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HCL Tech: Changing times? - Views on News from Equitymaster

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HCL Tech: Changing times?
Aug 21, 2006

Introduction to results
HCL Technologies announced its results for the fourth quarter and full-year ending June 2006 on Saturday (the company’s financial year ends in June). For FY06, revenues saw an impressive growth, driven primarily by the infrastructure management business. The other businesses of the company, viz. software services and BPO, grew at rates around the mid-20s. Margins, however, witnessed a contraction, due to higher SG&A expenses as a percentage of sales. The net profit, on the other hand, saw a decent growth rate despite lower margins and considerably lower other income, due to a lower effective tax rate during the fiscal. For the quarter, the performance was impressive, with both the topline as well as the bottomline showing strong double-digit sequential growth, aided by an expansion in margins.

Financial performance (US GAAP consolidated): A snapshot…
(Rs m) 3QFY06 4QFY06 Change FY05 FY06 Change
Sales 11,220 12,538 11.7% 33,627 43,882 30.5%
Expenditure 8,722 9,723 11.5% 25,983 34,153 31.4%
Operating profit (EBDIT) 2,498 2,815 12.7% 7,644 9,729 27.3%
Operating profit margin (%) 22.3% 22.5%   22.7% 22.2%  
Other income 255 56 -78.0% 1,062 573 -46.0%
Depreciation 530 562 6.0% 1,482 1,916 29.3%
Profit before tax 2,223 2,309 3.9% 7,224 8,386 16.1%
Tax 277 (23)   671 632 -5.8%
Minority interest & income of equity investee 17 1   464 22  
Profit after tax/(loss) 1,929 2,331 20.8% 6,089 7,732 27.0%
Net profit margin (%) 17.2% 18.6%   18.1% 17.6%  
No. of shares (m) 322.8 323.4   319.2 323.4  
Diluted earnings per share (Rs)       18.8 23.9  
P/E ratio (x)         24.8  

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 technology-led services (24% of revenues), enterprise consulting services (16%), applications consulting services (35%), BPO (13%) and infrastructure services (12%). 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 FY06?
It’s an ‘infrastructure-driven’ topline: During FY06, HCL Tech saw a strong 30.5% YoY growth in its topline. This was primarily driven by the impressive performance of the infrastructure management business. This business saw a scorching 64.8% YoY growth in topline, and contributed to nearly 20% of the incremental growth in the topline for the fiscal. This business saw an employee intake of 1,352 in FY06. Infrastructure management implies the remote management of a company’s IT infrastructure, such as servers, laptops, desktops and network management. HCL Tech’s leadership position in this business has served it well, and the company won numerous large deals on the strength of its competitive positioning in this business, such as the DSG International deal of US$ 335 m, the largest-ever IT services deal won by any Indian IT services company. Going forward, HCL Tech is focussing more on export revenues from this business, which will yield higher margins.

On the other hand, the company’s BPO business grew at a rate of 27.0% YoY, which was considerably slower than the 70%+ growth that this business had witnessed in FY05. The company recruited as many as 3,471 people for this business in FY06, and is a pointer to good visibility for future growth. The company is the fourth-largest third-party BPO services provider in India, as ranked by NASSCOM. HCL Tech’s software services business saw a decent growth rate of 25.8% YoY in FY06. This business saw an employee intake of 3,713 in FY06.

Gross revenues by segment: Growing through 'infrastructure'!
  FY05 % of revenue FY06 % of revenue Change
Software 26,197 77.3% 32,967 75.1% 25.8%
BPO 4,630 13.7% 5,878 13.4% 27.0%
Infrastructure 3,057 9.0% 5,038 11.5% 64.8%
Total 33,884 100.0% 43,883 100.0% 29.5%

SG&A expenses pressurise margins: During FY06, HCL Tech’s operating margins saw a marginal 56 basis points fall. This was primarily due to higher SG&A costs as a percentage of sales (15.0% in FY06, 14.3% in FY05). The management has said in the conference call that it will continue to invest in SG&A efforts going forward.

Segmental performance…
(Rs m) Software BPO Infrastructure
FY05 FY06 FY05 FY06 FY05 FY06
Sales 26,197 32,967 4,630 5,878 3,057 5,038
Direct Costs 16,408 20,494 2,929 3,707 2,012 3,371
% of sales 62.6% 62.2% 63.3% 63.1% 65.8% 66.9%
Gross profit 9,789 12,473 1,701 2,171 1,045 1,667
Gross margins 37.4% 37.8% 36.7% 36.9% 34.2% 33.1%
SG&A 3,577 4,941 548 749 689 892
% of sales 13.7% 15.0% 11.8% 12.7% 22.5% 17.7%
OP 6,212 7,532 1,153 1,422 356 775
OPM 23.7% 22.8% 24.9% 24.2% 11.6% 15.4%
Depreciation & Amortisation 985 1,086 399 477 174 353
EBIT 5,227 6,446 754 945 182 422
EBIT margins 20.0% 19.6% 16.3% 16.1% 6.0% 8.4%

As regards segmental EBITDA margins, it was the infrastructure management segment that saw strong margin expansion of 380 basis points. The other 2 segments of the company, software services and BPO, witnessed margin contraction. Going forward, it is clear that HCL Tech’s strength in the high potential infrastructure management business is expected to drive future performance. Given the company’s focus on garnering more export revenues, the margin expansion witnessed in FY06 could continue. However, the major software services business continues to under-perform, and EBITDA margins at under 23% are much lower than most of its top-tier peers.

Lower taxes aid the bottomline: HCL Tech saw a decent 27.0% YoY growth in its net profits in FY06. This under-performed the growth in topline, but was more or less in line with the growth in operating profits. Despite the lower margins and considerably lower other income, a lower effective tax rate has helped the bottomline grow at this rate. Going forward, in FY07, the management expects the tax rate to tread between 10% and 12% of PBT.

Performance in the recent past…
  1QFY06 2QFY06 3QFY05 4QFY06
Sales (QoQ growth, %) 4.6 8.6 6.4 11.7
Operating margins (%) 22.2 22.5 22.3 22.5
Profits (QoQ growth, %) 3.4 8.2 6.5 20.8
Employees (Nos.) 26,285 28,182 29,948 32,626

What to expect?
At the current price of Rs 594, the stock is trading at a price to earnings multiple of 24.8 times its FY06 earnings. The company’s board has recommended an interim dividend of Rs 4 per share, which takes the total dividend for FY06 to Rs 16 per share (dividend yield of 2.7%). The company has witnessed a decent performance in FY06, and the primary growth driver has been the infrastructure management business, where HCL Tech is amongst the leaders, along with Wipro. However, the major software services business, albeit having grown revenues at a decent pace of 25% this fiscal, continues to under-perform its larger peers in the sector. The fact that this business contributes to a lion’s share of HCL Tech’s revenues makes it imperative for the company to grow this business in a sustainable manner.

Going forward, we expect BPO, infrastructure management and ERP segments to be the major growth drivers for the company. However, as mentioned before, the company will need to maintain consistent growth in its performance over the long-term, which has been lacking in the past. On a sector-wide basis, we continue to prefer the ‘Top four’ software companies as investment options.

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