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HCL Infosystems: Strong performance - Views on News from Equitymaster
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HCL Infosystems: Strong performance
Aug 22, 2005

Introduction to results
HCL Infosystems recently announced its results for the fourth quarter and full-year ending June 2005 (the company’s financial year ends in June). Topline has shown a scorching pace of growth for the quarter as well as the full year, driven by the outstanding performance of the Office Automation and Telecommunications (OA&T) segment. However, margins that were already under pressure have declined further, due to higher cost of sales. As a result, the bottomline has grown at a good pace, but not quite the same rate as the topline.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change
Sales 12,957 21,918 69.2% 43,064 77,443 79.8%
Expenditure 12,347 21,243 72.1% 40,970 74,759 82.5%
Operating profit (EBDIT) 609 675 10.7% 2,094 2,684 28.2%
Operating profit margin (%) 4.7% 3.1%   4.9% 3.5%  
Other income 8 121 1453.8% 232 399 72.1%
Interest 6 (6)   31 (29)  
Depreciation 52 43 -17.9% 180 152 -15.4%
Profit before tax 559 759 35.8% 2,115 2,960 40.0%
Tax 101 169 67.6% 364 683 87.7%
Extraordinary items            
Profit after tax/(loss) 459 590 28.8% 1,751 2,277 30.0%
Net profit margin (%) 3.5% 2.7%   4.1% 2.9%  
No. of shares (m) 165.0 177.0   165.0 177.0  
Diluted earnings per share* (Rs) 10.4 13.3   9.9 12.9  
P/E ratio (x)         19.3 0.8%
(* 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 and mobile penetration in the country present a big opportunity for higher growth for HCL Infosys going forward. Its number one position in the industry is, however, under threat due to low barriers to entry in this business.

What has driven performance in FY05?
OA&T segment drives topline yet again:  Net revenues grew at a robust pace of 69% YoY in 4QFY05 and 80% YoY in FY05. The office automation & telecommunications (OA&T) business (76% of 4QFY05 consolidated revenues) has yet again driven revenues for HCL Infosystems during the quarter as has been the case in the previous few quarters as well. During 4QFY05, the OA&T segment grew at a strong 78% YoY, while for FY05, the growth was even better at an outstanding 101% YoY.

This was driven by strong growth in the Indian mobile handset market and stronger offtake of Nokia phones, of which the company is the largest distributor in the country. New models were launched at different price points and this helped contribute to the growth. 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 low compared to international standards, increasing competition making mobile phones more affordable to the common man and the strong Indian economy, going forward there appears to be tremendous scope for growth in this segment.

Segmental break-up…
  4QFY04 Share 4QFY05 Share Change
Computer Systems & Other Related Products 3,650 28.0% 5,278 24.1% 44.6%
Office Automation & Telecommunication 9,298 71.3% 16,553 75.5% 78.0%
Internet & Related Services 100 0.8% 100 0.5% 0.4%
Total 13,048   21,931    
* Includes inter-segment revenue

Revenues from the second largest business stream of the company, computer systems & other related products, also clocked in a strong YoY growth of 45% during 4QFY05 and 36% during FY05. Despite such strong growth rates, the contribution of this business to revenues declined from 33% in FY04 to 25% in FY05. This shows how strong the revenue growth has been in the OA&T segment. As per a report from International Data Corporation (IDC), HCL Infosystems was the market leader in Desktop PC sales for the fifth year in a row.

HCL Infosystems has followed a conscious strategy of tracking BSNL, India’s largest telecom company’s expansion in the country and this has helped the company to penetrate the smaller towns and cities of India. The company has benefited from large orders from some PSU clients like BSNL. During FY05, the company commissioned the country’s largest Internet backbone network for BSNL, a project that involved large-scale and multi-location systems integration. However, revenues from the third segment, Internet and related services, were flat during 4QFY05 and declined by 2% YoY in FY05.

Higher cost of sales pressurise margins:  Excise duty as percentage of sales reduced from 1.9% in 4QFY04 to 0.3% in 4QFY05. However, a jump in total cost of sales has dented the company’s margins in 4QFY05 as well as in FY05. These costs increased to 93% of sales during FY05 from 90% in FY04. We also believe that the company has faced pressure on realisations, as competition (both from unorganised and MNC players) is very intense in this sector, due to lower entry barriers. Despite competitive sales pressures and cost pressures on the manufacturing side, the company has still managed to grow sales at an impressive pace. This is a clear indication of the fact that volume growth has been very strong for the company. Margins dipped by 160 basis points during 4QFY05 and by 140 basis points during FY05. Going forward, the company will have to take steps to reduce the pressure on its margins, as, despite strong sales growth, margins have dipped quite substantially and this is a worrying factor.

Bottomline grows, but…:  The decline in operating margins did not have an adverse impact on the bottomline, as the company recorded a considerably higher other income and lower depreciation charges during 4QFY05 as well as FY05. However, the effect of these items was negated partially due to the considerably higher taxes paid by the company. HCL Infosystems incurred Rs 8.4 m on the payment of fringe benefits tax (FBT). Consequently, bottomline growth at 30%, while healthy, is nowhere near the 80% sales growth recorded. 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.

Performance in the recent past…
  1QFY05 2QFY05 3QFY05 4QFY05
Sales growth (YoY growth, %) 88.0 95.9 68.7 69.2
Operating margins 3.2 3.5 4.0 3.1
Profits (YoY growth, %) 33.0 44.5 17.9 28.8

What to expect?
At the current price of Rs 248, the stock is trading at a price to earnings multiple of 19.3 times FY05 earnings. The company has recommended a final dividend of Rs 2 per share (100% of face value and dividend yield of 0.8%).

With its direct customer service contacts at 260+ locations around the country, HCL Infosystems has managed to outperform the industry growth and emerge market leader in the desktop PC segment. The company leads in both the commercial segment as well as the consumer segment. It 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 our spectrum, we would advise investors to remain cautious.

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