HCL Tech: Same old story – growth at the expense of profitability; REDUCE.- Kotak Sec

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HCL Technologies (HCLT)
Technology
Same old story – growth at the expense of profitability; REDUCE. 1QFY11 marked
another quarter of strong revenue growth (+9% qoq) failing to translate into either
EBITDA growth (down 8% qoq) or FCF generation. The overarching drive for scale with
scant concern for profitability, FCF, and return ratios remain our key worries and
underline our negative stance on the stock. We cut our EPS estimates, building in lower
margins despite higher revenue growth assumption. Reiterate REDUCE.


Sep 2010 quarter – revenue beat, EBITDA/PAT miss
Revenues of US$804 mn (+9% qoq, +28% yoy) beat our estimate by 1%. However, EBITDA of
Rs5.64 bn (down 8% qoq, 16% yoy) came in 4% below expectation. EBITDA margin fell 230 bps
qoq versus our expectation of 150 bps decline. EBITDA margin decline was on account of (1) wage
hikes effected during the quarter; (2) increased transition costs on large deals; this partly reflects in
sharp qoq jump in other current assets to US$460 mn from US$398 mn at end-June 2010 and (3)
decline in utilization rates (excluding trainees) to 74% from 77%. Higher-than-expected forex loss
(US$14 mn versus estimated US$10 mn) led to a 12% miss on net income estimate (Rs3 bn versus
estimate of 3.4 bn).
Revenue/EBITDA growth gap widens further
1QFY11 earnings report of HCLT once again demonstrates its overarching drive for scale, even if it
is at significant cost to profitability, free cash flow and return ratios. Results are consistent with the
trend seen in the past few quarters – strong revenue growth (+9% qoq in US$ terms); decline in
operating margin (-230 bps qoq, -650 bps yoy) and poor free cash generation (negative US$27 mn
for the quarter). Even with yoy revenue growth of 28%, EBITDA declined 16%. We also note that
HCLT’s EBIT margin has now converged with Tier-1 US players. Exhibit 1 depicts the widening gap
in yoy revenue and EBITDA growth for HCLT.
Margin issue is more fundamental than temporary
A part of the blame for weak margins does fall on the ongoing restructuring in the BPO business –
this explains roughly 132 bps of the 515 bps yoy decline in OPM for HCLT. Even if one views this
impact as temporary, we believe HCLT’s margin underperformance has a fundamental reason, the
same being the company’s aggressive pursuit of large deals. To make up for its weak positioning
in the applications area and scale verticals (BFSI/TSP), the company has been aggressive on pricing
and commercial terms to win large deals in the past 24-36 months, in our view. In addition, we
are uncomfortable with dissecting margins on a segmental basis for companies as we believe some
business segments for every company are in investment phase at every point in time. We note that
the larger peers have managed a fine balance between investments and margins.