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HCL Tech: Not interesting!

Jan 25, 2005

Introduction to results
HCL Technologies, India's fifth largest software services exporter, continues with its streak of poor performance as is seen from the latest result announcement by the company. For the second quarter ending December 2004, the company has reported a sequential dip in its bottomline on the back of a marginal growth in topline. Contraction of operating margins and a substantially lower other income has also cast pressure on the net profits of the company in this quarter.

Financial performance (US GAAP consolidated): A snapshot…
Rs m 1QFY05 2QFY05 Change 1HFY04 1HFY05 Change
Sales 7,820 8,014 2.5% 11,831 15,834 33.8%
Expenditure 6,009 6,169 2.7% 9,631 12,178 26.4%
Operating profit (EBDIT) 1,811 1,845 1.9% 2,200 3,656 66.2%
Operating profit margin (%) 23.2% 23.0% 18.6% 23.1%
Other income 573 206 -64.1% 665 778 17.1%
Depreciation 316 364 15.1% 536 680 26.8%
Profit before tax 2,067 1,687 -18.4% 2,328 3,754 61.2%
Tax 210 136 -35.4% 289 346 19.9%
Minority interest & income of equity investee (239) (259) (173) (499) 187.8%
Extraordinary income - - 2,633 -
Profit after tax/(loss) 1,617 1,292 -20.1% 4,499 2,909 -35.3%
Net profit margin (%) 20.7% 16.1% 38.0% 18.4%
No. of shares 296.5 296.5 296.5 296.5
Diluted earnings per share* (Rs) 21.8 17.4 30.4 19.6
P/E ratio (x) 16.4
(* annualised)

What is the company's business?
HCL Technologies is the fifth-largest software exporter from the country and is focused on research and development (R&D) outsourcing. Its service offerings include technology development (22% of revenues), product engineering (16%), application development (40%), ITES (14%) and infrastructure services (8%). The past few quarters have been very volatile for HCL Tech. While the company has witnessed volatility in its core business, it has done well to grow its inorganic businesses. HCL Tech's focus on R&D outsourcing and its experience in technology development services gives it a competitive edge over its peers.

What has driven performance in 2QFY05?
Lacklustre growth in software services and BPO: Software services (78% of revenues) remain the Achilles heel for HCL Tech as the segment continues with its streak of poor performance. In 2QFY05, revenues from this business have declined sequentially by 1% and this paints a grim picture of the company's performance vis-à-vis its peers who have managed to maintain their growth momentum and have reported double digits growth in software services revenues. Even the BPO business of HCL Tech has failed to enthuse with a sedate sequential growth of 15% in this quarter. The third business segment of the company, infrastructure services, witnessed a sequential revenue growth of 10%, lower than what was has been witnessed in the preceding quarters.

The company added a net of 1,775 employees in 2QFY05, out of which 989 were added in the software services business and 681 on the BPO front. The company added 16 new clients in the quarter.

Stability in margins: Despite a sluggish sequential growth in the topline, HCL Tech almost managed to maintain its overall operating margins in 2QFY05, aided by steady margins for both the software services and BPO businesses. Also, the infrastructure business witnessed a margin expansion of 270 basis points in this quarter. Reduction in direct costs has been more or less countered by increases in SG&A costs for all these three segments in 2QFY05.

Lower other income dent profits: The sedate growth in the topline and maintenance of margins failed to affect a similar sequential growth in the profits in 2QFY05 and this was a result of a sharp decline in HCL Tech's other income component (down 64% QoQ). Even a lower tax outgo could not save the profits from declining on a sequential basis. This decline in other income seems as per the management's earlier expectations. The management, in the conference call for 1QFY05 results, had indicated that other income would be lower in the next few quarters as a result of changes in US GAAP regulations, as per which interest received on debt (treasury investments) would be credited to profit and loss account only at the time of redemption. As a matter of fact, HCL Tech has Rs 18.3 bn invested in treasury investments as on December 31 2004.

What to expect?
At the current price of Rs 323, the stock is trading at a price to earnings multiple of 16.5 times annualised 1HFY05 earnings. The company board has recommended an interim dividend of Rs 4 per share (200%). We are pretty much concerned about the volatile nature of the company's performance in the past few quarters. In this regard, and also considering valuations that are at the higher side of the spectrum, we believe that investors would be better off in choosing other stocks from the software sector.

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