After a strong Q2JY15, HCLT disappointed the street with below par numbers in Q3JY15 :: HDFC Securities

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--> In our Q2JY15 results review dated Feb 06, 2015, we recommended investors to buy HCLT at the then CMP of Rs. 1955 (cum-bonus) and to average it on dips to Rs. 1730- 1788 for a price target of Rs. 2111 over the next quarter. Thereafter the stock met our price target on March 11, 2015, later touched a high of Rs. 2116.4 on March 11, 2015 and subsequently touched a low of Rs. 834 (ex bonus) on April 21, 2015. The stock became ex-bonus (bonus of 1:1) on March 19, 2015. Currently, it is quoting at Rs. 879.5. HCLT’s Q3JY15 results were below our as well as the street estimates all on parameters. We present an update on the stock. Key highlights of Q3JY15 results: (US GAAP) • USD Revenue remained flat on Q-o-Q basis at US$ 1,490.8, which was below our estimates, impacted by cross currency headwinds (by 270 bps). Growth in Constant Currency (CC) stood at 2.7%. Geographically, growth in US was subdued. Amongst the service offerings, IT Services & IMS services reported below par growth (in CC) of 0.8% & 3.1% Q-o-Q respectively. The growth was supported by BPO business (up 7.9% Q-o-Q). In INR terms, revenues de-grew by 0.2% Q-o-Q. • EBITDA declined by 6.3% Y-o-Y & 9.8% Q-o-Q, while EBITDA margins declined by 417 bps Y-o-Y & 242 bps Q-o-Q to 22.6%. Sharp sequential margin contraction was due to cross currency headwinds, S&M investments and wage hike. Also there is time gap between deferred costs and deferred income. While deferred costs get immediately booked into, the deferred revenues will be booked only when they are realized. HCLT’s deferred cost has nearly doubled to US$214 mn as of March 2015 from US$110 mn as of June 2014. • PAT grew by 3.7% Y-o-Y, but declined by 12.1% Q-o-Q, impacted by higher depreciation (up 3.7% Q-o-Q), higher effective tax rate (up 91 bps Q-o-Q to 21.9%) and forex loss of Rs. 180 mn compared to forex gain of Rs. 150 mn in Q2JY15. EPS for the quarter stood at Rs. 12 vs. Rs. 11.6 in Q3JY14 & Rs. 13.6 in Q2JY1

Other highlights  HCLT signed 14 transformational deals with total contract value in excess of US$1bn in Q3JY15. Over the last 5-6 quarters, the company has been signing large deals in excess of USD1bn, which is encouraging. As per the management, the deal pipeline continues to remain healthy. There was a continuous shift from project business to more of outsourcing business be it servicing or manufacturing or warranties to these manufacturing businesses across the geographies.  In Infrastructure services business, the key growth drivers were Cloud enablement, Automation and Self healing kind of solutions. There are significant wins of contracts in past quarters in the Manufacturing Cloud based infrastructure service solution and managing and providing automated solutions to these contracts, which provides strong visibility in this vertical.  Management reiterated the OPM guidance of around 21-22% due to increased investments for future growth.  The company had total hedges worth USD1.4 bn as on March 31, 2015 as against USD1.6 bn as on Dec 31, 2015.  The DSO's (excluding unbilled receivable) increased to 62 days in Q3JY15 from 58 days in Q2JY15.  The cash and cash equivalents for the quarter stood at USD 1,579 mn as against USD 1,646 mn in Q2JY15.  HCLT announced dividend of Rs 4 per share, 49th consecutive quarter of dividend payout for the quarter ended March 31, 2015. Conclusion & Recommendation After a strong Q2JY15, HCLT disappointed the street with below par numbers in Q3JY15. The results were below our estimates on all parameters. While the Q-o-Q USD revenue growth was impacted sharply by cross currency headwinds, the growth in CC was also below par (slowest since Q3FY12). Subdued growth in Americas (in CC), degrowth in Retail & CPG verticals, lower growth in Core Software Services (after 4% Q-o-Q growth in Q2JY15, the core software services grew by 0.8%) & IMS (compared to previous two quarters), decline in the utilization levels and muted growth across the client brackets were some of the negative highlights of the quarter. Higher than expected sequential margin contraction due to cross currency headwinds, S&M investments and wage hike was another discouraging factor. Sequential PAT growth was impacted by higher depreciation, higher effective tax rate & forex loss. However, good growth in Europe & ROW (in CC), decline in the IT services attrition rate (though marginal), decent client additions, strong growth across verticals like Energy-Utilities & Telecom (in CC) & BPO service (in CC) were some positive highlights of the quarter. While the Q3 results were disappointing, management commentary was optimistic about future outlook. It stated that the deal pipeline is better than the same period last quarter and the value proposition is also strong. It expects the growth momentum to continue in the coming quarters. The company is witnessing healthy traction in the re-bid markets, wherein clients are looking for more flexibility and innovation. It said it is well placed to be a preferred choice in Cloud enablement and automation services among the vendors. Momentum is strong and customers are looking for more innovation and transparency. As regards the EBIT margins, it is confident of retaining at 21-22% over the next few quarters. As regards the inorganic initiatives, the management indicated that inorganic growth is a part of its strategy and it would continue to look for targets. However, in the near term, it stated that it does not see any acquisitions taking place. We feel strong order pipeline could enable HCL Tech to maintain its healthy growth momentum going forward. However, slower growth in core software services & IMS (after a strong recovery in Q2) is a concern. The coming one to two quarters would give us better clarity on whether the slowdown in these services is temporary or they have once again started to witness moderation.

While the increasing investments in business would continue to drive the revenue growth (it would enable the company to get into internet of things, the newer areas, the digitalization as well as the next gen total IT outsourcing), it is likely to put pressure on the company’s margins over the next one to two years. Wage hikes would also weigh on the margins. However, we expect that to be partly offset by higher offshoring & better utilization rates (though limited headroom). We expect HCLT’s margins to decline over the next two years. Industry lobby Nasscom has factored in weaker technology budgets and cut its software exports growth forecast from last year to 12-14% for this financial year. Further, worldwide IT spending is also expected to shrink by 1.3%, according to technology researcher Gartner. This, along with subdued Q3FY15 reported by HCLT makes us feel that the company could fall short of our revenue & profit projections for JY15 & JY16. Hence we are downgrading our net sales, operating profit & PAT estimates by 2%, 6.3% & 5.4% respectively for JY15 and by 2.4%, 7.5% & 4.9% respectively for JY16. Accordingly, revised EPS for JY15 & JY16 would stand at Rs. 51.3 & Rs. 55.7 respectively. We have incorporated projections for JY17, wherein we expect the net sales, operating profit & PAT to grow by 13%, 11.6% & 12.4% respectively. EPS for JY17 is estimated at Rs. 62.6. Valuing the stock at 14.5xJY17E EPS, we arrive at a price target of Rs. 908. We are reluctant in assigning higher PE to the stock price until the company impresses the street with better numbers in the coming quarters. In the near term the stock price could underperform on the back of subdued Q3, pressure on margins and lowering of software exports growth by Nasscom (which indicates that the IT industry and the companies could grow at a slower rate than what we anticipated earlier). The stock has limited upside from current levels. Hence for better returns and margin of safety, we feel investors could enter the stock only on dips to Rs. 799-830 (12.75- 13.25xJY17E EPS) for our price target over the next quarter. Key concerns include i) substantial slowdown in the IT industry; ii) slower than anticipated deal wins in the coming quarters, which could impair the long-term revenue growth visibility & iii) Rupee appreciation vs. USD, as every 1% appreciation affects margins by 30-40 bps.

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