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HCL Technologies (HCL Tech) – 2QFY2011 Result Update
Angel Broking maintains Buy on HCL Technologies (HCL Tech) with a Target Price of Rs. 590.
For 2QFY2011, HCL Tech reported strong set of numbers, outperforming the
titans, Infosys and TCS, at the volume front. The company is expected to
outperform the Tier-I IT pack, with revenue (USD terms) and PAT CAGR of 28.6%
and 38.1%, respectively over FY2010–12E. Valuing the company at 17x FY2012E
EPS of `34.7, we recommend a Buy rating.
Broad-based growth momentum continues: For 2QFY2011, HCL Tech reported
revenue of US $864.1mn (v/s our estimate of US $869.2mn), up 7.5% qoq.
Growth was backed by volume growth of 6.8% in IT services.
EBIT margin inches up: During the quarter, EBIT margin increased by 24bp qoq
to 13.1% on the back of operational efficiencies, such as a) lower SG&A
investments, b) higher productivity and c) slight improvement in utilisation, aiding
margins by 82bp, negating the 58bp effect of stronger INR against USD.
Outlook and valuation: Management is witnessing a strong demand environment
and has signed 17 transformational deals in 2QFY2011 itself, ranging from US
$20mn–100mn. Management has also indicated positive budgets for CY2011.
We expect HCL Tech to be the outperformer amongst Tier-I IT companies, with
revenue (INR terms) CAGR of 25.6% over FY2010–12E, on the back of its higher
value services portfolio. At the operating front, levers such as normalising
employee pyramid, lowering SG&A, expanding utilisations and turn around in the
BPO segment will help improve margins. Thus, we expect EBITDA to grow at a
20.3% CAGR over FY2010–12. PAT, on the other hand, is expected to post a
much higher CAGR of 38.1%, with nil forex losses, higher other income and
improving profitability. We recommend Buy with a Target Price of `590.
Broad-based growth
For 2QFY2011, HCL Tech reported strong revenue of US $864.1mn v/s our
expectation of US $869.2mn, up 7.5% qoq. Growth was on the back of 6.5% qoq
volume growth and 1.0% qoq benefit due to cross-currency movement derived due
to USD depreciation of 1.9%, 5.1% and 9.1% qoq as against the GBP, Euro and
AUD, respectively. In constant currency (CC) terms, revenue grew by 6.5% qoq to
US $856.5mn. Growth again proved to be broad-based, spanning across
verticals, geographies and service lines.
HCL Tech’s growth was led by robust volume growth of 6.7% in core software
services and 8.5% qoq (CC terms) revenue growth in infrastructure services. IT
services (core software plus infrastructure services) continued to demonstrate robust
volume growth, reporting 6.8% qoq volume growth in 2QFY2011. Volume growth
of 6.7% qoq in core software services was on account of strong volume growth of
7.1% and 5.6% qoq in offshore as well as onsite, respectively.
In INR terms, revenue came in at `3,888cr (v/s our expectation of `3,898cr), up
4.9% qoq, reporting lower growth as compared to USD revenue due to the 3.5%
qoq appreciation in INR appreciated against USD in 2QFY2011.
Core software led growth: During the quarter, core software services posted robust
7.3% qoq revenue growth (USD terms) to US $617.7mn on the back of strong
growth of 7.6% in custom application services (contributing 31.8% to revenue).
Amongst other core software services, growth of 4.7% and 5.9% qoq (CC terms)
was witnessed in enterprise application services (EAS), contributing 21.3% to
revenues; and engineering and R&D services (ERD), contributing 18.5% to revenue,
respectively. Demand for ERD across industries was driven by increased demand
for electronics to enhance device intelligence and processing as well as to address
the customisation needs of emerging markets. Primarily, the spend in product
engineering is going strong on the back of ’hope-based investments’ in the US i.e.,
to tap the future consumer spending opportunity and cost savings drive initiated by
clients in Japan. Growth in consumer electronics is driving growth in sectors such
as semi conductors.
Infrastructure services segment continues its growth momentum: The infrastructure
services segment reported whopping 9.4% qoq growth in revenue (USD terms) to
US $196.9mn on the back of strong 8.5% qoq growth (CC terms) in infrastructure
management services (IMS), contributing 22.8% to revenue; and cross-currency
benefit of 0.9%. Currently, the segment is witnessing demand from
transformational outsourcing and system integration/life cycle management.
US and Europe continue to accelerate traction for reducing operations cost, which
is driving transformational outsourcing. A large part of the deal flow is due to
contract renewals.
BPO grows yet again: The BPO segment has returned to its growth path, with
revenue of US $49.5mn, up 2.9% qoq. In CC terms, the segment grew by 2.4%
qoq. The demand environment is heating up as clients are looking at globalisation
of delivery capabilities, which is driving transformation and enterprise-wide cost
efficiency. The company is continuously investing in building platforms for non
voice-based business in this segment.
The anchor verticals, including financial services (contributing 24.6% to revenue)
and manufacturing (contributing 27.1% to revenue) continued their growth
momentum, up 3.3% and 6.7% qoq (CC terms), respectively. In the financial
services space, sectors such as banking in Asia and Europe; capital markets in the
US; and insurance in Europe emerged as IT spenders. In addition, the telecom
vertical (contributing 10.8% to revenue), which has been the troubled vertical in the
past, posted growth of 5.0% qoq (CC terms), where HCL Tech outperformed its
peers that posted a decline in this vertical during the quarter. The retail and
consumer product group (CPG) vertical (contributing 9.1% to revenue) and energy,
utilities and public sector (EPU) vertical (contributing 7.2% to revenue) came as the
primary growth drivers with double-digit revenue growth of 14.2% and 12.3% qoq
(CC terms). Other verticals such as, healthcare and media, publishing and
entertainment (MPE) also posted decent growth of 7.1% and 6.0% qoq (CC terms),
respectively.
Since 4QFY2009, US has been the primary growth driver for HCL Tech, while
Europe remained a soft spender. However, with business for manufacturing as well
as energy and utilities clients in Europe returning to normalcy, clients in these
industries are back to spending on higher value-added services such as EAS and
ERD. The business motive of European clients to spend on IT is primarily related to
drive cost efficiencies by outsourcing run-the-business (RTB) type of work and
through rationalisation of existing multiple applications and systems. US has been
the frontrunner in awarding transformational deals to the company, as industries
such as retail are focusing on digital consumer behavior and industry verticals such
as energy and utilities, infrastructure, healthcare, public sector work-transportation,
logistics and travel are gaining good traction. On the other hand, rest of the world
is witnessing more of greenfield projects, relating to clients looking out for global
expansion. Amongst emerging geographies, Japan, South America and Brazil are
coming up in a big way.
During the quarter, HCL Tech reported modest growth across all geographies.
Geographies such as North America and Europe grew by 5.8% qoq each (CC
terms), while rest of the world reported whopping 10.8% qoq growth (CC terms).
Hiring spree continues, utilisations sustained
During the quarter, HCL Tech added 8,379 gross employees, out of which 4,705
were lateral additions. The company added 2,049 net employees, taking its total
employee base to 72,267. In the core software services segment, 3,530 gross and
1,475 net employees were added during the quarter. The gross lateral employee
addition in this segment stood robust at 2,625, which indicates that the company is
witnessing a strong deal pipeline for transformational projects. Attrition rate for the
core software services segment increased up by 50bp qoq to 17.1% (LTM basis)
The infrastructure services segment, which has been growing at a scorching pace,
reported net addition of 784 employees in 2QFY2011. Gross addition in the
segment stood at 1,459 employees, out of which 1,346 were laterals. Attrition rate
for the segment also grew by 60bp qoq to 17.5% (LTM basis).
The BPO segment again witnessed employee rationalisation in 2QFY2011,
reporting a reduction of 210 net employees. The quarterly offshore attrition rate
for this segment grew by 50bp to 10.8% during the quarter.
Utilisation onsite and offshore-excluding trainees inched up by 20bp and 90bp to
95.9% and 75.0%, respectively. Utilisation levels improved as the company hired
laterals to address assignments and as freshers hired in 4QFY2010 have started
getting billed. Utilisation offshore-including trainees stayed at 70.1%.
The company is trying to improve its utilisation level further to 74–75%, which can
be an important lever to improve margins.
EBIT margin inches up
During 2QFY2011, HCL Tech’s EBITDA and EBIT margins inched up by 5bp and
24bp qoq to 16.3% and 13.1%, respectively, in line with our expectation. The
improvement in EBIT margin was on account of 1) lower SG&A investment
2) higher productivity and 3) a slight improvement in utilisation.
EBIT margin growth was because of an 82bp positive effect derived on account of
operational efficiency, defying the negative impact of 58bp due to INR
appreciation.
Segment wise, EBIT margin for core software services declined by 18bp qoq to
14.6%, while EBIT margin for infrastructure services increased by 30bp qoq to
14.5% in 2QFY2011. The BPO segment managed to pull up its gross margin by
151bp to 19.6%. However, at the EBIT level, the segment reported losses and will
continue to do so, as it is expected to be in the investment mode for the next four
quarters.
Client pyramid strengthens
During the quarter, HCL Tech witnessed qualitative client addition, as clients from
various brackets migrated to higher billing segments such as US $40mn–50mn
and US $50mn–100mn. Further, out of the 46 new clients, 19 were added in the
US $1mn–5mn bracket. The top clients of the company also registered decent
growth, with the top 5, top 10 and top 20 clients growing by 2.8%, 6.3% and 6.9%
qoq (LTM basis), respectively
Outlook and valuation
HCL Tech has been witnessing an 8.0% volume CQGR over 2QFY2010–
2QFY2011 in its core software business due to return of discretionary type of
spending i.e., more transformational engagements with increasing components of
EAS. Also, clients are increasingly looking at outsourcing ERD services to encash
the surge in consumer spending. Infrastructure management, which proved to be
the growth driver even in the downturn, has also witnessed double-digit revenue
growth at a 10.5% CQGR over 2QFY2010–2QFY2011.
Further, management is witnessing a rise in outsourcing infrastructure and
applications by clients to drive cost efficiencies.
We expect HCL Tech to be the outperformer at the volume front amongst Tier-I IT
companies on the back of its higher value services portfolio, which is gaining
momentum with clients’ businesses getting to normalcy and they bracing
themselves for future growth. We expect revenue in USD terms to grow at a 28.6%
CAGR over FY2010–12, with a 25.6% CAGR in INR terms over the same period.
At the operating front, the company has many levers such as 1) normalising
employee pyramid (i.e. hiring more low-cost freshers), 2) reaping the benefits of
high investments in SG&A planned in 1HFY2011, 3) increasing utilisation
(including trainees) in core software, which was as low as 70.1% (end of
2QFY2011) and 4) turning around the BPO business by returning it to profitability
by 2HFY2012. Thus, we expect EBITDA margins to remain subdued in FY2011 at
17.3% (v/s 20.5% in FY2010) and expand to 18.7% in FY2012 on the back of the
mentioned levers. Going forward, we expect EBITDA to grow at a 20% CAGR over
FY2010–12, but PAT growth will be much higher at a 38% CAGR over the same
period on the back of nil forex losses, improved profitability in FY2012 and better
other income to be accrued from higher liquid investments.
At the CMP of `508, the stock is trading at 14.6x FY2012E EPS of `34.7.
The outperformance registered by the company warrants the discounts to Infosys to
be bridged. Thus, we value the company at 17x FY2012E EPS i.e., at a discount of
32% to Infosys’ target multiple (v/s historical discount of 35–40%). We revise our
rating on the stock to Buy (earlier Accumulate) with a Target Price of `590.
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