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HCLT - is its evolving financial model a stripped down
version of Cognizant's? We think not as HLCT has still
to prove its mettle on gross margins
• Increasingly, HCL Technologies’ (HCLT’s) financial model appears to be
perceived by investors to be a somewhat stripped down version of
Cognizant’s*. Cognizant’s financial model is famously premised on delivering
industry-leading growth at constant, non-GAAP operating (EBIT) margins of
19-20% (substantially lower than its offshore-peers such as TCS/Infosys). It is
an investment-led growth model. Investors clearly like Cognizant’s model and
reward it as evidenced by its significant valuation (P/E) premium to Infosys of
26% on both CY11 (or FY12 for Infosys) and CY12 (FY13 for Infosys). So,
does HCLT have a credible case to continue to get re-rated by investors by
adopting a similar model of robust revenue growth at constant operating EBIT
margins (though much lower than Cognizant’s - say 15%)? We think not,
unless HCLT overcomes some key challenges as we explain below.
• A credible model premised on constant margins pre-supposes tight control
over gross margins (measure of core business profitability). Cognizant has
kept its gross margins in a tight, narrow range (40-42%) through cycles. This
has allowed it to keep its investment needs (as % of revenues) almost
unchanged. If companies lose control of gross margins, they tend to keep SG&A
on a tight leash, lowering it as % of revenues, to maintain constant margins.
Lowered investments will eventually tell on revenue growth thus making the
model of constant margins untenable. In fact, it may eat into the viability of the
business model itself (trying to precariously preserve steady operating margins
in the face of weakening gross margins) – the typical vicious cycle syndrome. In
our view, Cognizant’s credible positioning of its financial model is made
possible by its ability to operate in a tight gross margin range.
• No other player in the Indian IT industry with the exception of TCS has
managed to improve/hold gross margins through the recent cycle. Notably, 60%
of TCS’s improvement in operating margins of 600 bps (since start of FY09)
occurs in gross margins (the balance is in SG&A). On the other hand, HCLT’s
gross margins have declined 700 bps since the start of FY09. During the
same period, its SG&A as % of revenues has declined 230 bps to 14.7%
from 17% – not necessarily a happy development.
• Thus, we think HCLT needs to inspire on its ability to improve gross
margins on a secular basis; here, we must differentiate between cyclical and
secular factors. If the revival of HCLT’s gross margins over the next 2-3
quarters is led by cyclical factors (such as improved utilization, spreading of
wage hikes, muted quarterly hiring), then continued re-rating is unlikely. For
continued re-rating, we think HCLT needs to show improvement in gross
margins due to secular shifts (such as sustainable BPO turnaround, deeper client
mining for better client economics, a fuller services portfolio, greater offshoring
of business from AXON [SAP consulting firm acquired in Dec-08]). A constant
margin model by continually tweaking SG&A lower is not sustainable in
the long run, in our opinion.
• Maintain OW on HCLT but we still prefer TCS (OW) and Wipro (OW).
Unless gross margins improve due to upwardly secular shifts, HCLT’s
positioning of a financial model ala Cognizant will not stand, in our view
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
HCLT - is its evolving financial model a stripped down
version of Cognizant's? We think not as HLCT has still
to prove its mettle on gross margins
• Increasingly, HCL Technologies’ (HCLT’s) financial model appears to be
perceived by investors to be a somewhat stripped down version of
Cognizant’s*. Cognizant’s financial model is famously premised on delivering
industry-leading growth at constant, non-GAAP operating (EBIT) margins of
19-20% (substantially lower than its offshore-peers such as TCS/Infosys). It is
an investment-led growth model. Investors clearly like Cognizant’s model and
reward it as evidenced by its significant valuation (P/E) premium to Infosys of
26% on both CY11 (or FY12 for Infosys) and CY12 (FY13 for Infosys). So,
does HCLT have a credible case to continue to get re-rated by investors by
adopting a similar model of robust revenue growth at constant operating EBIT
margins (though much lower than Cognizant’s - say 15%)? We think not,
unless HCLT overcomes some key challenges as we explain below.
• A credible model premised on constant margins pre-supposes tight control
over gross margins (measure of core business profitability). Cognizant has
kept its gross margins in a tight, narrow range (40-42%) through cycles. This
has allowed it to keep its investment needs (as % of revenues) almost
unchanged. If companies lose control of gross margins, they tend to keep SG&A
on a tight leash, lowering it as % of revenues, to maintain constant margins.
Lowered investments will eventually tell on revenue growth thus making the
model of constant margins untenable. In fact, it may eat into the viability of the
business model itself (trying to precariously preserve steady operating margins
in the face of weakening gross margins) – the typical vicious cycle syndrome. In
our view, Cognizant’s credible positioning of its financial model is made
possible by its ability to operate in a tight gross margin range.
• No other player in the Indian IT industry with the exception of TCS has
managed to improve/hold gross margins through the recent cycle. Notably, 60%
of TCS’s improvement in operating margins of 600 bps (since start of FY09)
occurs in gross margins (the balance is in SG&A). On the other hand, HCLT’s
gross margins have declined 700 bps since the start of FY09. During the
same period, its SG&A as % of revenues has declined 230 bps to 14.7%
from 17% – not necessarily a happy development.
• Thus, we think HCLT needs to inspire on its ability to improve gross
margins on a secular basis; here, we must differentiate between cyclical and
secular factors. If the revival of HCLT’s gross margins over the next 2-3
quarters is led by cyclical factors (such as improved utilization, spreading of
wage hikes, muted quarterly hiring), then continued re-rating is unlikely. For
continued re-rating, we think HCLT needs to show improvement in gross
margins due to secular shifts (such as sustainable BPO turnaround, deeper client
mining for better client economics, a fuller services portfolio, greater offshoring
of business from AXON [SAP consulting firm acquired in Dec-08]). A constant
margin model by continually tweaking SG&A lower is not sustainable in
the long run, in our opinion.
• Maintain OW on HCLT but we still prefer TCS (OW) and Wipro (OW).
Unless gross margins improve due to upwardly secular shifts, HCLT’s
positioning of a financial model ala Cognizant will not stand, in our view
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