JPMorgan:: HCL-Technologies - FY12 revenue outlook continues to look good but gross margin improvement is key to re-rating

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HCL-Technologies Overweight
HCLT.BO, HCLT IN
FY12 revenue outlook continues to look good but
gross margin improvement is key to re-rating


 We think HCLT’s revenue growth prospects for FY12 look bright but the
company needs to do better on gross margins. HCLT is likely to keep TCS close
company in the revenue leadership race in FY12. Business traction is healthy across
verticals (barring telecom). Also, the company has said that momentum in Europe is
still holding up due to first-time outsourcers.
 We worry about the progression of margins – especially of gross margins which
we see as truly indicative of the core profitability of the company. In this quarter,
much of the promised improvement in margins has been delivered through SG&A
streamlining. We would like to see a better trend for gross margins of HCLT. Gross
margins also determine the extent to which companies can funnel their investments
via SG&A.
 4QFY11 marked by yet another occurrence of strong growth for infrastructure
management, further cementing HCLT’s leadership here. Revenues in infra
management grew 10.5% Q/Q to hit US$827 mn for FY11, only TCS is slightly
ahead. On the positive side, we see bundled deals increasingly at HCLT
(infra+applications). This is one area where the company has made good progress in
the past two years. Volume growth in software services at 3% was muted. But this is
likely to be a mere quarterly aberration in a year when four-quarter volume CQGR
was an impressive 5.6%.
 Operating cash flow (OCF) in FY12E is healthy. HCLT has been able to convert
150% of its PAT to OCF. This is one area that the company has done well in the
recent past. Good receivables management has partly contributed.
 Margins to hold in FY12 versus FY11. HCLT has announced intent to hold
operating (EBIT) margins flat Y/Y in FY12 versus FY11. However, the company
has not spelled out how it intends to do this via gross margins and SG&A. As we
said, the ideal combination should result in an increase in gross margins funding
SG&A increase, which would set up HCLT nicely in FY13 as well.
 Retain OW with a Jun-12 PT of Rs560. We see better picks in the space, TCS
(TCS.BO, Rs1,147.15, rated OW). Our revised EPS estimates for FY12/FY13 are
likely lower than consensus by 7%/5%. Consensus EPS estimates could be revised
downwards.
 Our June-12 PT of Rs560 values HCLT at 15x FY13E EPS, with leading revenue
growth being the primary driver of our OW. Our multiple is at a 30% discount to
that of TCS, which we believe is justified. We believe that Rs450 is an attractive
entry point for ~20%+ upside potential over the next 9-12 months.


Takeaways from Management Commentary
 Currently, the deal pipeline is looking very strong due to vendor churn and
first-time outsourcing primarily from Continental Europe, despite a weak
macro environment. Companies from Continental Europe have started
outsourcing to improve efficiency or for transformation projects to place
themselves better to face macro weakness. Management also pointed out that
there is significant vendor churn.
Deals which had been signed in FY05 to FY07 are close to completion now and
clients are more open/liberal about changing vendors, particularly if incumbents
were not flexible regarding clients’ interests during the downturn. Management
suggested that earlier only 5% of the renewal deals used to be signed with new
vendors, but now the proportion is estimated to have increased to about 30%.
The IT vendors who will win more than a proportionate share of these deals are
likely to report strong revenue growth in 4QCY11. HCLT expects CY12 IT
budgets to be lower than CY11, but revenue growth should remain strong due to
market share gains.
 Management pointed out that the deal pipeline is healthy for all verticals and
service lines barring Telecom. Manufacturing is likely to lead, but all other
verticals are also witnessing healthy demand. TPI expects budget flush in the
second half of CY11, which might boost revenue growth.
 Management reiterated its focus on revenue growth and guided for flat margins
in FY12. The company also guided to give a 12-14% wage hike offshore and 2-
4% wage hike onshore in FY12. Salary increases are likely to cause 200 bps of
margin headwinds and fresher hiring is further likely to impact margins by 50
bps. These headwinds should be offset by various margin levers such as
utilization, non-linear pricing, fixed-price projects, SG&A efficiency, etc.
 BPO business should breakeven in the first quarter of next calendar year as the
restructuring is likely to be completed by the end of this year.
 Tax rate is likely to remain between 24-25% in FY12 and should come down to
22-23% in FY13 due to higher proportion of revenues from SEZs.
 The company had hedges worth $390 mn at the end of the quarter, increasing
modestly from $265 mn in 3QFY11.