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HCL Technologies (HCLT)
Technology
The margin story. We take a closer look at HCLT’s margin performance over the past
two years. Contrary to the popular belief on the Street, HCLT’s margin decline has little
to do with BPO weakness and Axon acquisition. Also, SG&A trends do not suggest
meaningful investments in business. OPM decline reflects sharp downtick in gross
margins in the core IT services business, a reflection of the company’s aggressive ‘chase
revenue growth’ strategy, in our view. We continue to see revenue growth and margin
uptick an either/or story for HCLT. Reiterate our negative stance on the stock.
The obvious does not tell the real story
HCLT’s splendid revenue growth trajectory over the past 2+ years has come at the expense of
margins – revenue CQGR of 6.1% over the past 9 quarters (since March 2009, which included full
quarter impact of Axon acquisition – hence, the CQGR since reflects organic performance) has
translated into a 4.5% EBITDA CQGR, despite the strong EBITDA growth reported in the past two
quarters. The street has attributed the decline in margins to three factors:
Weakness in BPO business – absolute revenues and EBITDA have seen a sharp decline
Impact of Axon acquisition
Investments in sales and marketing
Our analysis, however, paints a different picture. Reported EBITDA margins for the June 2011
quarter were 270 bps lower than March 2009 levels; however, ex-BPO margins are also 220 bps
lower while ex-BPO, ex-Axon margins are almost 300 bps lower. We also note that EBITDA
margins over this timeframe have benefitted from a sharp 200 bps decline in SG&A as % of
revenues. Reported gross margins are down 470 bps versus March 2009 levels and an even higher
810 bps from June 2008 levels. Decline in gross margins is a similar 410 bps on an ex-BPO basis,
and 550 bps on an ex-BPO, ex-Axon basis.
HCLT management indicates that it has continued to increase S&M investments and the decline in
SG&A has been purely on account of G&A leverage. However, a 200 bps G&A leverage since
March 2009 and 350 bps since June 2008 (in fact even higher if one assumes S&M as % of
revenues has increased) appears very high.
We continue to believe that HCLT’s revenue growth and margin performance should be viewed in
conjunction as the combination reflects the strategic choices the management has made to
overcome its weak relative positioning versus larger Indian peers.
Per employee revenue/ EBITDA metrics trend perplexing
Some clues on HCLT’s strategic choices
Exhibit 1 depicts the per employee revenue and EBITDA metrics (in US$/annum) for the Tier-I
Indian IT companies since the June 2008 quarter. Interesting observations on HCLT:
HCLT’s revenue per employee has grown 28% since the June 2008 quarter to hit
US$51,196 per annum in June 2011. It is now higher than both Infosys and TCS.
EBITDA per employee, however, has remained roughly constant at around US$9,000 per
annum. This essentially implies that increase in cost per employee has been equal to
increase in revenue per employee or zero incremental EBITDA margin, in other words.
We note that HCLT’s EBITDA per employee should have benefitted from two factors in
the June 2008-June 2011 timeframe – (1) impact of Axon acquisition – even as Axon’s
margins were lower than HCLT, its absolute EBITDA per person was higher given the
higher onsite-centricity; the acquisition should have been accretive to absolute EBITDA
per person, and (2) declining contribution from BPO (down to 5% in the June 2011
quarter versus 11.2% in June 2008) – BPO business generates substantially lower
absolute revenue and EBITDA per employee compared to IT and Infra services.
HCLT’s cost per employee is now nearly 20% higher than Infosys or TCS. Given similar
SG&A levels as Infosys and lower SG&A levels versus TCS, the difference in delivery cost
per employee is even starker.
HCLT’s revenue as well as EBITDA per employee in the Infra segment has seen a sharp jump
in the past 2 years. Revenue per person in this segment has increased 75% from March
2009 levels while EBITDA per employee has jumped 57%. Revenue per employee in Infra
services is now 12% higher than software services; it was 28% lower as late as March 2009.
We believe HCLT has, in its bid to aggressively chase revenues, gone in for deals (1) with
high onsite infra management components, and (2) involving a high degree of employee
re-badging.
In several cases, HCLT has also gone in for multi-country onsite deals involving geographies
where it does not have delivery capabilities, in our view. This then leads to the company subcontracting
a good portion of work – revenue accretive given that the work is onsite but
absolute EBITDA (and margin) dilutive given the low margins made on sub-contracted work.
This and high degree of employee re-badging possibly explain the trends in revenue and
EBITDA per employee.
We note that we are not arguing for or against a certain kind of business. All we are
highlighting is the margin trade-off that HCLT has had to make in chasing total outsourcing
contracts and getting into employee re-badging deals. On the positive side, this reflects
greater-than-peers flexibility on engagement models, which could come in handy in certain
client situations. Nonetheless, the margin sacrifice that comes with this approach needs to
be factored into relative valuation multiple. We discuss this next.
Key to stock performance is margin expansion and/or sustenance of revenue
growth without any further margin sacrifice
HCLT should trade at a 30-40% discount to TCS/Infosys for similar growth rates given the
difference in margins and cash flow generation profile. Multiple re-rating therefore hinges
on sustained margin expansion, which appears unlikely to us – recent management
commentary also talks about margin stability at best. Key to stock performance, then lies in
EPS estimate upgrade – with margins unlikely to contribute to this, HCLT needs to continue
surprising on revenue growth. This is a possibility, though a difficult one, in our view.
Nonetheless, higher-than-expected revenue growth remains the key risk to our negative call
on the stock.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
HCL Technologies (HCLT)
Technology
The margin story. We take a closer look at HCLT’s margin performance over the past
two years. Contrary to the popular belief on the Street, HCLT’s margin decline has little
to do with BPO weakness and Axon acquisition. Also, SG&A trends do not suggest
meaningful investments in business. OPM decline reflects sharp downtick in gross
margins in the core IT services business, a reflection of the company’s aggressive ‘chase
revenue growth’ strategy, in our view. We continue to see revenue growth and margin
uptick an either/or story for HCLT. Reiterate our negative stance on the stock.
The obvious does not tell the real story
HCLT’s splendid revenue growth trajectory over the past 2+ years has come at the expense of
margins – revenue CQGR of 6.1% over the past 9 quarters (since March 2009, which included full
quarter impact of Axon acquisition – hence, the CQGR since reflects organic performance) has
translated into a 4.5% EBITDA CQGR, despite the strong EBITDA growth reported in the past two
quarters. The street has attributed the decline in margins to three factors:
Weakness in BPO business – absolute revenues and EBITDA have seen a sharp decline
Impact of Axon acquisition
Investments in sales and marketing
Our analysis, however, paints a different picture. Reported EBITDA margins for the June 2011
quarter were 270 bps lower than March 2009 levels; however, ex-BPO margins are also 220 bps
lower while ex-BPO, ex-Axon margins are almost 300 bps lower. We also note that EBITDA
margins over this timeframe have benefitted from a sharp 200 bps decline in SG&A as % of
revenues. Reported gross margins are down 470 bps versus March 2009 levels and an even higher
810 bps from June 2008 levels. Decline in gross margins is a similar 410 bps on an ex-BPO basis,
and 550 bps on an ex-BPO, ex-Axon basis.
HCLT management indicates that it has continued to increase S&M investments and the decline in
SG&A has been purely on account of G&A leverage. However, a 200 bps G&A leverage since
March 2009 and 350 bps since June 2008 (in fact even higher if one assumes S&M as % of
revenues has increased) appears very high.
We continue to believe that HCLT’s revenue growth and margin performance should be viewed in
conjunction as the combination reflects the strategic choices the management has made to
overcome its weak relative positioning versus larger Indian peers.
Per employee revenue/ EBITDA metrics trend perplexing
Some clues on HCLT’s strategic choices
Exhibit 1 depicts the per employee revenue and EBITDA metrics (in US$/annum) for the Tier-I
Indian IT companies since the June 2008 quarter. Interesting observations on HCLT:
HCLT’s revenue per employee has grown 28% since the June 2008 quarter to hit
US$51,196 per annum in June 2011. It is now higher than both Infosys and TCS.
EBITDA per employee, however, has remained roughly constant at around US$9,000 per
annum. This essentially implies that increase in cost per employee has been equal to
increase in revenue per employee or zero incremental EBITDA margin, in other words.
We note that HCLT’s EBITDA per employee should have benefitted from two factors in
the June 2008-June 2011 timeframe – (1) impact of Axon acquisition – even as Axon’s
margins were lower than HCLT, its absolute EBITDA per person was higher given the
higher onsite-centricity; the acquisition should have been accretive to absolute EBITDA
per person, and (2) declining contribution from BPO (down to 5% in the June 2011
quarter versus 11.2% in June 2008) – BPO business generates substantially lower
absolute revenue and EBITDA per employee compared to IT and Infra services.
HCLT’s cost per employee is now nearly 20% higher than Infosys or TCS. Given similar
SG&A levels as Infosys and lower SG&A levels versus TCS, the difference in delivery cost
per employee is even starker.
HCLT’s revenue as well as EBITDA per employee in the Infra segment has seen a sharp jump
in the past 2 years. Revenue per person in this segment has increased 75% from March
2009 levels while EBITDA per employee has jumped 57%. Revenue per employee in Infra
services is now 12% higher than software services; it was 28% lower as late as March 2009.
We believe HCLT has, in its bid to aggressively chase revenues, gone in for deals (1) with
high onsite infra management components, and (2) involving a high degree of employee
re-badging.
In several cases, HCLT has also gone in for multi-country onsite deals involving geographies
where it does not have delivery capabilities, in our view. This then leads to the company subcontracting
a good portion of work – revenue accretive given that the work is onsite but
absolute EBITDA (and margin) dilutive given the low margins made on sub-contracted work.
This and high degree of employee re-badging possibly explain the trends in revenue and
EBITDA per employee.
We note that we are not arguing for or against a certain kind of business. All we are
highlighting is the margin trade-off that HCLT has had to make in chasing total outsourcing
contracts and getting into employee re-badging deals. On the positive side, this reflects
greater-than-peers flexibility on engagement models, which could come in handy in certain
client situations. Nonetheless, the margin sacrifice that comes with this approach needs to
be factored into relative valuation multiple. We discuss this next.
Key to stock performance is margin expansion and/or sustenance of revenue
growth without any further margin sacrifice
HCLT should trade at a 30-40% discount to TCS/Infosys for similar growth rates given the
difference in margins and cash flow generation profile. Multiple re-rating therefore hinges
on sustained margin expansion, which appears unlikely to us – recent management
commentary also talks about margin stability at best. Key to stock performance, then lies in
EPS estimate upgrade – with margins unlikely to contribute to this, HCLT needs to continue
surprising on revenue growth. This is a possibility, though a difficult one, in our view.
Nonetheless, higher-than-expected revenue growth remains the key risk to our negative call
on the stock.
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