onto the PeopleHub platform. Within these contract wins and extensions was expanding the scope of service for Telenor to include Finland, c 1,800 employees, and for SAS to include its UK employees. Zalaris has signed two letters of intent with two large customers, one German retailer and another global IT services provider, which together have NOK40m in annual contract value (ACV). As we noted in our initiation report, a key leading indicator for Zalaris is deal newsflow and the extension of existing contracts, and the company is certainly delivering on this. Reflecting this, the net retention revenue in Q224 was 106% as existing clients expand their geographic footprints and employee bases. Zalaris continues to benefit from low churn in the Managed Services business and long-term relationships with its client base, as existing customers accounted for 82% of revenue, up from 78% in Q223.

For the Professional Services business, Q224 was slightly weaker year-on-year, with revenue down 3.7% to NOK69.7m (Q223: NOK72.3m), predominantly owing to lower application maintenance revenue in Poland. There was a significant drop-off in revenues on a quarter-on-quarter basis, which management believes was due to four fewer working days in Q224 versus Q124, as well as a higher amount of annual leave taken in the quarter, resulting in fewer billable hours. The Professional Services business continues to make inroads into German municipal organisations, winning an agreement to implement a new SAP HCM solution for the City of Berlin with a total contract value of NOK170m, as well as winning a contract for application maintenance services for the State of North Rhine Westphalia, which has a contract value of NOK32m over four years.

APAC also delivered good progress in Q224, with revenue growing significantly to NOK10.8m (Q223: NOK4.3m) as it saw significant client wins in the region, including Yancoal, Campari, the Port of Melbourne and Crawford. Within this, 59% of revenue was recurring revenue, with the remaining 41% derived from individual projects. The progress made in APAC highlights Zalaris’s ability to successfully enter greenfield geographies and deliver on multi-country contracts.

Zalaris grew adjusted EBIT in the quarter by 40.4% y-o-y to NOK28.4m (Q223: NOK20.2m), at an improved margin of 8.8% (Q223: 7.2%), benefiting from APAC contributing its first quarter of profitability and EBIT improvements as Zalaris continues to shift the proportion of its service delivery locations from onshore to nearshore and offshore locations. Reflecting this shift in the personnel cost base, despite Zalaris increasing its headcount by 78 full-time employees year-on-year, personnel costs as a percentage of revenue have fallen to 53.3% in Q224 (Q223: 55.1%). Managed Services grew adjusted EBIT by 12.3% to NOK33.4m, although at a lower margin of 13.8% (Q223: 14.6%). Profitability in the Professional Services was affected by the rehiring of a SuccessFactor team of seven employees who had left the firm 18 months prior. This team was not fully utilised through May and June and, consequently, adjusted EBIT fell 27.2% to NOK2.4m (Q223: NOK3.2m). Management noted that this SuccessFactor team is now fully utilised, and the segment should benefit from the additional revenue it should generate going forward.

Operating cash flow improved in Q224 with a positive inflow of NOK18.4m (Q223: NOK3.3m), owing to the improved profitability and more favourable working capital in the quarter. Net debt (excluding leases) reduced to NOK286.5m (Q124: NOK297.9m) due to a slightly higher cash balance and lower bank debt, owing to favourable foreign exchange movements given Zalaris’s euro-denominated bond loan.

During Q224, management finalised its EBIT improvement programme, targeting NOK30m of improvements by Q225 and NOK40m of improvements within 24 months. Zalaris’s German business has historically been a drag to group margins as it relied on onshore service centre locations, with the FY23 EBIT margin just 1.7% compared to the group level of 8.5%. However, management has defined its improvement programme to target adjusted EBIT within Germany of NOK61.0m in the medium term, equivalent to a margin of 13.9%.

Within Germany, management expects the improvements to come from:

Following the sale of the Leipzig office in Q124, the German margin is lowered by 0.5% due to rental costs. Adding these improvements to the FY23 German EBIT of NOK6.7m, Zalaris estimates a pro forma FY23 adjusted EBIT of NOK48.4m, equivalent to a margin of 12.4%.

Management expects in the medium term that new signed contracts will add 1.5% of incremental margin to get the medium-term target of 13.9%, resulting in a total adjusted EBIT of NOK61.0m.

We have upgraded our revenue forecasts for the second consecutive quarter, reflecting the strong contract momentum and the weighting towards the second half that Zalaris has historically reported. Management’s commentary in relation to robust levels of demand and a strong new contract pipeline underpin this upgrade. We now expect revenue growth of 15.5% for FY24 to NOK1,306.5m (previously NOK1,275.4m), driven by an improved Managed Services performance, while we anticipate Professional Services returning to a higher level of growth in H224 as the new SuccessFactor team build up to full utilisation. The higher level of Managed Services revenue, combined with the higher-than-expected share-based payments expense to date, has nudged the adjusted EBIT margin up to 11.2% (previously 10.9%).

Consequently, our FY25 revenue estimates have also edged up to NOK1,435.3m (previously NOK1,410.1m), as we maintain the growth rate in Managed Services but slightly reduce our Professional Services growth expectations. This, along with a higher share-based payment expense, brings the adjusted EBIT margin to 11.8% (previously 11.3%).

The changes to our estimates result in an improved net debt (excluding leases) to adjusted EBITDA leverage position in both years: 0.9x in FY24 (previously 1.1x) and 0.6x in FY25 (previously 0.8x).

Our 10-year DCF uses a weighted average cost of capital (WACC) of 8%, reflecting a cost of equity of 9.7% (Norwegian base rate of 4.5%, beta of 1.14 (source: LSEG Data & Analytics) and an equity risk premium of 4.6% (source: Damodaran)) and an after-tax cost of debt of 4.1%. Following the changes to our revenue growth estimates and subsequent improvements at the EBIT level, our valuation has increased from NOK88.8 per share to NOK91.1 per share. Our assumptions of a 4% revenue CAGR in the medium term and a 12% EBIT margin from FY26 are relatively conservative when compared to the EBIT margin range of 12–15% guided by management.

Our valuation indicates 27% upside to Zalaris’s current share price of NOK71.6. We believe the strong contract momentum and potential EBIT margin improvement are not fully reflected in the current share price.