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A play on margin expansion
HCL Tech has reported a 9% QoQ growth in revenues (USD terms) to US$804mn, ahead of our estimates of a 5.6% QoQ growth at US$779mn. The company garnered 14 multi-year, multi-million dollar deals during the quarter and expects to close multiple large deals in 2QFY11. We believe HCL Tech would continue to beat both our estimates and consensus and drive upgrades on a QoQ basis. We reiterate Outperform with a TP of `490 (`474 earlier).
Highest-ever incremental revenue additions in 1QFY11
HCL Tech added US$66mn in incremental revenues in 1Q (the highest ever for HCL Tech). Custom application development and Infrastructure services accounted for 71% of incremental revenue additions. With discretionary spends picking up and a reasonable portion of the company’s pipeline coming from these spends, we believe the quarters going forward could see an increase in average realized billing rates.
Negative free cash flows an aberration
HCL Tech reported negative free cash flows of ~`1200mn on the back of project related advances for a large deal around smart grids that are expected to yield revenues in 3QFY11. Adjusted for this expense HCL Tech would have reported healthy cash flows. The company has consistently derived operating cash flows in excess of its net income in the past and the management believes that this would be no different going forward.
Margin concerns overplayed in our view
Margins can clearly be managed by recruiting higher number of freshers, increasing utilization and lowering SG&A. We believe HCL Tech’s margins are lower than peers due to its higher focus on growth and model of execution by recruiting a significantly higher proportion of laterals vs peers (90:10 vs 40:60). HCL Tech’s higher growth focus is clearly visible from its incremental revenue additions in FY10. The company added more revenues incrementally than any other Indian IT services vendor in FY10 – US$336mn (organically ex-Axon) vs US$138mn for Infosys, US$62mn for Wipro and US$313mn for TCS (including CGSL).
Reiterate Outperform with a TP of `490
We revise our FY11E EPS downward by 2.5% on management guidance of flat margins for 2QFY11, on higher investments in SG&A to pursue large deals, and equity dilution. We increase our FY12E EPS by 3.5% to `32.7 as we believe the margin profile should improve going forward. On the back of higher earnings growth, we increase our TP to `490 (`474 earlier). Reiterate Outperform.
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