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HCL Technologies (HCLT)
Technology
Growth or profitability? HCLT’s revenue growth, margin and net income was in line
with our estimate though stock price reaction was not. We do not share street’s
optimism on profitability—drive for scale and poor business mix may act as key
impediments. Decline in IT services margins despite strong growth is a reasonable
indication of the challenges faced by the company. We maintain our below-consensus
earnings forecast of Rs29.6/Rs34.1 for FY2012E/13E and TP of Rs440. REDUCE.
In-line quarter – strong revenue momentum sustained, margins flat qoq
HCLT reported decent quarter with 7.5% qoq US$ revenue growth, flat margins and net income
of Rs3.72 bn, all in line with our estimates. Revenue growth was led by IT (+7.3% qoq) and
infrastructure (+9.4% qoq). EBITDA at Rs6.05 bn grew 7.4% qoq but more importantly declined
1.5% yoy. EBITDA margin was flat qoq but down 460 bps yoy. We note that consolidated flat
margin was aided by a decline in BPO losses (+25 bps benefit). Lower-than-expected forex losses
and higher-than-expected tax payouts led to in-line net income of Rs3.7 bn.
Two reasons for our negative stance – (1) growth/profitability challenge and (2) stock’s expensive
Even as we find HCLT’s revenue performance over the past few quarters impressive, sustained
weak margin performance reflects the ‘growth or profitability’ choice that the company has had to
make to overcome competitive challenges. Management’s commentary in 2QFY11 earnings call
(‘our focus is on margin improvement for the next two quarters and hence we are willing to give
up a little on growth’) is in contrast with its stance in the past few quarters (‘we have consciously
chosen to invest and sacrifice margins to drive growth’) and clearly suggests that growth and
profitability remain an either/or situation for the company, for now. In addition, we do not find the
stock inexpensive – HCLT is trading at just a 2.5% discount to Infosys on FY2012E EV/FCF; PE
discount is higher at ~24% and may make the stock look inexpensive. We elaborate our thoughts
on both these aspects in detail in this note.
Growth/profitability challenge
Harsh as it may sound; strong revenue growth over the past few quarters has translated into
nearly negligible EBITDA growth – revenue CQGR of 7.3% over the past four quarters, EBITDA
CQGR of 0.6%. Performance continues to be at odds with the conventional wisdom of scale-led
margin leverage and reflects the tough choices the management has had to make to overcome
business portfolio challenges. In addition, margin performance also indicates a gradual shift in
revenue composition towards recently signed complex/large (but not necessarily margin-accretive)
multi-service contracts. This reflects in the contrasting movements in per-employee rev/EBIDTA.
Rev/employee over the past 8 quarters has grown 28% while EBITDA/employee is down 8%.
Relative valuation expensive in light of inferior FCF profile
Contrary to the Street, we do not find HCLT inexpensive relative to larger peers. Even as the
PE discount to Infosys at ~24% on consensus estimates may appear attractive to some, we
note that the discount on EV/FCF (we use EV and not market cap to adjust for differences in
excess cash) for HCLT versus Infosys is just 2.5%. We believe that the margin and working
capital management differential between the two companies (which will inevitably lead to
inferior FCF/EBITDA profile for HCLT) demands a 35-40% PE discount – this is based on
assumption of identical growth rates for both the companies. We illustrate this with a
theoretical exercise below comparing two companies with different EBITDA margin profiles.
Highlights from results/ management commentary
7.5% qoq and 32.6% yoy revenue growth to US$864 mn, in line with our estimate.
EBITDA margins flat qoq and down 460 bps yoy to 15.7%. Absolute EBITDA grew 7.4%
sequentially but was still down 1.5% yoy to Rs6.05 bn, in line with our estimate.
Revenue growth was led by infra services (+9.4% qoq) and custom applications services
(+9.2%), while BPO segment grew a modest 2.9% qoq.
Among verticals, Retail (+15% qoq), Energy & Utilities (+14% qoq) and Healthcare
(+7.5% qoq) reported strong growth; among geographies Americas (+5.8% qoq) and
Europe (+7.1% qoq) grew below company average while other geographies grew 14.5%
qoq.
Client metrics were robust – HCLT added 46 clients during the quarter, # of US$50 mn+
clients increased to 7 from 6, and # of US$1 mn+ clients grew to 312 from 292. The
company announced a total of 17 new major deal signings.
Net hiring was a weak 2,049, impacted by headcount decline in the BPO segment. The
company has guided for subdued hiring for the next two quarters given the focus on
increasing utilization to drive margin improvement.
Attrition (LTM) in the IT services segment was steady at ~18% on a quarterly annualized
basis.
Dividend raised to Rs2/share per quarter from Rs1.5/share in the Sep 2010 quarter.
Outstanding hedge book now stands at US$256 mn.
Modest change to estimates; reiterate REDUCE
We broadly maintain our revenue and EBITDA estimates for FY2012E; our EPS estimate for
FY2012E stands revised—2.9% higher than earlier to Rs29.6. We note that the revision is on
account of lower tax and RSU expense guidance from the management. For FY2013E, we
raise our revenue estimate but lower our margin assumption, leaving EPS estimate broadly
unchanged at Rs34.1. We reiterate our REDUCE rating with an unchanged target price of
Rs440/share.
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
HCL Technologies (HCLT)
Technology
Growth or profitability? HCLT’s revenue growth, margin and net income was in line
with our estimate though stock price reaction was not. We do not share street’s
optimism on profitability—drive for scale and poor business mix may act as key
impediments. Decline in IT services margins despite strong growth is a reasonable
indication of the challenges faced by the company. We maintain our below-consensus
earnings forecast of Rs29.6/Rs34.1 for FY2012E/13E and TP of Rs440. REDUCE.
In-line quarter – strong revenue momentum sustained, margins flat qoq
HCLT reported decent quarter with 7.5% qoq US$ revenue growth, flat margins and net income
of Rs3.72 bn, all in line with our estimates. Revenue growth was led by IT (+7.3% qoq) and
infrastructure (+9.4% qoq). EBITDA at Rs6.05 bn grew 7.4% qoq but more importantly declined
1.5% yoy. EBITDA margin was flat qoq but down 460 bps yoy. We note that consolidated flat
margin was aided by a decline in BPO losses (+25 bps benefit). Lower-than-expected forex losses
and higher-than-expected tax payouts led to in-line net income of Rs3.7 bn.
Two reasons for our negative stance – (1) growth/profitability challenge and (2) stock’s expensive
Even as we find HCLT’s revenue performance over the past few quarters impressive, sustained
weak margin performance reflects the ‘growth or profitability’ choice that the company has had to
make to overcome competitive challenges. Management’s commentary in 2QFY11 earnings call
(‘our focus is on margin improvement for the next two quarters and hence we are willing to give
up a little on growth’) is in contrast with its stance in the past few quarters (‘we have consciously
chosen to invest and sacrifice margins to drive growth’) and clearly suggests that growth and
profitability remain an either/or situation for the company, for now. In addition, we do not find the
stock inexpensive – HCLT is trading at just a 2.5% discount to Infosys on FY2012E EV/FCF; PE
discount is higher at ~24% and may make the stock look inexpensive. We elaborate our thoughts
on both these aspects in detail in this note.
Growth/profitability challenge
Harsh as it may sound; strong revenue growth over the past few quarters has translated into
nearly negligible EBITDA growth – revenue CQGR of 7.3% over the past four quarters, EBITDA
CQGR of 0.6%. Performance continues to be at odds with the conventional wisdom of scale-led
margin leverage and reflects the tough choices the management has had to make to overcome
business portfolio challenges. In addition, margin performance also indicates a gradual shift in
revenue composition towards recently signed complex/large (but not necessarily margin-accretive)
multi-service contracts. This reflects in the contrasting movements in per-employee rev/EBIDTA.
Rev/employee over the past 8 quarters has grown 28% while EBITDA/employee is down 8%.
Relative valuation expensive in light of inferior FCF profile
Contrary to the Street, we do not find HCLT inexpensive relative to larger peers. Even as the
PE discount to Infosys at ~24% on consensus estimates may appear attractive to some, we
note that the discount on EV/FCF (we use EV and not market cap to adjust for differences in
excess cash) for HCLT versus Infosys is just 2.5%. We believe that the margin and working
capital management differential between the two companies (which will inevitably lead to
inferior FCF/EBITDA profile for HCLT) demands a 35-40% PE discount – this is based on
assumption of identical growth rates for both the companies. We illustrate this with a
theoretical exercise below comparing two companies with different EBITDA margin profiles.
Highlights from results/ management commentary
7.5% qoq and 32.6% yoy revenue growth to US$864 mn, in line with our estimate.
EBITDA margins flat qoq and down 460 bps yoy to 15.7%. Absolute EBITDA grew 7.4%
sequentially but was still down 1.5% yoy to Rs6.05 bn, in line with our estimate.
Revenue growth was led by infra services (+9.4% qoq) and custom applications services
(+9.2%), while BPO segment grew a modest 2.9% qoq.
Among verticals, Retail (+15% qoq), Energy & Utilities (+14% qoq) and Healthcare
(+7.5% qoq) reported strong growth; among geographies Americas (+5.8% qoq) and
Europe (+7.1% qoq) grew below company average while other geographies grew 14.5%
qoq.
Client metrics were robust – HCLT added 46 clients during the quarter, # of US$50 mn+
clients increased to 7 from 6, and # of US$1 mn+ clients grew to 312 from 292. The
company announced a total of 17 new major deal signings.
Net hiring was a weak 2,049, impacted by headcount decline in the BPO segment. The
company has guided for subdued hiring for the next two quarters given the focus on
increasing utilization to drive margin improvement.
Attrition (LTM) in the IT services segment was steady at ~18% on a quarterly annualized
basis.
Dividend raised to Rs2/share per quarter from Rs1.5/share in the Sep 2010 quarter.
Outstanding hedge book now stands at US$256 mn.
Modest change to estimates; reiterate REDUCE
We broadly maintain our revenue and EBITDA estimates for FY2012E; our EPS estimate for
FY2012E stands revised—2.9% higher than earlier to Rs29.6. We note that the revision is on
account of lower tax and RSU expense guidance from the management. For FY2013E, we
raise our revenue estimate but lower our margin assumption, leaving EPS estimate broadly
unchanged at Rs34.1. We reiterate our REDUCE rating with an unchanged target price of
Rs440/share.
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