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HCL TECHNOLOGIES
Focusing on margin improvement
Continues to outpace peers…
HCL Technologies (HCLT) reported another quarter (Q2FY11) of superior growth
compared to larger peers and beat expectations. It reported revenue of USD 864
mn; revenue grew 6.5% Q-o-Q on constant currency basis compared to 4.7%
for Infosys and 6.0% for TCS. EBITDA margin remained stable against its
guidance of 60bps decline primarily led by lower losses in BPO. Net income, at
INR 3.72 bn, was marginally higher than our forecast of INR 3.61 bn.
…but expect some deceleration for the sake of margins
The company reported stable EBITDA margin for Q2FY11 at the consolidated
level, but margin in core software services (ex-BPO and IMS) declined 40bps Qo-
Q. It has guided for 150bps improvement in margin over the next two quarters
led by SG&A leverage in the business and improvement in utilisation. HCLT,
during the post results call, stated that margin improvement will take
precedence over growth in the next two quarters. Hence, it may turn the tap to
slowdown SG&A investments and hiring. As markets usually anticipate higher
growth from HCLT compared to larger peers, we believe, the company’s margin
versus growth thesis in the short term may sound concerning. But, given the
robust demand environment, we believe focus on margins for a short period is
required to change the organization’s mindset and bring in operational discipline.
De-risking to offer platform-based solutions
HCLT is following a partnership-based model to offer platform-based solutions.
While platform-based solutions offer scope of higher margins, they entail
significant investments. The company is investing around USD 30 mn to
build/revamp a platform for the insurance vertical. It is now forging partnerships
with vendors who have created platforms in the logistics, banks & financial
services, and telecom verticals on revenue share basis. This also enables quicker
time-to-market and limits upfront investment.
Outlook and valuations: Moving in the right direction; maintain ‘BUY’
HCLT’s Q2FY11 performance was in line with expectations with stable margins
coming as a relief. The stock has outperformed the CNX IT Index 23% in the
past three months due to valuation discount to peers and rising belief on its
ability to manage margins. At 16.5x FY12E earnings, as margins improve, we
believe the valuation gap with peers will narrow. We maintain ‘BUY / Sector
outperformer’ on the stock.
Key highlights
• Consolidated revenues, at USD 864 mn, rose 7.5% Q-o-Q, largely on account of strong
volume growth of 6.7% in IT services. In constant currency, Q-o-Q growth was 6.5%.
In INR terms, revenues were at INR 38.6 bn, up 6.9% Q-o-Q and 27.4% Y-o-Y.
• Gross profit stood at INR 12.2 bn, up 6.6% Q-o-Q and 12.7% Y-o-Y. Gross margin,
at 31.6%, was flat sequentially. The negative impact of exchange rate was offset by
operating efficiencies which enabled margins to be flat during the quarter.
• EBITDA margins, at 16.3%, were flat Q-o-Q and dipped 470bps Y-o-Y. This is after
four consecutive quarters of margin decline.
• HCLT’s net profit, at INR 3.7 bn, was up 24.0% Q-o-Q and 35.8% Y-o-Y. Net
margins, at 9.6%, rose 130bps against the previous quarter on account of higher
other income and lower forex loss.
Segmental performance
• IT services: IT services (contributing over 94% to total revenues) rose 37.1% Y-o-
Y (up 7.8% Q-o-Q) to USD 815 mn against USD 756 mn in the previous quarter. The
revenue growth was led by 6.7% spurt in core software volume. Operating margin
declined 20bps Q-o-Q.
• Core software: Revenues, at INR 27.6 bn, increased 6.7% Q-o-Q and 28.4% Y-o-
Y, led by 7.1% Q-o-Q volume growth. Operating margin (EBIT) declined 20bps Q-o-
Q to 14.6%.
Growth momentum in IMS business continues: Revenues jumped 8.8% Q-o-Q
to INR 8.8 bn. EBIT margins jumped 230bps to 16.6%, primarily on account of
higher gross margins.
• BPO revenue spurts, but margin declines: BPO revenues increased 2.5% Q-o-Q
(2.4% in constant currency) to INR 2.2 bn. HCLT reported operating loss (EBIT) of
INR 242 mn during the quarter. Management expects loss of USD 6 mn per quarter
for the next four quarters from this segment.
• Client addition improving: The company added 46 new clients in the quarter.
Total active clientele is now at 434 against 426 in the previous quarter.
• Forex losses: HCLT reported INR 133 mn of forex loss during the quarter. These
have been primarily due to older hedges (taken at ~INR 41/USD, which extinguish
in the quarter).
• Infrastructure services revenues grew 8.5% Q-o-Q (constant currency), recording the
highest growth across service offerings followed by custom application, which grew
7.6%. Engineering and R&D services’ revenue grew 5.9% Q-o-Q after growing at
3.9% Q-o-Q in the previous quarter.
Geo split: ROW posted strong growth of 10.8% (constant currency) while US and
Europe business grew 5.8% Q-o-Q (constant currency).
Retail CPG and energy & utility drive growth: Retail CPG and energy & utility grew
14.2% and 12.3% Q-o-Q, respectively, in constant currency terms. The manufacturing
vertical grew 6.7% Q-o-Q in constant currency. Financial services business grew 3.3%
against 7.2% in the previous quarter.
• Attrition: HCLT reported an increase in attrition across the three segments. Attrition
in IT services increased to 17.1% (LTM basis) from 16.6% in the previous quarter.
Attrition in IMS increased to 17.5% from 16.9% in the previous quarter, while
quarterly attrition in BPO increased to 10.8% from 10.3% in the previous quarter.
• Uptick in utilisation: Offshore utilisation (including trainees) was flat sequentially
at 70.1%; excluding trainees it stood at 75.0% versus 74.1% in the previous
quarter.
• DSO were flat at 61 days.
Company Description
HCLT is India’s fourth-largest IT services company. It provides software-led IT solutions,
remote infrastructure management, and BPO services, focused mainly on
transformational outsourcing. The company leverages its extensive offshore
infrastructure and global network of offices in 26 countries to deliver solutions across
select verticals, including financial services, retail and consumer, life sciences aerospace,
automotive, semiconductors, telecom and media publishing, and entertainment. The
company’s employee force stands at 72,267 and its revenues for the past twelve months
stood at INR 139.8 bn (USD 3.1 bn).
Investment Theme
Industry revenues are forecasted to grow 18-20% over FY10-12, and as a scale player
HCLT is expected to gradually increase its share of the total pie largely through its
rapidly growing infrastructure management practice. HCLT has been aggressively
pursuing large deals in the past few quarters, though the hit ratio has cooled off. Some
of the largest deals announced recently by HCLT in the Indian IT space are Xerox, Sony
Corporation, Nokia Corporation, Dr Pepper Snapple Group, The Linde Group, Agilent
Technologies, which provides long-term revenue visibility. Its well-established
infrastructure management practice, combined with recent acquisition of Axon (SAP
consulting provider), provides significant cross-selling opportunity, which could help
HCLT win some of the large size deals. Industry has seen growth CAGR of 61.9% in IMS
over FY05-09, and HCLT is poised to benefit.
Key Risks
Key risks to our investment theme include: (a) sustained slowdown in the US; (b) failure
in maintaining margins at current levels, while pursuing large deals; (c) inability to fully
integrate Axon and (d) appreciation of the INR against the USD, EUR and GBP.
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