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HCL: Focus to shift to margin expansion; Discount to Infosys should widen
HCL continued its strong volume growth recording a 6.7%
growth QoQ outpacing Infosys and TCS. While volume
growth, marginal increase in pricing/realization and
favourable cross currency helped the company maintain
EBITDA margins, software services’ margin continued to
decline. More focus on margin expansion in the coming
quarters could help assuage some of the concerns that we
have currently. We currently value the company at 28%
discount to Infosys due to a much lower ROIC (largely due
to an EBIT margin that is less than half of that of Infosys’
and higher capital intensity). We maintain our Hold rating.
Inline results; Margins flat: HCL reported a 7.5%
sequential topline growth in USD which was largely inline
with our expectations. Revenue growth was led by 6.7%
volume growth. EBITDA margin was flat at 16.3%.
Software services and Infrastructure services grew by 5%
and 7% respectively while BPO was flat. Lower forex losses
and higher other income helped PAT grew by ~21% QoQ.
Europe, APAC Strong, US slowest: APAC led the growth
(~14%) while Europe (7.4%) grew faster than US (5.8%) for
HCL, a trend that has been exhibited so far by both TCS
and Infosys as well. IMS and retail were the primary
volume drivers.
Outlook cautious; Reiterate Hold: We believe IT services
growth will normalize in 2011 growing at 18%-22%. The
sector however could outperform in H12011 owing to
flight of funds away from domestic sectors due to higher
inflation/ interest rates, corporate governance, policy
paralysis and raw material cost pressure towards
companies with quality, earnings visibility in general and
IT sector in particular on the back of improving US growth
expectation (likely temporary) and relative underownership.
Low margins and low return ratios for HCL
should translate into higher PE discount to Infosys (from
~20% currently to 28%) going forward. We maintain our
Hold rating on the stock.
Segment Performance
Software services and Infrastructure services posted good sequential growth while BPO remain
muted. Although still showing loss at the EBIT level, EBIT margin in BPO improved by 380 bps which
are good signs. EBIT margins for software services declined by 20bps while that of Infrastructure
services expanded by 30 bps on a sequential basis.
Company will be focussing more on margin expansion in the next two quarters by improving
utilization levels and rationalizing SG&A spend. Non strategic businesses in BPO would be carved
out to bring it back to profit. Margin expansion would help assuage some of the concerns that we
have. HCL EBITDA margin is ~15 percentage point lower than Infosys or TCS.
Company expects BPO to post losses of no more than $6mn/quarter for next four quarters before
turning positive. Company is taking a three pronged approach to achieve this namely a) Investment
in platforms to the tune of $30mn b) Partnership with existing platform players on a revenue sharing
basis and c) disinvestment of some non-strategic businesses of BPO.
Strongest Volume growth among peers
Topline growth of 7.5% in dollar terms was driven by another quarter of strong volume growth. HCL
outpaced its larger peers Infosys and TCS in volume growth although it lagged in pricing/realization
improvement.
Growth led by IMS and retail;
IMS and Customer application services led the growth among service lines while retail, energy,
healthcare and manufacturing were the main volume drivers among the industry verticals.
Company is expecting good traction in IMS due to the $40bn second generation outsourcing deals
that will come up in the future.
Divergence of trend among geographies
APAC led the growth while Europe grew faster than US for HCL, a trend that has been exhibited so
far by both TCS and Infosys as well. While strong momentum in APAC is good news, slow US could
be signs of worry if it becomes a secular trend. We believe with an estimated nominal US GDP
growth of 3.5% in 2011, US should revert back to its long term trend growth. Management
indicated that spending is happening in the three geographies for entirely different reasons which
was not the case a year back. While stimulus measures in US continue to boost consumer
confidence which is leading to discretionary spending, EU is affected by the austerity measures.
Europe therefore is spending for cost efficiency. APAC on the other hand is spending due to growth
expectations. Fiscal policy over the next year will be crucial in deciding the trend in IT spending.
Outlook
Management gave a positive outlook for 2011 and demand environment. The voices so far from the
Tier I companies have been mixed with TCS and HCL being bullish and Infosys maintaining a
conservative stance. We however are cautious and believe growth in US GDP of 3.5% in nominal
terms could result in 18-22% volume growth for Tier I IT companies in 2011. The sector could out
perform relative to market in the first half on 2011 due to concerns on domestic sectors on higher
inflation/ interest rates, corporate governance, policy paralysis and raw material cost pressure.
Discount to Infosys should widen
Return ratios of HCL Tech are one of the lowest among peers. HCL Tech is employing far greater
amount of capital to deliver one unit of revenue compared to most of its other peers and that too at
lower margins. HCLT is currently trading at a discount of ~20% to Infosys. We believe the discount
should be around 28% going forward because of its capital inefficiency and low ROIC compared to
Infosys.
Estimate Change to reflect improved margins; Maintain Hold
Guided by the management’s intent of improving the EBIT margins over the next two quarters and
BPO unit losses to continue for next four quarters, we have tweaked our numbers to reflect the
same. 15.2x March 2012 FDEPS now gives us a target price of Rs490, downside of 3.5% from current
levels. We maintain hold
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
HCL: Focus to shift to margin expansion; Discount to Infosys should widen
HCL continued its strong volume growth recording a 6.7%
growth QoQ outpacing Infosys and TCS. While volume
growth, marginal increase in pricing/realization and
favourable cross currency helped the company maintain
EBITDA margins, software services’ margin continued to
decline. More focus on margin expansion in the coming
quarters could help assuage some of the concerns that we
have currently. We currently value the company at 28%
discount to Infosys due to a much lower ROIC (largely due
to an EBIT margin that is less than half of that of Infosys’
and higher capital intensity). We maintain our Hold rating.
Inline results; Margins flat: HCL reported a 7.5%
sequential topline growth in USD which was largely inline
with our expectations. Revenue growth was led by 6.7%
volume growth. EBITDA margin was flat at 16.3%.
Software services and Infrastructure services grew by 5%
and 7% respectively while BPO was flat. Lower forex losses
and higher other income helped PAT grew by ~21% QoQ.
Europe, APAC Strong, US slowest: APAC led the growth
(~14%) while Europe (7.4%) grew faster than US (5.8%) for
HCL, a trend that has been exhibited so far by both TCS
and Infosys as well. IMS and retail were the primary
volume drivers.
Outlook cautious; Reiterate Hold: We believe IT services
growth will normalize in 2011 growing at 18%-22%. The
sector however could outperform in H12011 owing to
flight of funds away from domestic sectors due to higher
inflation/ interest rates, corporate governance, policy
paralysis and raw material cost pressure towards
companies with quality, earnings visibility in general and
IT sector in particular on the back of improving US growth
expectation (likely temporary) and relative underownership.
Low margins and low return ratios for HCL
should translate into higher PE discount to Infosys (from
~20% currently to 28%) going forward. We maintain our
Hold rating on the stock.
Segment Performance
Software services and Infrastructure services posted good sequential growth while BPO remain
muted. Although still showing loss at the EBIT level, EBIT margin in BPO improved by 380 bps which
are good signs. EBIT margins for software services declined by 20bps while that of Infrastructure
services expanded by 30 bps on a sequential basis.
Company will be focussing more on margin expansion in the next two quarters by improving
utilization levels and rationalizing SG&A spend. Non strategic businesses in BPO would be carved
out to bring it back to profit. Margin expansion would help assuage some of the concerns that we
have. HCL EBITDA margin is ~15 percentage point lower than Infosys or TCS.
Company expects BPO to post losses of no more than $6mn/quarter for next four quarters before
turning positive. Company is taking a three pronged approach to achieve this namely a) Investment
in platforms to the tune of $30mn b) Partnership with existing platform players on a revenue sharing
basis and c) disinvestment of some non-strategic businesses of BPO.
Strongest Volume growth among peers
Topline growth of 7.5% in dollar terms was driven by another quarter of strong volume growth. HCL
outpaced its larger peers Infosys and TCS in volume growth although it lagged in pricing/realization
improvement.
Growth led by IMS and retail;
IMS and Customer application services led the growth among service lines while retail, energy,
healthcare and manufacturing were the main volume drivers among the industry verticals.
Company is expecting good traction in IMS due to the $40bn second generation outsourcing deals
that will come up in the future.
Divergence of trend among geographies
APAC led the growth while Europe grew faster than US for HCL, a trend that has been exhibited so
far by both TCS and Infosys as well. While strong momentum in APAC is good news, slow US could
be signs of worry if it becomes a secular trend. We believe with an estimated nominal US GDP
growth of 3.5% in 2011, US should revert back to its long term trend growth. Management
indicated that spending is happening in the three geographies for entirely different reasons which
was not the case a year back. While stimulus measures in US continue to boost consumer
confidence which is leading to discretionary spending, EU is affected by the austerity measures.
Europe therefore is spending for cost efficiency. APAC on the other hand is spending due to growth
expectations. Fiscal policy over the next year will be crucial in deciding the trend in IT spending.
Outlook
Management gave a positive outlook for 2011 and demand environment. The voices so far from the
Tier I companies have been mixed with TCS and HCL being bullish and Infosys maintaining a
conservative stance. We however are cautious and believe growth in US GDP of 3.5% in nominal
terms could result in 18-22% volume growth for Tier I IT companies in 2011. The sector could out
perform relative to market in the first half on 2011 due to concerns on domestic sectors on higher
inflation/ interest rates, corporate governance, policy paralysis and raw material cost pressure.
Discount to Infosys should widen
Return ratios of HCL Tech are one of the lowest among peers. HCL Tech is employing far greater
amount of capital to deliver one unit of revenue compared to most of its other peers and that too at
lower margins. HCLT is currently trading at a discount of ~20% to Infosys. We believe the discount
should be around 28% going forward because of its capital inefficiency and low ROIC compared to
Infosys.
Estimate Change to reflect improved margins; Maintain Hold
Guided by the management’s intent of improving the EBIT margins over the next two quarters and
BPO unit losses to continue for next four quarters, we have tweaked our numbers to reflect the
same. 15.2x March 2012 FDEPS now gives us a target price of Rs490, downside of 3.5% from current
levels. We maintain hold
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