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HCL Tech: Better this quarter!

Apr 26, 2005

Introduction to results
HCL Technologies announced its results for the third quarter and nine-month period ending March 2005 late yesterday. For 3QFY05, the revenues have shown a decent 7% growth, driven mainly by a rise in volumes. Due to a slightly higher-than-proportionate rise in direct expenses, margins for the quarter have reduced by 20 basis points. For the nine-month period, revenues and profits have grown YoY by 36% and 47% respectively. Aided by considerably lower costs, this has translated into a 390 basis point jump in margins.

Financial performance (US GAAP consolidated): A snapshot…
(Rs m) 2QFY05 3QFY05 Change 9mFY04 9mFY05 Change
Sales 8,014 8,582 7.1% 17,739 24,088 35.8%
Expenditure 6,169 6,629 7.5% 14,353 18,555 29.3%
Operating profit (EBDIT) 1,845 1,953 5.9% 3,386 5,532 63.4%
Operating profit margin (%) 23.0% 22.8%   19.1% 23.0%  
Other income 206 162 -21.1% 1,062 914 -13.9%
Depreciation 364 412 13.3% 779 1,079 38.6%
Profit before tax 1,687 1,703 1.0% 3,669 5,367 46.3%
Tax 136 187 37.6% 352 524 49.0%
Minority interest & income of equity investee (259) 57   (320) (432) 35.0%
Profit after tax/(loss) 1,292 1,572 21.7% 2,997 4,411 47.2%
Net profit margin (%) 16.1% 18.3%   16.9% 18.3%  
No. of shares 296.5 296.5   296.5 296.5  
Diluted earnings per share* (Rs) 17.4 21.2   13.5 19.8  
P/E ratio (x)         18.1  
(* 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 (23% of revenues), product engineering (16%), application development (37%), ITES (15%) and infrastructure services (9%). 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 3QFY05?
Software lacklustre, BPO drives growth:  The software services business of HCL Tech has shown a fairly lacklustre growth during 3QFY05 on a QoQ basis, growing by just 3.3%. In fact, what puts this performance in an even poorer light is the fact that software service revenues during the previous quarter had actually declined 1% sequentially and as a result, this lacklustre 3.3% growth has been achieved on a lower base. For 9mFY05 period, the story is a little more encouraging, with revenues from this segment growing by 26.8% on a YoY basis, though it is still considerably lower than what its peers like Infosys, Wipro and Satyam had managed to achieve.

The BPO business on the other hand, has shown a slightly better rate of growth, with revenues from this segment during the quarter increasing by 17.9% sequentially. During 9mFY05, the picture is even more encouraging, as revenues have risen by as much as 92.6% on a YoY basis. Volumes overall have shown a 3.5% growth. The third segment of the company, infrastructure management services, has grown at 24.8% this quarter sequentially, while for 9mFY05, the growth is 19.0% YoY.

HCL Tech added a net of 1,785 employees in 3QFY05, out of which 1,122 were added in the software services business, 498 on the BPO front and 165 in the infrastructure management business. The company added 18 clients in the quarter. The total number of active clients now stands at 489.

Flat costs result in flatter margins:  During 3QFY05, due to a slightly higher than proportionate increase in direct and sales, general and administrative (SG&A) costs, margins remained flat, reducing by 20 basis points. However, during 9mFY05, the picture is a lot better. Costs have risen at a considerably lower rate than revenues and HCL Tech also appears to have leveraged on SG&A expenses incurred in the past, which reduced as a percentage of revenues from 16.5% during 9mFY04 to 13.9% during 9mFY05. The end result is that margins have shot up by as much as 390 basis points. Employee costs have been kept under control due to hiring at lower levels by the company, resulting in lower costs per employee.

Profits surge despite lower other income:  Profits during 3QFY05 have risen by as much as 21.7% QoQ despite considerably lower other income, higher depreciation and higher taxes. The main reason behind this is that, during the previous quarter, HCL Tech had incurred a loss of Rs 259 m on account of its share in the losses of associate companies. During this quarter, however, the company earned a profit on this count. The picture for 9mFY05 reflects a slightly different picture, with the rise in margins chiefly responsible for the impressive 47.2% jump in profits. This was achieved despite lower other income, higher depreciation charges and considerably higher taxes paid during the period. However, it must also be noted that the 9mFY04 figure excludes a one-time gain of Rs 2.6 bn that the company earned on the divestment of its stake in HCL Perot Systems. If that figure were to be included, then the 9mFY05 profit figure would be 22% lower on a YoY basis.

What to expect?
At the current price of Rs 359, the stock is trading at a price to earnings multiple of 18.1 times annualised 9mFY05 earnings. This is at the higher end of the valuation spectrum. The company board has recommended an interim dividend of Rs 4 per share (dividend yield of 1.1%). We are concerned about the volatile nature of the company's performance in the past few quarters, particularly on the profits front. We believe that unless HCL Tech starts to show some sort of consistency in its performance, particularly on the profits front, its stock will not get the valuations commanded by its top rung peers. Also, investors would be better off sticking to software companies that have had a record of consistently delivering the goods without much volatility.

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