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India Equity Research Reports, IPO and Stock News
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We initiate coverage of HCL Tech with a 1-Overweight rating and 12-month price target
of INR485, based on a 30% discount to our target multiple for Infosys. We believe that
HCL Tech should be able to maintain its industry-leading growth rate going forward on
the back of strong performance of its infrastructure business. HCL also appears well
positioned to exploit any resurgence in growth of its enterprise solutions business
through its acquisition of Axon. Furthermore, a turnaround in its BPO business could
lead to small margin expansion for HCL going forward while peers face margin
pressure. HCL is also a beneficiary of the recent rupee depreciation on the account of its
low hedge positions.
Investment summary
Strategy change to focus on revenues: HCL Tech’s management has been able to deliver
one of the strongest revenue growth rates in the Indian IT sector for the past eight quarters.
Its relentless focus on large contracts, the strong positioning of its IT infrastructure business
and its good execution capabilities could be key to this achievement. HCL Tech also
announced new contracts totalling US$2bn in past six months, indicating that business
momentum remains favourable for the company.
Margins could surprise near-term: HCL Tech’s EBITDA margin has expanded by 220bps in
past three quarters on the back of: 1) manpower rationalization that has expanded gross
margin by 110bps; and 2) reduced operating costs as a percentage of overall revenues.
Going forward, the company should be able to further leverage its margins on the back of:
1) changing employee mix towards more junior people; 2) its BPO business breaking even
and returning to profitability; and 3) a further reduction in G&A expenses.
Axon buy leverages HCL Tech to upturn in the market: The acquisition of Axon in 2008
allowed HCL Tech to enter the lucrative market of enterprise solutions. While the current
uncertain market environment could keep this business muted for a while, we believe that
any recovery in the market would lead to significant growth for HCL Tech.
Reasonable valuations: HCL Tech is trading at discounts of 24% to Infosys and 30% to TCS
despite HCL Tech’s higher operating profit growth rate. A part of this discount could be due
to perceived weakness in the business model, but we believe that valuations could be
supported around a P/E of 12.25x.
Valuation
Our 12-month target price of INR485 for HCL Tech is based on a P/E of 11.8x, which we
apply to the average of our EPS estimates for FY2013 and FY2014, which is INR41.30. For
HCL Tech, our target multiple is based on a 30% discount to our target multiple of 17.5x for
Infosys because of the inferior margin profile and smaller scale of business. Our target
multiple for Infosys is in line with Infosys’s past five-year average.
For the Indian IT vendors, we believe P/E is the most appropriate valuation method because
earnings best incorporate the two main drivers of the business: revenue growth that is a
result of new contract signings and margin resilience that comes from operational
efficiencies and position in the IT services value chain.
We rate HCL Tech as 1-Overweight because our price target represents 23% potential
upside, which is at the upper end of its peer group. We believe that HCL Tech should be able
to maintain its industry leading-growth rate going forward on the back of the strong
performance of its infrastructure business.
Risks
The key risk that could keep our price target from being achieved, in our view, is the
weakening of the macroeconomic environment that could jeopardize revenue growth or
margins (or both) for the company. Also, HCL Tech’s margin profile has historically been
inferior to those of Infosys and TCS and, while it has delivered on top-line growth, profit
growth has not been matched. Margin performance and revenue growth are key factors in
stock performance and slip ups here would pose a risk.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
We initiate coverage of HCL Tech with a 1-Overweight rating and 12-month price target
of INR485, based on a 30% discount to our target multiple for Infosys. We believe that
HCL Tech should be able to maintain its industry-leading growth rate going forward on
the back of strong performance of its infrastructure business. HCL also appears well
positioned to exploit any resurgence in growth of its enterprise solutions business
through its acquisition of Axon. Furthermore, a turnaround in its BPO business could
lead to small margin expansion for HCL going forward while peers face margin
pressure. HCL is also a beneficiary of the recent rupee depreciation on the account of its
low hedge positions.
Investment summary
Strategy change to focus on revenues: HCL Tech’s management has been able to deliver
one of the strongest revenue growth rates in the Indian IT sector for the past eight quarters.
Its relentless focus on large contracts, the strong positioning of its IT infrastructure business
and its good execution capabilities could be key to this achievement. HCL Tech also
announced new contracts totalling US$2bn in past six months, indicating that business
momentum remains favourable for the company.
Margins could surprise near-term: HCL Tech’s EBITDA margin has expanded by 220bps in
past three quarters on the back of: 1) manpower rationalization that has expanded gross
margin by 110bps; and 2) reduced operating costs as a percentage of overall revenues.
Going forward, the company should be able to further leverage its margins on the back of:
1) changing employee mix towards more junior people; 2) its BPO business breaking even
and returning to profitability; and 3) a further reduction in G&A expenses.
Axon buy leverages HCL Tech to upturn in the market: The acquisition of Axon in 2008
allowed HCL Tech to enter the lucrative market of enterprise solutions. While the current
uncertain market environment could keep this business muted for a while, we believe that
any recovery in the market would lead to significant growth for HCL Tech.
Reasonable valuations: HCL Tech is trading at discounts of 24% to Infosys and 30% to TCS
despite HCL Tech’s higher operating profit growth rate. A part of this discount could be due
to perceived weakness in the business model, but we believe that valuations could be
supported around a P/E of 12.25x.
Valuation
Our 12-month target price of INR485 for HCL Tech is based on a P/E of 11.8x, which we
apply to the average of our EPS estimates for FY2013 and FY2014, which is INR41.30. For
HCL Tech, our target multiple is based on a 30% discount to our target multiple of 17.5x for
Infosys because of the inferior margin profile and smaller scale of business. Our target
multiple for Infosys is in line with Infosys’s past five-year average.
For the Indian IT vendors, we believe P/E is the most appropriate valuation method because
earnings best incorporate the two main drivers of the business: revenue growth that is a
result of new contract signings and margin resilience that comes from operational
efficiencies and position in the IT services value chain.
We rate HCL Tech as 1-Overweight because our price target represents 23% potential
upside, which is at the upper end of its peer group. We believe that HCL Tech should be able
to maintain its industry leading-growth rate going forward on the back of the strong
performance of its infrastructure business.
Risks
The key risk that could keep our price target from being achieved, in our view, is the
weakening of the macroeconomic environment that could jeopardize revenue growth or
margins (or both) for the company. Also, HCL Tech’s margin profile has historically been
inferior to those of Infosys and TCS and, while it has delivered on top-line growth, profit
growth has not been matched. Margin performance and revenue growth are key factors in
stock performance and slip ups here would pose a risk.
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