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HCL-Technologies
Overweight
HCLT.BO, HCLT IN
Delivering good revenue growth and promise of
improving margins; reiterate OW
• Strength in revenue growth sustained: HCLT’s results confirm that its
revenue-generating engine continues to fire and lead the industry (in revenue
growth). Revenues came in at US$864MM (7.5% growth Q/Q), with almost
every segment faring well (IT Services delivered revenue growth of 7.3% Q/Q
with retail and energy/utilities standing out) while Infra management grew 9.4%
Q/Q, both with stable margins.
• Losses in BPO declined, with mild BPO revenue growth: HCLT’s BPO
division, in the throes of a turnaround, limited its loss (EBIT) to US$5.4MM
(from US$7.1MM last quarter). We expect the BPO business to turn around and
start reporting steady-state EBIT margins around 10-15% in the next four-six
quarters (through realizing operating leverage from revenue growth).
• Encouragingly, management reiterated its emphasis on improving margins
over the next two quarters, as we expectated: Management prefers to temper
its robust top-line growth (>30% Y/Y) to boost margins. We forecast EBIT
margins to rise to 15% by FY12 (currently 12.5%, including non-cash cost of
options) supported by improved utilization, SG&A leverage, and a turnaround
in BPO. Thus, we expect HCLT to recover lost ground on margins, though not
all of it (EBIT margins stood at 17% over FY06-09).
• Other positives also seen in the results: (a) Operating cash flows at 9.5% of
revenues (at US$80MM versus US$10MM in Sep-10 quarter). (b) Attrition in IT
Services and infra management is easing (quarterly annualized). (c) For the first
time in several quarters, we see client metrics at higher size thresholds improve
(US$10MM+ size). (d) Improvement in pricing/realization (onsite up 1.3%,
while offshore up 0.7%) though this is not constant-currency.
• We increase our estimates and price target (PT) and reiterate OW. Our
estimates rise by ~4% for FY12/13 primarily as a result of revenue
upgrades: Given the new normal for EBIT margins at 15% versus 17-18%
during FY05-09, we peg our one-year forward P/E valuation discount for HCLT
to TCS (our valuation benchmark) at 30% (versus the 22% five-year median
discount relative to Infosys in the past). Our revised Dec-11 PT is now Rs560 (up
from Rs465). The increase in our PT is explained by the (a) higher one-year
forward benchmark valuation (P/E) of 22x (of TCS, against which we peg
HCLT’s discount), (b) rolling forward of our timeframe by one quarter, and (c)
higher FY12/13 EPS estimates. We retain our OW rating on the stock. HCLT is
our second pick in the large-cap Indian IT sector, after TCS (OW), our top pick.
Our Dec-11 PT of Rs560 is based on a one-year forward P/E multiple
of 15.4x, or EV/EBITDA multiple of 9.6x – reasonable, we believe,
with an estimated 33%+ EPS CAGR FY10-12E. This embeds a oneyear
forward valuation discount of 30% and 40% to TCS on P/E and
EV/EBITDA, respectively, which we believe is fair and warranted,
given the margin profile and return ratios of HCLT. Our ascribed
discount is higher than the historical mean and we note that this
discount can widen if HCLT’s margin profile does not improve as we
expect
Key risks to our price target are a slowdown in deal ramp-ups and
appreciation of the rupee against the US$. Taking on a higher-thannormal
share of lower-margin and/or asset heavy deals can impact
operating margins and return ratios impacting HCLT’s valuation.
2Q FY11 Highlights
• Revenues came in at $864 million, up 7.5% Q/Q, and at Rs39 billion in
rupee terms, up 6.9% from last quarter. Volumes were up 6.5% Q/Q, which
contributed most of the revenue growth.
• The growth was primarily driven by Infrastructure Services with 9.4% (in $
terms) revenue growth and Software Services (+7.3%), while BPO
continued to lag as top-line growth moderated to 2.9% Q/Q from 5.7% last
quarter
• Software services, which contributes more than 70% of the total company
revenues, witnessed pricing increase of 0.6% Q/Q as both onshore (+1.3%)
and offshore (+0.7%) pricing registered modest up-ticks. Volumes for
Software Services were up 6.7% Q/Q driven by offshore volumes (+7.1%),
while Onsite volumes (+5.6%) were strong as well.
• Retail & CPG and Energy-Utilities-Public sector reported double-digit Q/Q
growth of 15.5% and 13.2%, respectively. Healthcare grew 7.4%,
Manufacturing revenues increased 7.2%, MPE grew 6.2%, while Financial
Services lagged slightly with 5.2% growth. Telecom, which competitors
reported to be weak, grew 5.8% for HCL Technologies.
• On LTM basis, revenues from the top 10 clients were up 6.3% Q/Q.
Revenue growth from top 20 clients was 6.9%. Non-top 20 clients grew at a
higher rate than top 20 clients.
• Proportion of fixed-price contracts increased 40bp from last quarter to
41.5%. It has increased 190bp y/y.
• TCS reported net addition of 2,049 employees during the quarter,
moderating significantly from 5,661in the last quarter. IT Services saw net
addition of 2,259 employees and gross addition of 4,989 people, while BPO
services headcount decreased by 210 people, despite gross addition of 3,390
employees. Gross additions for the company totaled 8,379 in 2Q.
• Attrition for IT services increased modestly to 17.2% on an LTM basis,
compared to 16.7% last quarter. BPO services had significant quarterly
attrition of 10.8%, up from 10.3% last quarter. Headcount decreased for
BPO business despite gross addition of 3,390 employees. On an absolute
basis, 6,330 employees left the firm (up 3.4% from 6,124 in Q1), including
2,730 in IT Services and 3,600 in BPO business.
• HCLT’s new client additions continued to be strong as the company
added 46 clients in CY10. On an LTM basis, the net increase in milliondollar
clients was 20, compared to 9 in Q1. HCL won 17 transformational
deals during the quarter.
• Utilization (including trainees) for software services remained flat at 70.1%,
but increased modestly excluding trainees to 75.0% from 74.1% last quarter.
• By geography, Europe witnessed strong growth of 7.2% and Americas grew
5.8% Q/Q. However, ROW was the most significant growth driver with
14.6% revenue growth.
• By horizontals, Infrastructure services registered strong growth of 9.4% and
Custom application services grew 9.1%. Engineering and R&D services and
Enterprise application services’ revenues increased 6.3% and 5.5%,
respectively.
• Gross and EBITDA margins remained flat at 31.6% and 16.3%,
respectively. Operating margins improved nominally (20bp) to 13.1%.
Margins remained flat for IT Services businesses as mild weakness in
Software Services (-20bp) was offset by modest expansion in Infrastructure
Services’ margins (+30bp). BPO incurred losses as the company continued
to invest in the business. Operating margins continued to be weak
despite strong revenue growth, which is our primary concern regarding
HCL.
• DSO stood at 61 days (LTM basis), flat from last quarter. Repeat business
was 94.3% compared to 93.7% in Q2.
Takeaways from Management Commentary
• To us, the important takeaway was that management articulated a focus
on margins over growth by concentrating on utilization and SG&A
efficiency. Current utilization rate (excluding trainees) of 75% provides
significant headroom for improvement. Any meaningful up tick in margins
should boost earnings and stock price, in our view.
• Enterprise application and infrastructure services led growth in ROW region
suggests strong discretionary spending growth in the region, which we
believe should be a positive for top-line.
• Management will continue investing in BPO services business and incur
about $6MM losses in each quarter of CY11. The business should report
profits starting 1Q CY12. We view management commentary as
conservative for the business and have been more realistic about the
prospects of the BPO business in our earnings model.
• In BPO business, management reiterated intent to reduce voice based
business and focus more on strategic non-voice kind of business, primarily
platform based services.
• Tax rate for 2Q was 20.5% (20.0% in 1Q) and management guided for
continued increase in tax rate. Management expects the effective tax rate to
be 25% for 4Q FY11, 22% for FY11 and 24% for FY12.
• The company had hedges worth $256MM at the end of the quarter,
decreasing modestly from $297MM last quarter. HCLT stands favorably
placed in substantially reducing its hedging loss to near-zero in the
coming quarters.
Further support for our Dec-11 price target of Rs560
The grid below shows that our Dec-11 PT of Rs560 embeds assumptions of
approximately (a) earnings CAGR of 15% through FY13-17, (b) earnings CAGR of
10% thereafter for the next 10 years over FY18-27, and (c) 5% to perpetuity. We
believe that these assumptions are reasonable and rational.
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