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HCL Infosystems: Riding the GSM wave! - Views on News from Equitymaster
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HCL Infosystems: Riding the GSM wave!
Jan 27, 2006

Performance summary
HCL Infosystems recently announced its results for the second quarter ending December 2005 (fiscal ends in June). The company has recorded strong topline growth, driven by the impressive performance of the Office Automation and Telecommunications (OA&T) segment, while the Computer Systems segment was relatively subdued. Margins have remained low and, in fact, contracted during the quarter under review. Bottomline growth was, however, sluggish, due mainly to a negative other income component, caused by the volatility of the rupee. The performance for the half-year has been decent.

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Sales 19,859 28,002 41.0% 35,512 50,783 43.0%
Expenditure 19,160 27,080 41.3% 34,307 49,107 43.1%
Operating profit (EBDIT) 699 922 31.8% 1,205 1,675 39.0%
Operating profit margin (%) 3.5% 3.3%   3.4% 3.3%  
Other income 152 (5) -103.3% 238 92 -61.3%
Interest (1) 5   1 (4)  
Depreciation 36 31 -14.9% 71 71 -0.8%
Profit before tax 816 880 7.8% 1,370 1,701 24.1%
Tax 216 243 12.6% 338 442 30.8%
Profit after tax/(loss) 601 638 6.1% 1,033 1,259 21.9%
Net profit margin (%) 3.0% 2.3%   2.9% 2.5%  
No. of shares (m) 165.7 167.9   165.7 167.9  
Diluted earnings per share* (Rs)         14.9  
P/E ratio (x)*         17.1  
* On a trailing 12-month basis

India’s largest PC maker
HCL Infosystems, India’s largest personal computer (PC) maker, is primarily engaged in the information technology related hardware business. Its other interests (apart from PCs) in hardware include trading and assembling of equipments like printers, scanners, photocopiers, cellular phones and EPABX systems. It is one of the largest distributors of Nokia cell phones in the country. The meager levels of PC and mobile penetration in the country present a big opportunity for higher growth for HCL Infosys going forward. Its number one position in the industry is, however, under threat due to low barriers to entry in this business.

What has driven performance in 2QFY06?
OA&T enthuses, PCs disappoint: During 2QFY06, the office automation & telecommunications (OA&T) segment was the major growth driver for HCL Infosystems. This business grew at a strong 51.3% YoY, increasing its share to over 80% of total revenues in the quarter. This performance was driven by the strong subscriber addition of GSM customers. HCL Infosystems leveraged its countrywide distribution network to exploit this opportunity. The company also increased its focus on the semi-urban and rural areas of the country to drive growth. It should be noted that the metros are more or less saturated and the real growth going forward for telecom majors and handset manufacturers will undoubtedly be in the semi-urban and rural areas. Given increasing affordability of handsets, attractive financing schemes with low equated monthly installments (EMIs) and cheap pre-paid offers, the rural areas are expected to witness increased penetration, going forward.

Segmental break-up…*
  2QFY05 Share 2QFY06 Share Change
Computer Systems & Other Related Products 4,932 24.8% 5,501 19.6% 11.5%
Office Automation & Telecommunication 14,826 74.6% 22,437 80.0% 51.3%
Internet & Related Services 117 0.6% 96 0.3% -17.8%
Total 19,875   28,034   41.1%
* Includes inter-segment revenue

The second-largest business stream of the company, computer systems & other related products, saw a relatively lacklustre growth during 2QFY06. The segment grew at 11.5% YoY, which is considerably below its recent growth of between 25% and 35%. This is a big disappointment during 2QFY06. The contribution of this business to revenues continues to decline from 24.8% in 2QFY05 to 19.6% in 2QFY06. During the quarter, HCL launched the country’s first broadband-ready PCs in partnership with PSU telecom major, MTNL. The company also pre-loaded free Indian local language software across all its brands, in a bid to maximise PC adoption among non-English speaking people. Among other products launched by HCL during the quarter, were notebooks for the consumer and SMB (small and medium business) segment. These new product launches are expected to drive growth in the segment. The sub-Rs 10,000 PC launched recently has sold around 40,000 units so far. Revenues from the third segment, Internet and related services, continue to remain lacklustre, declining by 17.8% YoY during 2QFY06.

Margins fall: Due mainly to a decrease in stock-in trade, even as the cost of sales declined as a percentage of revenues by 525 basis points, the company saw a 23 basis points fall in operating margins. This is undoubtedly a cause for concern, as HCL in any case operates on very thin margins, as can be expected for a hardware company, where the value-addition is low.

Volatile rupee adversely impacts bottomline: Even as operating profits grew at 31.8% YoY despite the margin contraction, due mainly to the volatile rupee, HCL recorded a negative other income component. The effect of exchange fluctuations on import liabilities paid adversely impacted the other income. If we take away the impact of the exchange movements, then net profit has grown at over 42% YoY.

Performance in the recent past…
  3QFY05 4QFY05 1QFY06 2QFY06
Sales (YoY growth, %) 68.7 69.2 45.5 41.0
Operating margins (%) 4.0 3.1 3.3 3.3
Profits (YoY growth, %) 17.9 28.8 43.9 6.1

What to expect?
At the current price of Rs 255, the stock is trading at a price to earnings multiple of 7.9 times our estimated FY08 earnings. The company has recommended a second interim dividend of Rs 2 per share (dividend yield of 0.8%).

As we have always maintained in the past, the industry that HCL Infosystems operates in is highly competitive. MNC majors like HP and Lenovo are also in the running for a major piece of the pie, apart from other Indian companies like Zenith. The fact that HCL has just around 13% of the market despite being the market leader is an indication of how competitive the industry is. Therefore, it will surely be a game of volumes and profitability will have to take a backseat.

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