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HCL Tech: Other income saves the day - Views on News from Equitymaster

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HCL Tech: Other income saves the day
Aug 14, 2007

Performance summary
  • Topline grows by 38% YoY for FY07, driven by strong traction in all major verticals - core software, infrastructure management service and BPO.

  • Operating margins stable at 22% for the fiscal.

  • FY07 bottomline expands by 75% YoY, largely due to 644% YoY growth in other income.

  • Utilisation on a blended basis rise by 2% and attrition remains stable at 17.5%.

Financial performance: A snapshot…
(Rs m) 3QFY07 4QFY07 Change FY06 FY07 Change
Sales 15,771 16,120 2.2% 43,882 60,336 37.5%
Expenditure 12,104 12,646 4.5% 34,153 46,966 37.5%
Operating profit (EBDIT) 3,667 3,474 -5.3% 9,729 13,370 37.4%
Operating profit margin (%) 23.3% 21.6%   22.2% 22.2%  
Other income 615 2,873 367.2% 573 4,261 643.6%
Depreciation 659 693 5.2% 1,916 2,531 32.1%
Profit before tax 3,623 5,654 56.1% 8,386 15,100 80.1%
Tax 283 777 174.6% 632 1,485 135.0%
Minority interest & income of equity investee 23 10 -56.5% 22 66 200.0%
Profit after tax/(loss) 3,317 4,867 46.7% 7,732 13,549 75.2%
Net profit margin (%) 21.0% 30.2%   17.6% 22.5%  
No. of shares (m)         675.3  
Diluted earnings per share (Rs)         20.1  
P/E ratio (x)         16.2  

What is the company’s business?
HCL Technologies is the fifth-largest software services exporter from the country and is focused on research and development (R&D) outsourcing. Its service offerings include enterprise application services (12% of revenues), engineering and R&D services (24%), industry solutions (36%), infrastructure services (15%) and BPO services (13%). While the company has witnessed stable growth in its core business, it has done well to grow its inorganic businesses in the past few quarters. HCL Tech’s focus on Engineering and R&D outsourcing and its experience in technology development services gives it a competitive edge over its peers. The company’s strategy to move up the value chain and improving operational efficiencies is paying off as well.

What has driven performance in FY07?
IMS leads the way: During FY07, HCL tech witnessed good traction across all its business segments - core software, IMS, and BPO. However, the pick of the three was IMS, which recorded a 68% YoY growth in its topline and 90% YoY growth in earnings before interest and tax (EBIT). The operating margins in this segment expanded by 2% largely due to leveraging of direct costs. BPO services recorded a 36% YoY growth in topline and 38% YoY growth in EBIT. Operating margins here were stable at 24.5%. The core software segment recorded a 33% YoY growth in topline and 31% YoY growth in EBIT. Though prima facie it may look that the growth has been little slower in the core software segment when compared to others, but of the incremental revenues in FY07 over FY06, core software contributed to 66%. The segment contributes to 73% of revenues (down from 75% in FY06) while IMS contributes to 14% of revenues (up from 12% in FY06).

In terms of geographies, HCL Tech is one of the few companies which in not highly dependent on the US for its business. The company’s US revenues recorded a growth of 33% YoY but its share in total revenues came down from 56% in FY06 to 54% in FY07. Europe and Asia Pacific region recorded growth of 41% YoY and 48% YoY respectively.

In terms of business verticals, financial services and life sciences segments recorded growth of 67% YoY and 64% YoY respectively. The share of financial services in total revenues increased from 24% in FY06 to 29% in FY07. Hi-Tech and telecom segments also notched up growth of 27% YoY and 42% YoY respectively. The only laggard was retail, where revenues declined by 3% YoY. HCL Tech added a net of 9,391 employees during the year and the attrition rate remained stable at 17.5%. The company added 65 new clients during the year with one client in the range of over US$ 100 m.

Operating margins remains stable: HCL Tech’s operating margins, on a consolidated basis, remained stable at 22%. On a segmental basis, the operating margins of IMS division expanded by 2% largely due to SG&A leverage. The operating margins of BPO division expanded marginally by 40 basis points while the margins of core software stood at 22.7% (marginal decline of 0.1%).

Segmental performance…
  FY06 FY07
Core Software
Revenue contribution 32,966 43,870
% of revenues 75.1% 72.7%
EBITDA Margins 22.8% 22.7%
EBIT Margins 19.6% 19.3%
Infrastructure Services
Revenue contribution 5,038 8,481
% of revenues 11.5% 14.1%
EBITDA Margins 15.4% 17.3%
EBIT Margins 8.4% 11.7%
BPO Services
Revenue contribution 5,878 7,985
% of revenues 13.4% 13.2%
EBITDA Margins 24.2% 24.6%
EBIT Margins 16.1% 17.3%

Other income aids bottomline: HCL Tech’s bottomline expanded by 75% YoY during FY07, which was mainly driven by a 644% YoY rise in other income, constituted by foreign exchange gains. This also helped the PAT margins to expand by almost 5% over FY06. As a result of higher other income, the effective tax rates also increased from 7.5% in FY06 to 10% in FY07.

Performance in the recent past…
  2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07
Sales (QoQ growth, %) 8.6 6.4 11.7 10.0 6.2 7.6 2.2
Operating margins (%) 22.5 22.3 22.5 21.7 22.1 23.3 21.6
Profits (QoQ growth, %) 8.2 6.5 20.8 7.4 6.4 15.9 46.7
Employees (Nos.) 28,182 29,948 32,626 36,452 38,317 40,149 42,017

What to expect?
At the current price of Rs 324, the stock is trading at a multiple of 13.6 times our estimated FY09 earnings. HCL Tech has announced seven new multi-service deals, which are expected to boost revenue growth going forward. However, the risks with respect to its sustainable performance remain, as has been the case in the past. High attrition rates and rupee appreciation are our key concerns with respect to the company. We shall soon update our research report on the company.

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