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HCL Infosystems: Volumes scorch!

Apr 27, 2005

Introduction to results
HCL Infosystems had recently announced its results for the third quarter and nine-month period ending March 2005 (the company's financial year ends in June). Topline has shown a scorching pace of growth, registering a 69% rise during 3QFY05 and an 81% growth during 9mFY05, while the bottomline has also grown at a decent 18% during 3QFY05 YoY and at 31% YoY during 9mFY05, though clearly not as much as topline, owing to a rise in manufacturing costs and intense competition. Consequently, the resultant pricing pressure seems to have taken its toll on margins.

Financial performance (Consolidated): A snapshot…
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Sales 11,925 20,118 68.7% 30,915 55,861 80.7%
Expenditure 11,321 19,314 70.6% 29,430 53,852 83.0%
Operating profit (EBDIT) 604 804 33.3% 1,485 2,009 35.3%
Operating profit margin (%) 5.1% 4.0%   4.8% 3.6%  
Other income 103 41 -60.5% 224 278 24.0%
Interest 6 (24) 25 (23)  
Depreciation 43 38 -12.0% 128 110 -14.4%
Profit before tax 656 831 26.6% 1,556 2,201 41.5%
Tax 102 177 74.1% 263 515 95.3%
Profit after tax/(loss) 555 654 17.9% 1,293 1,687 30.5%
Net profit margin (%) 4.7% 3.3%   4.2% 3.0%  
No. of shares (m) 33.0 33.4   33.0 33.4  
Diluted earnings per share* (Rs) 66.5 78.4   51.7 67.4  
P/E ratio (x)         11.3 0.9%
(* annualised)            

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 penetration in the country (around 5 per 1,000 population) present the biggest opportunity for higher growth for HCL Infosys going forward. Its number one position is, however, under serious threat due to low barriers to entry in this business.

What has driven performance in 3QFY05?
OAT segment drives topline: The office automation & telecommunication (OAT) business (73% of 3QFY05 consolidated revenues) has once again been the major revenue driver for HCL Infosystems. In this quarter, revenues from this segment grew by 92% YoY. The 9mFY05 YoY growth figure is 112%. A major driver of growth in this segment appears to be strong growth in its Nokia handset distribution business. The rapid expansion by major cellular players across the length and breadth of the country has helped HCL Infosystems add new customers to its fold, thus leading to a strong growth of this business. Given the fact that cellular teledensity in India is still at a low 5% level, going forward, there appears to be tremendous scope for growth in this segment, which could continue to be the major growth driver for HCL.

Revenues from the second largest business stream of the company, computer systems & other related products, also clocked in a strong YoY growth of 27% during 3QFY05 and 27% during 9mFY05. This segment now contributes to 27% of the company's revenues. As per a report from IDC, HCL Infosystems was the market leader in 2004 in both the commercial and consumer PC segments, making it the most preferred PC brand. The company has also benefited from large orders from some PSU clients. During 3QFY05, the company commissioned the country's largest Internet backbone network for BSNL, the country's largest telecom company, a project that involved large-scale and multi-location systems integration. Revenues from the third segment, Internet and related services (1% of revenues), however, declined YoY during 3QFY05 by 29% and during 9mFY05 by 3%.

High manufacturing costs dent margins: Despite a fall in excise duty (as percentage of sales) from 2.0% in 3QFY04 to 0.5% in 3QFY05, a jump in the total cost of sales has dented the company's margins in 3QFY05 as well as 9mFY05. These costs have increased to 94% of sales during the period 9mFY05 from 86% in the corresponding quarter last fiscal. Also, while the press release does not explicitly state this fact, we believe that the company has faced pressure on realisations, as competition (both from unorganised and MNC players) is very intense in this sector. Despite competitive pressures on the selling side and cost pressures on the manufacturing side, the company has still managed to grow sales at such a scorching pace. This is a clear indication of the fact that volume growth has been the main growth driver. Margins dipped by 110 basis points during 3QFY05 and by 120 basis points during 9mFY05.

Lower operating margins affect net profits: Factors like the decline in operating margins, considerably lower other income during the quarter and a considerably higher tax outgo have affected net profit growth during the quarter. Net profit growth has consistently trailed growth in topline in the past few quarters as well and this is indicative of the competitive pressures and cost pressures faced by the company.

What to expect?
At the current price of Rs 765, the stock is trading at a price to earnings multiple of 11.3 times annualised 9mFY05 earnings. The board of the company has recommended a quarterly interim dividend of Rs 7 per share (70%), as well as a sub-division of each equity share of Rs 10 each to 5 equity shares of Rs 2 each.

With its direct customer service contacts at 260-plus locations around the country, HCL Infosystems has managed to outperform the industry growth and emerge market leader in the desktop PC segment (13.7% share). The company leads in both the commercial segment as well as the consumer segment. The company has also benefited from a rapid growth in demand for GSM handsets. We believe that, going forward, as income levels rise and consequently the demand for desktop PCs and cellular handsets, strong growth is likely to continue for the company. Potentially larger investments in hardware from Indian corporates also promise strong times ahead.

However, much will depend on how the company is able to modify its product offerings in times of rapidly changing technology and ward-off intensifying competition from the unorganised sector (private PC assemblers) and MNCs like IBM, Dell and HP. Considering these factors, and that valuations are at the higher end of the spectrum, we would advise investors to practice caution.

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