Case 002Earnings and resultsHard

Quarzen Software beats revenue estimates by 1%, but guides next quarter to 2% sequential growth against a street expectation of 3.5%, and large deal bookings fell 20%. The stock falls 9%. Explain the move and rebuild next year's revenue.

The situation

Quarzen Software sells enterprise software and implementation services. The street expected quarterly revenue of Rs 2,000 crore; Quarzen reported Rs 2,020 crore, a 1% beat. The street's model had revenue growing 3.5% a quarter from here.

Management guided next quarter to 2% sequential growth, which on the higher base is Rs 2,060.4 crore against a street estimate of Rs 2,070.0 crore. Large deal bookings, contracts that turn into revenue over two to three years, fell 20% from a year ago. The operating margin is 22%, and in the short run about half of any lost revenue falls straight to operating profit because the delivery team is already hired. The stock traded at 30x next year's earnings before results and fell 9% on the day.

Your task

Why did a beat produce a 9% fall, and what should next year's revenue be now?

Quick check

Which number in the release most explains the 9% fall?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The stock fell because the path ahead dropped, not because the quarter missed. The 2% guide leaves next quarter below the street, and weaker large deal bookings slow the quarters after. Rebuilt at 2% then 2.5% a quarter, next year's revenue is about Rs 8,556 crore, 1.9% below the street. With half of lost revenue hitting profit, EPS falls about 4.4%, and a lower multiple for slower growth explains the rest.

Step 1Why can a stock fall on a beat?

A cricket team that wins today's match but loses its best bowler to injury for the season is a worse bet for the trophy, whatever today's score. A share price is a claim on future profits, so the quarter just reported matters only for what it says about the quarters ahead. Quarzen's beat added Rs 20 crore to a quarter that is over; the guide and the bookings changed every quarter still to come.

The beat is behind the stock; the next four quarters are in front of it1,9002,0002,1002,2002,300Reported 2,020: a 1% beatStreet had 2,000 for the quarterStreet path, +3.5% a quarter: 2,295Guided path: 2,219Guide +2%: 2,060 vs 2,070Q-3Q-2Q-1Q0Q+1Q+2Q+3Q+4results dayQuarterly revenue, Rs crore
Quarzen's reported quarter of Rs 2,020 crore beat the street's Rs 2,000 crore, but the guided path of 2% and then 2.5% a quarter ends next year at about Rs 2,219 crore a quarter, against Rs 2,295 crore on the street's 3.5% path.
Step 2How do you rebuild next year's revenue?

Start from the new base and the guide, then decide what the bookings drop means for the quarters beyond it. Large deal bookingsThe value of big multi-year contracts signed in the period. They turn into revenue gradually as the work is delivered. lead revenue by several quarters, so a 20% fall will show up after the guided quarter, not before. Take the guide for next quarter, then trim the street's 3.5% to 2.5% for the three quarters after, and say that the 2.5% is your assumption. Next year sums to about Rs 8,556 crore against the street's Rs 8,725 crore, a cut of 1.9%.

Rs croreQ+1Q+2Q+3Q+4Year
Street, +3.5% a quarter from 2,0002,0702,1422,2172,2958,725
Rebuilt: guide, then +2.5% from 2,0202,0602,1122,1652,2198,556
Gap-10-31-53-76-169
The rebuilt year is Rs 169 crore below the street, 1.9%, and the gap widens every quarter because the lower growth rate compounds on itself.
Step 3Does a 2% revenue cut really explain a 9% fall?

On its own, no. Two things multiply. First, profit falls faster than revenue: half of the Rs 169 crore of lost revenue drops to operating profit because salaries are already paid, so next year's EPS falls about 4.4%. Second, the growth rate the market is paying for has changed, from about 15% a year to about 10%. If the market trims the multiple from 30x to about 28.6x, that is another 4.8%, and the two together give the 9%.

A 9% fall is two cuts multiplied: earnings, then the multiplePrice before results100Next year's EPS cut-4.4, EPS -4.4%Multiple falls, 30x to 28.6x-4.6, multiple -4.8%Price after results91axis starts at 60 so the two cuts can be seen
A price of 100 falls to 91 in two steps: a 4.4% cut to next year's EPS, then a 4.8% lower multiple, from 30x to 28.6x, as expected growth drops from about 15% to 10% a year.

Close with what you would check, because that is the view. If the bookings fall came from one delayed mega deal that signs next quarter, the move is overdone. If it is spread across clients cutting discretionary spend, the multiple has further to fall. The question for management is the pipeline of large deals and the win rate, not the quarter just reported.

Where candidates lose it

The common answer blames the size of the beat: the market wanted more than 1%. That misses that the stock trades on the next quarter's path, and the guide and bookings both lowered it.

The second loss is cutting revenue without carrying it through. A 2% revenue cut becomes a bigger EPS cut when costs are fixed in the short run, and a lower growth rate also lowers the multiple. Candidates who stop at revenue cannot explain 9%.

What the interviewer asks next

  • What would you want to see in next quarter's release to say the fall was overdone?
  • How do you tell a delayed deal from a demand slowdown in the bookings data?
  • If management cuts hiring, how quickly can margin recover the lost profit?
  • Why might the stock fall even more on the next quarter if it meets the lowered guide?

Company names and figures are illustrative.