HCL Technologies 2Q: Volume momentum to continue:: Macquarie Research,

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HCL Technologies
2Q: Volume momentum to continue
Event
 We reiterate our OP recommendation on HCLT post impressive 2Q results
(year-end June), that were ahead of expectations on both top line and bottom
line. The company delivered another quarter of robust volume growth (6.6% QoQ)
and 2Q EBIT margins improved 20bps sequentially. We have increased our
FY11 and FY12 revenue forecast and are raising our target price to Rs615.

Impact
 Higher volume growth drives upgrade in revenues... HCLT has delivered
robust volume growth consistently for the past four quarters that has been
higher/in line with industry leaders. Our channels checks suggest FY12 to be
another strong year and we are increasing FY12 volume growth estimate to
26% (vs. 21% earlier) driving upgrade in our US$ top-line forecast to 30%.
 …even as we trim margin forecast to factor in potential cost pressure.
Despite our bullish outlook we prefer to remain conservative on margin front
as strong demand environment implies that costs (both employee and sales
related) would remain elevated. Upgrade in revenues and favourable forex
assumption prevails over the reduced margin forecast – as a result we are
raising our EPS estimates by 8% for FY12 and 15% for FY13.
 Expect consensus upgrades to follow. Our revised FY12 estimates are 10-
12% above street estimates on revenues, EBITDA and PAT. Strength in Infra
services (revenues up 9% QoQ, 49% YoY) and higher volume forecast in
Software services segment would be the key drivers for the upgrades.
 BPO segment – Returning to growth. BPO reported revenues of US$49.5m
(up 2.9% sequentially). 2Q segmental EBITDA loss was Rs107m, implying a
negative EBITDA margin of 4.8%. This marks an improvement of 400bps vs
the previous quarter.
 2Q results detail. HCLT reported revenues of US$864m (up 7.4% QoQ),
EBIT margins of 13.1% (up 20bp QoQ) and PAT of Rs4bn (up 20.7% QoQ
and up 34.3% YoY). Refer Figures 4 and 5 for details.
Earnings and target price revision
 We are increasing our FY11E–13E EPS by 1%, 8%, 15%, respectively, to
account for revised currency forecast.  Our revised TP is Rs615 (Rs515
previously) to factor in raised EPS estimates.
Price catalyst
 12-month price target: Rs615.00 based on a DCF methodology.
 Catalyst: Large Deal wins and uptick in EAS offerings
Action and recommendation
 Reiterate OP. The stock is currently trading at one year forward PER of ~15x
vs. previous up-cycle multiples of 18-20x. Recommend investors to
accumulate the stock.


2Q key highlights: (A) Lateral Hiring changing pyramid structure for HCLT
 Higher Lateral Hiring as % of gross hiring signifies shift in Pyramid Structure for HCLT. We
note that lateral hires make a higher share of gross hiring in comparison to Tier 1 player like
Infosys. Our channel checks and talks with industry people suggest that the Tier 1 players are
focused on increasing the number of freshers in the pyramid structure to provide flexibility and
scale advantage. HCLT seems to be working on a different strategy of increasing lateral hires
which can translate into higher top-line growth and improved blended rates but can lead to
margins being in check for next quarters.




2Q key highlights: (B) Infrastructure services, Retail vertical shines.
 Infrastructure Services grows 55% on LTM basis. The segment contributes higher than
company average margins and growth rates. This is the fastest growing service offering for HCLT
in the quarters to come.
 Retail, Manufacturing and Telecom growth steady.  Retail, Manufacturing and Telecom
registered healthy constant currency growth of 15.5% (vs 5.8% at INFO), 7.2% (vs 7.1% at INFO)
and 5.8% (vs -3.9% in INFO) respectively in 2Q. Telecom’s positive performance came as a
surprise since the vertical has not done well for TCS and INFO during this quarter.


 2Q results detail. HCLT reported revenues of Rs38.9bn (up 4.9% QoQ and 28.2% YoY), EBITDA
of Rs6.3bn (up 5.2% QoQ and down 0.6% YoY) and PAT of Rs4bn (up 20.7% QoQ and up 34.3%
YoY). Overall EBITDA came in 1.8% higher than our estimates and EBITDA margins of 16.3% for
the quarter was 7bps higher sequentially. US$ revenues came in at US$864m (up 7.4% QoQ).
 Software Services segment - Robust volume growth continues, pricing uptick. HCLT
reported 6.6% QoQ volume growth (Vs 7.9% in 1Q) in the Software services segment. A strong
demand environment helped with 1% uptick in blended pricing, resulting in QoQ top-line growth in
US$ terms.
 Infrastructure Services segment – Growing by leaps and bounds. The segment reported US$
revenues of US$197m (9.4% sequential growth at reported currency basis), and we expect this to
the key driver for growth for the company. HCLT sees a large part of the demand in this service
offering being fuelled by “churn” in contract renewals.
 BPO segment – Returning to growth. BPO reported revenues of US$49.5m (up 2.9%
sequentially). 2Q segmental EBITDA loss was Rs107m, implying a negative EBITDA margin of
4.8%. This leads to an improvement of 400bps to come at -4.8% vs -8.8% in 2Q. We believe
EBITDA level profitability in the segment is still two quarters away.
 2QFY11 Operational details. HCLT had net employee addition of 2,049 (vs. 5,661 last quarter).
Volume growth came in at 6.6% (vs.3.1% for INFO). Blended pricing was up 1.0% on a sequential
basis (vs. 0.5% at INFO).


Valuation: DCF-derived target price of Rs615 implies FY12E PER of 18x
 Our target price for HCLT is based on a three-stage DCF model. We have factored in a 14% FCF
CAGR over a seven-year period (FY14-21) for the second stage of our DCF. Our terminal growth
assumption is 5% and we have used a WACC of 14.5%.


Analysis of our key estimate changes
 Our estimate changes are largely linked to revised currency forecast and there are minor changes
to our business assumptions.
 US$ Revenue Growth. After three successful quarters of 7%+ US$ revenue growth, we revise
our FY11 revenue growth estimate to 33%. We are increasing FY12 volume growth estimate to
26% (vs. 21% earlier) driving upgrade in our US$ top-line forecast.
 EBITDA Margin. We believe our revised margin assumptions adequately capture the pressure
from wages and increased investment in the business.
 EPS. Factoring in all the above changes and revised tax rates our new EPS estimates for FY11,
FY12 and FY13 are Rs24, Rs34 and Rs43, respectively.