JPMorgan: HCL tech: Encouraging revenue growth ; retain OW

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HCL tech -Encouraging revenue growth trend keeps pace with
industry leaders; margins need watching; retain OW





• Good revenue performance in 1QFY11 but margin performance could
have been better given revenue growth. HCL Technologies (HCLT) declared
1QFY11 results that confirm that its revenue growth engine chugs just as well
as the top-tier peers such as Infosys and TCS. Revenues at USD 804 mn came
in at 9% growth Q/Q - well ahead of our and consensus expectations. In our
view, it is on the margin side that HCLT needs to work harder.
• Well-rounded revenue growth. HCLT's revenue growth over the past 12-18
months was infra-management led, an area in which HCLT has developed good
positioning and capability. In this quarter, software services (ex-infra) grew at
9.3% Q/Q (notably, customer applications 15% up Q/Q).
• From a geography perspective, ROW (mainly Asia) led growth at 20% Q/Q
while on verticals retail & healthcare grew at double digit (%) Q/Q. This
demonstrates that HCLT scores well in registering new business from
developing markets and less penetrated verticals. BPO, the laggard, also revived
growing at 5.7% Q/Q (to USD 48 mn revenues) accompanied by significant
improvement in gross margins to 18.1% (from 12.5% in 4QFY10). We see the
BPO turnaround as a sign of management's ability to address ailing businesses.
• Balance sheet metrics will improve. While we believe HCLT does well in
driving topline growth, we note that free cash flow was negative in this quarter
at USD 27mn- mainly due to an increase in other assets. Operating cash flows
stood at USD 7.7 mn (< 1% of revenues). We see this as temporary and expect
it to improve in coming quarters as these assets are largely pre-paid in nature.
• Margin performance needs monitoring; EBITDA margins at 13.7% is an
all-time low since 2000. Some part of the sequential decrease in EBIT margins
owes to SG&A investments (over and above the expected wage hikes in this
quarter) which we find pleasing. But in our view, margins need to recover
significantly to hold the current 12-month forward P/E valuation discount (25-
30%) to larger peers. This might be difficult if the Rupee stays strong.
• Investment view. Maintain OW with Sep-11 PT of Rs 490. We roll forward
our Mar-11 PT of Rs 440 to Sep-11 (12 month) and raise our price target to Rs
490. The increase in our price target is due to the time roll-over. Our Sep-11 PT
assumes 15x forward trading multiple, about a 25% discount to TCS/Infosys
which incorporates noticeable margin improvement hereon.