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HCL Tech: Research meet excerpts - Views on News from Equitymaster
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HCL Tech: Research meet excerpts
Feb 24, 2005

We recently had a conference call with HCL Tech to understand the growth prospects of the software sector, the reasons for the recent poor performance of the company and the growth prospects going forward. Here are the excerpts of the interaction.

Background
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 (see chart below). 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.

Key impressions from the research meeting
BPO to drive growth: The management believes that the company’s BPO business (currently 14% of revenues) is likely to be a major growth driver going forward. This growth is likely to be on account of the ramp ups on the existing large number of clients that the company has in this segment. We expect the company’s BPO business to grow at CAGR of around 65% over the next three years, much faster than CAGR growth in IT services that is estimated at around 22% through FY07. The company has witnessed improved billing rates in this segment in this quarter. How, we believe that while rates are likely to remain stable going forward, a higher utilisation will be the kicker for the growth in revenues from this segment. As a matter of fact, utilisation levels in BPO at the end of 2QFY05 were as low as 66%. This, the management has stated, was on account of the fact that most of the people hired recently were on training. The company is also planning to start a day shift and this will also boost growth of this segment.

As far as the software services business is concerned, the company has performed poorly over the past few quarters. The management has indicated that a major reason for this performance has bee the appreciation of the rupee vis-ŕ-vis the US dollar. Our calculations show that the company’s onsite volumes have been under pressure in recent times and this, combined with factors like reduced utilisation and stable rates, have led to this poor performance on the IT services front. Going forward, we expect onsite and offshore volumes to grow at CAGR of 15% and 25% respectively and billing rates to be stable, though with a negative bias.

Scale benefits to aid margin stability: HCL Tech’s FY04 operating margins stood at 19.5%, which was higher than 18.6% of FY03. The management is of the belief that operating margins are likely to witness a slower decline going forward. Some of its basic assumptions are:

  1. Salary increases will continue to put pressure on margins. However, since most of the recruitment will be at the lower level, salary rises would not have that much of an impact.

  2. The company, like all other major Indian players expect to garner scale benefits from the sales and marketing investments already made. However, we expect expenditure on this front to grow as a % of revenues as the company tries to penetrate deeper into the global technology marketplace.

  3. On the billing rates front, HCL Tech is getting upward revisions from its clients, which is a positive.

Considering the abovementioned factors, we have assumed margins to remain stable in FY05 and then decline over the next 2 years (to 18.5% in FY07).

Conclusion
Based on our inferences from the research meeting, we have marginally upgraded HCL Tech’s expected FY05 EPS by 2.6%, mainly on account of a strong growth in BPO business and stability in overall margins.

At the current price of Rs 333, HCL Tech is trading at a price to earnings multiple of 17.3 times FY06 expected EPS. While the management has done well in recent times in restructuring its subsidiary portfolio, we remain apprehensive about the company’s growth going forward. Despite the upgradation in earnings, we expect HCL Tech to grossly underperform its peers like Infosys, TCS, Wipro and Satyam on several performance parameters. The company’s return on equity is expected to lie low at 15.9% in FY05 (compared to Infosys 44%). While the management has stated that its policy of quarterly dividends go in favour of improving the return on equity, we believe that the stock will continue to lie low on the radar of investors going forward.

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