RBS:: Buy HCL Technologies -Risk-reward favourable; target Rs580

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HCL Technologies
Risk-reward favourable
We expect a strong 23% CAGR in HCL Tech's revenue over FY11-13 considering
its increasing traction in most of its services and verticals. Even on margins and
profitability, we believe the worst is behind HCL. We initiate with a Buy, as we
believe risk-reward is favourable hereon.

Opportunity high in HCL Tech’s carved-out niche

HCL Technologies differentiates itself from other vendors by focussing on high-growth

services, including infrastructure management services (IMS), enterprise solutions (with

growth synergies through the AXON acquisition not yet fully reflected in financials) and

engineering/R&D services (ERS), besides having a fair revenue contribution from traditional

outsourcing services. While gaining ground in traditional verticals, it further differentiates

itself with a relatively high focus on emerging verticals (c28% of its revenues), where the

opportunity for global sourcing of traditional services is high. Given the aforementioned

revenue drivers, we expect a strong 23% CAGR in its USD revenues over FY11-13.

Despite recent challenges on margins, their long-term visibility is high

We are concerned about the recent decline in HCL Tech’s margins with its aggressive

pricing, up-front investment in transition costs, ongoing restructuring of the business portfolio

and the resulting impact on margins. However, we believe the worst on margins is behind

HCL Tech and scope for margin improvement is higher hereon, with several levers including:

1) SG&A leverage; 2) employee pyramid; 3) increased offshoring; 4) a higher fixed price; and

5) a turnaround in BPO (business processing outsourcing). In addition, the expiry of legacy

hedges in 2Q11A will likely improve cash flow.

We initiate with Buy rating and target price of Rs580

Given our expectations for continued high revenue growth in the coming years and margin

improvement (from 2Q11A levels), we believe risk-reward is favourable. We initiate coverage

with a Buy rating with a target price of Rs580, implying a target P/E multiple of 16x EPS on

the four-quarters ending March 2013 (vs an EPS CAGR of 33% over FY11-13 based on the

March end). Our target price implies a target EV/EBITDA of c10x EBITDA on the four

quarters ending on March 2013 (vs an EBITDA CAGR of 24% over FY11-13F, based on the

March end). Our target PE multiple is at a 20% discount to Infosys.

The basics

Catalysts for share price performance

We expect the key near-term catalysts to be:

􀀟 The opportunity of renewal of large outsourcing deals worth US$174bn due over the next eight

quarters beginning with 4QCY10. About 45% of this is from ISO (infrastructure outsourcing),

where HCL Tech has a better-than-peer success ratio.

􀀟 Cognizant’s guidance for CY11 (in February 2011), and Infosys’s guidance for FY12 in April

2011. While building in its typical conservatism, we expect Infosys to take a more confident

stance on FY12 guidance.

􀀟 Finalisation of CY11F IT client budgets, which we believe are likely to be positive and better

than those of CY10A, with higher growth expected in outsourcing and offshoring.

􀀟 Higher growth in discretionary spending for the industry. We think HCL Tech has an edge in

discretionary services, compared with some of its peers because of its higher focus on

enterprise solutions, engineering and R&D outsourcing services.

􀀟 A pick-up in demand momentum from Europe (besides continuing momentum from the US),

with expected higher outsourcing. Again, through its acquisition of AXON, we believe HCL

Tech is better poised in Europe than some of its peers.

􀀟 Any higher-than-expected improvement in margins (with the worst of margin downside behind,

in our view), which would drive earnings upgrade.

Earnings momentum

􀀟 We expect HCL Tech’s revenue growth to remain strong in the coming years, given its focus

on high-growth services and emerging verticals.

􀀟 We are concerned about the recent decline in HCL Tech’s margins. However, we believe the

worst on margins is behind HCL Tech and that there is scope for margin improvement via

various levers. In addition, expiry of legacy hedges in 2Q11A would improve cash flow.

􀀟 Our forecast assumes FY11-13 USD revenue, INR EBITDA and INR EPS CAGRs of 23%,

23% and 28%, respectively.

Valuation and target price

We value HCL Tech based on a PE multiple derived as a discount to Infosys (which we take as

our industry benchmark). Given our expectations of continued high revenue growth in the coming

years and margin improvement (from 2Q11A levels), we believe risk-reward is favourable. We

initiate coverage with a Buy recommendation and a target price of Rs580, implying a target P/E

multiple of 16x EPS on the four-quarters ending March 2013. Our target price implies a target

EV/EBITDA of c10x EBITDA for the four quarters ending in March 2013. Our target PE multiple is

at a 20% discount to Infosys (slightly higher than the long-term average discount versus Infosys).

How we differ from consensus

Our FY12 and FY13 EPS forecasts are 4-5% lower than Bloomberg consensus, due to our lower

EBITDA estimates.

Risks to central scenario

􀀟 Higher dependence on discretionary services, which accounts for more than 45% of HCL

Tech’s revenues based on our estimates.

􀀟 Any further deterioration in the macro environment in western economies, with the US and

Europe contributing more than 80% of HCL Tech’s revenues.

􀀟 Any sharp appreciation in the INR vs the USD is significantly negative. Even a sharp

depreciation of other foreign currencies, EUR, GBP and AUD vs the USD is relatively more

negative for HCL Tech than peers, considering its higher invoicing in EUR/GBP.

􀀟 Austerity and resulting protectionism measures in western economies.

Opportunity high in carved out niche

We expect HCL Tech to report a strong 23% CAGR in USD revenue over FY11-13, given its

improving traction in traditional services/verticals and its increased focus on high-growth

services and emerging verticals.

HCL Technologies differentiates itself from other vendors by focussing on high-growth services,

including infrastructure management services, enterprise solutions (with growth synergies/benefits

through the acquisition of AXON not yet fully reflected in financials) and engineering/R&D

services, besides having a fair revenue contribution from traditional outsourcing services. While

gaining ground in traditional verticals, it further differentiates itself with a relatively high focus on

emerging verticals (c28% of revenues), where the opportunity for global sourcing of traditional

services is high. Given the aforementioned revenue drivers, we expect a strong 23% CAGR in its

US$ revenues over FY11-13.

IMS focus helping to increase HCL Tech’s wallet share within large deals

Unlike Indian peers that have been pioneers within ADM (application development and

maintenance), HCL Tech has positioned itself strongly in IMS. Given an increasing industry trend

of offshoring within IMS, total outsourcing (combination of ADM/IMS/BPO) together with HCL

Tech’s pioneering position within IMS (with its improving scale in other services, including ADM,

enterprise solutions), we believe HCL Tech’s positioning has improved while competing for

various large outsourcing deals. This is driving healthy growth across its portfolio of services.

This focus enables HCL Tech to not only gain ground in IMS but also in the application

outsourcing space, where it previously lagged its peers. Chart 1 indicates that large deal

restructuring is now occurring more within IMS+ADM, a sweet spot for HCL Tech, contributing

more than 50% of its revenues.

Considering increasing wallet share of HCL Tech in IMS and ADM (as shown in Table 3) and

increasing trend of outsourcing deal awards in IMS and ADM (combined) (as shown in Chart 1),

we believe the opportunity from the renewal of large outsourcing deals worth US$174bn (which is

due in the next eight quarters beginning in 4QCY10) offers great potential for HCL Tech.

Renewal opportunity significant in Infrastructure Services Outsourcing (ISO)

With the Indian IT share of large deal awards/renewals increasing, we believe the US$174bn

worth of renewals in outsourcing contracts is a big opportunity for Indian IT over the next two

years (as per IDC). Within this US$174bn opportunity, the ISO opportunity stands out to us. It

represents as much as US$78bn (about 45% of the total). In addition, we believe offshoring in ISO

is likely to outperform and is likely to grow at a double-digit rate over CY10-14 (see Chart 3). With

HCL Tech’s wallet share within IMS increasing (see Table 3), we believe it is likely to outperform

in IMS in the coming years.

Increased focus on enterprise services/R&D services to drive growth

Enterprise application services to outperform

Through the acquisition of AXON in late 2008, HCL Tech bridged the gap in its service portfolio by

adding scale and domain expertise in SAP implementation services. Prior to the acquisition of

AXON, only about 11% of HCL Tech’s revenue came from enterprise solutions (with almost an

equal contribution coming from SAP and Oracle practices). With the acquisition of AXON, HCL

Tech’s revenues from enterprise solutions increased to more than 20% (one of the highest among

peers, excluding Infosys). Through AXON, HCL Tech has added a rich team of more than 1,500

local SAP consultants/technical experts, giving it another competitive advantage vs its peers with

AXON’s strong SAP domain and enterprise consulting expertise in the public sector, high-tech,

aerospace, defence, etc. HCL Tech can cross-sell AXON’s high-domain-rich services to its own

clients and strengthen its client relationship via a strong local workforce of sales and marketing

employees.

The AXON acquisition increased HCL Tech’s SAP service revenues to more than US$450m. With

the worst of the global economic crisis behind us, we expect growth in the enterprise application

business. We believe our view is corroborated by SAP’s strong traction in licence revenue growth

in recent quarters. Generally, implementation services lag the licence sales by two to three

quarters. Therefore, we believe the aforementioned trends/developments will benefit HCL Tech

given its rich portfolio of enterprise services and AXON’s niche presence in some of the less

crowded verticals, including high-tech, aerospace, the public sector and defence.

Even engineering design and R&D outsourcing likely to outperform

HCL Tech is one of the few Indian IT companies with a significant focus on engineering and R&D

outsourcing services (ERS), with a revenue contribution from such as high as 19%. Within ERS,

HCL Tech offers end-to-end engineering services and solutions in hardware, embedded,

mechanical and software product engineering to industry leaders across the aerospace &

defence, automotive, consumer electronics, industrial manufacturing, medical devices, networking

& telecom, office automation, semiconductor, servers & storage, and software products sectors.

Based on our analysis, top global companies in the semiconductor space began to experience a

turnaround in revenue and EBITDA growth in CY10, indicating an improved outlook and resulting

in higher IT spending within ERS for HCL Tech. We expect HCL Tech’s current growth

momentum in ERS to continue in CY11 and CY12. Even IDC predicts a CAGR of 11% in

worldwide R&D and product engineering spending for CY10-14 vs muted growth of about 4% in

CY09 and CY10F. With its increased spending, we believe HCL Tech will be a preferred vendor,

given its high focus on this area vs some peers.

Greater focus in less crowded verticals…

HCL Tech focuses on less crowded verticals, including high-tech and manufacturing, which

combined comprise 27% of its revenues (with a differentiated sub-vertical focus on independent

software vendors [ISVs], semiconductors, medical devices, aerospace and networking). Other

emerging verticals that include media-publishing-entertainment, life sciences, energy and utility,

public sector and defence also contribute as much as 28% of HCL Tech’s revenues. The highly

penetrated verticals of BFSI, telecom and retail make up the remaining 45% of HCL Tech’s

revenues.

….High global outsourcing opportunity in emerging verticals

As we discussed at length in our sector note, according to a NASSCOM-McKinsey study, the

addressable global outsourcing opportunity from new verticals (including the public sector,

healthcare, media and utilities) is likely to be US$190bn-220bn by 2020. Despite non-traditional

verticals (excluding BFSI, telecom, retail and manufacturing) comprising 40-45% of global

services spending, Indian IT’s exposure to such verticals is minimal at about 14% (of Indian ITBPO

exports in FY10), while the same for HCL Tech is about 28% (as of 2Q11A).

We believe that besides gaining ground in traditional verticals, HCL Tech will benefit more than

peers from increased outsourcing growth from emerging verticals.

Worst on margins behind HCL Tech

Post the recent margin challenges, we believe the worst is behind HCL Tech. The mediumto

long-term visibility on margins is high, considering the various levers that the company

has for margin improvement.

We are concerned about the recent decline in HCL Tech’s margins with its aggressive pricing,

up-front investment in transition costs, ongoing restructuring of the business portfolio and the

resulting impact on margins. Cross-currency movements also affected HCL Tech’s margin more

than its peers’, given HCL Tech’s high invoicing in GBP and EUR.

Headroom in margin levers looks highest for HCL Tech

However, we believe the worst on margins is behind HCL Tech and scope for margin

improvement is higher hereon, with several levers including: 1) SG&A leverage; 2) employee

pyramid; 3) increased offshoring; 4) a higher fixed price; and 5) a turnaround in BPO (business

processing outsourcing). In addition, the expiry of legacy hedges in 2Q11A will likely improve cash

flow.

HCL Tech’s gross margin has historically been much lower than its peers’, for various reasons:

aggressive pricing, initial investment in transition costs, low margins in the BPO business and its

high use of lateral employees vs campus hires (freshers). We believe that given a steady

transition of large deals recently, management’s increased focus on recruiting higher freshers

over the medium to long term and expected improvement in BPO margins should result in better

gross margins in the future. In addition, given our expectation of improved gross margins and with

most of the required investment in sales and marketing behind HCL Tech, we expect margin

improvement at HCL Tech hereon.

Risk-reward favourable; we initiate at Buy

We expect HCL Tech to report a strong USD revenue CAGR of 23% over FY11-13F

considering its increasing traction in most of its services/verticals. Even on margins, we

believe the worst is behind it. We initiate with a Buy, as risk-reward is favourable hereon.

We continue to believe HCL Tech’s focus on IMS and enterprise solutions (both likely to be highgrowth

services going forward) will result in its revenue growth at the higher end of the industry

average going forward. Although we are concerned about the recent decline in HCL Tech’s

margins (on the back of ongoing restructuring of the business portfolio), we strongly believe HCL

Tech’s scope for margin improvement exceeds that of its peers hereon. We would like to note that

while HCL Tech has compromised on margins of late, its revenue wallet share increased by 30bp

to 14.6% over 4Q09-2Q11A, the second-largest gain after TCS. Infosys also gained during the

same period, while Wipro lost market share to peers.

We believe the risk-reward ratio is favourable and we initiate coverage with a Buy

recommendation and a target price of Rs580, implying a target P/E multiple of 16x EPS on the

four-quarters ending March 2013 (vs an EPS CAGR of 33% over FY11-13 based on the March

end). Our target price implies a target EV/EBITDA of c10x EBITDA on the four quarters ending in

March 2013 (vs an EBITDA CAGR of 24% over FY11-13F, based on the March end). Our target

PE multiple is at a 20% discount to Infosys, which we believe is fair given a long-term historical

discount range of about 19% (our target EV/EBITDA multiple is at a 27% discount to Infosys given

HCL Tech’s recently increased gap in margins).

Management team

HCL Tech Chairman and Chief Strategy Officer Mr Shiv Nadar, along with his family and

associate companies, owns a 64.8% equity stake in the company. Although HCL Tech is still a

family-owned company, Mr Shiv Nadar has created a strong second-line team of professionals,

including Mr Vineet Nayar and others. Mr Vineet Nayar is vice-chairman and chief executive

officer of HCL Technologies. Under the leadership of Mr Shiv Nadar and Mr Vineet Nayar, HCL

Tech has became the fourth-largest listed Indian IT company, with a 2Q11A annualised revenue

run rate of close to US$3.5bn. Compared with other Indian large-cap companies, HCL Tech has a

liberal dividend payout policy with a dividend payout ratio averaging about 40-60% pa for FY07-10

(except in FY10, when it was about 20% due to global recessionary pressure).