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HCL Tech: Lagging its peers
Aug 23, 2005

Introduction to results
HCL Technologies has announced its results for the fourth quarter and full-year ending June 2005. For 4QFY05, revenues have grown at a strong 8% QoQ, driven by the infrastructure management services segment and software services, which grew at a decent pace after two successive quarters of unimpressive growth. On the other hand, the BPO segment has driven revenue growth during the fiscal. Operating margins were flat in 4QFY05, while they expanded significantly during FY05 due to margin expansion in the BPO business. Due to a fall in other income, bottomline growth was relatively subdued for both the periods.

Financial performance (US GAAP consolidated): A snapshot…
(Rs m) 3QFY05 4QFY05 Change FY04 FY05 Change
Sales 8,582 9,276 8.1% 26,129 33,230 27.2%
Expenditure 6,629 7,164 8.1% 20,843 25,617 22.9%
Operating profit (EBDIT) 1,953 2,111 8.1% 5,286 7,613 44.0%
Operating profit margin (%) 22.8% 22.8%   20.2% 22.9%  
Other income 162 139 -14.5% 1,814 1,048 -42.3%
Depreciation 412 463 12.3% 1,157 1,536 32.8%
Profit before tax 1,703 1,787 4.9% 5,943 7,124 19.9%
Tax 187 140 -25.1% 407 662 62.5%
Minority interest & income of equity investee 57 (27)   (438) (457) 4.3%
Profit after tax/(loss) 1,573 1,620 3.0% 5,098 6,006 17.8%
Net profit margin (%) 18.3% 17.5%   19.5% 18.1%  
No. of shares 296.5 319.2   296.5 319.2  
Diluted earnings per share* (Rs) 19.7 20.3   16.0 18.8  
P/E ratio (x)         23.6  
(* annualised)            

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 development (22% of revenues), product engineering (15%), application development (39%), ITES (14%) and infrastructure services (10%). 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 FY05?
BPO is the growth driver:  The BPO business has driven revenue growth for HCL Tech in FY05. Gross revenues of this segment grew at an annual rate of 71% this year and it was clearly the standout performer amongst the company’s major segments. BPO contributed to 29% of the incremental revenues for the year. However, for 4QFY05, revenue growth in the segment was flat. This segment crossed US$ 100 m in revenue in FY05 and was ranked as the third-largest third-party BPO services provider by NASSCOM in its latest rankings.

On the other hand, the software services segment has finally shown decent growth, growing by 9% sequentially. This segment has not been performing too impressively in the recent past and the fact that it has finally shown some sort of momentum is a good sign for the company. In fact, in 4QFY05, this segment accounted for as much as 82% of the incremental revenue growth. For FY05, the segment grew at a relatively sedate 19%, clearly under-performing its peers like Infosys and TCS. Given that this segment contributes a lion’s share to HCL’s revenues, it is imperative that the company takes steps to ensure sustainable growth of this business. The third segment of the company, infrastructure management services, has grown at 15% this quarter sequentially, while for FY05, the growth is 18% YoY.

HCL Tech added a net of 2,056 employees in 4QFY05, out of which 1,420 were added in the software services business, 479 on the BPO front and 157 in the infrastructure management business. In FY05, HCL Technologies added a net of 7,732 people, taking the total manpower strength of the company to 24,090. The company added 19 clients in the quarter and the total number of active clients now stands at 490. Client metrics have improved, with 137 clients giving the company billings in excess of US$ 1 m at the end of FY05, as compared to 126 at the end of 3QFY05.

Cost control helps margin expansion:  During FY05, HCL Tech has managed to leverage on its selling, general and administrative (SG&A) expenses, which, as a percentage of sales, reduced from 15.9% to 14.3%. The company’s margins in the BPO segment expanded substantially, from 11.5% to 24.9% in FY05. In fact, even in software services and infrastructure management services, margin expansion was witnessed. As a result, overall margins rose by 270 basis points. However, it must be noted that at 22.9% margins, the company is still some way short of industry bellwether Infosys, which, despite witnessing a 150 basis point decline in margins in the June quarter, still had margins at 32.0%, over 9% more than that of HCL Tech. Going forward, the management has indicated that it expects margins to remain stable, with the possibility of an increase.

Subdued profit growth despite margin expansion:  Net profit during FY05 grew at a relatively sedate pace of 18% YoY, which is clearly well below its peers. In fact, Infosys and Wipro both grew profits for FY05 at well over 50%. Considerably lower other income, higher depreciation costs and a considerably higher effective tax rate resulted in net margins declining by 140 basis points, despite the margin expansion. For 4QFY05, the decline in other income was the main reason for the fall in net margins and net profit, as a result, rose at a slower pace than revenues. HCL Tech earned lower foreign exchange profits during the quarter as well as the full year, resulting in the lower other income. It should be noted that the 18% growth in bottomline in FY05 is excluding extraordinary gains of Rs 2.9 bn received on sale of the company’s stake in HCL Perot Systems. Overall, the company has clearly under-performed its peers in terms of profit growth. Management has said that it expects sales and profits to grow in the region of 30% to 40% in FY06.

Performance in the recent past…
  1QFY05 2QFY05 3QFY05 4QFY05
Sales (QoQ growth, %) 5.9 2.5 7.1 8.1
Operating margins (%) 23.2 23.0 22.8 22.8
Profits (QoQ growth, %) (22.5) (20.1) 21.7 3.0
Employees (Nos.) 18,474 20,249 22,034 24,090

What to expect?
At the current price of Rs 444, the stock is trading at a price to earnings multiple of 23.6 times its FY05 earnings. This is at the higher end of the valuation spectrum. The company board has recommended an interim dividend of Rs 4 per share, taking the total dividend for the year to Rs 16 per share (dividend yield of 3.6%). We are concerned about the volatile nature of the company’s performance in the past few quarters, particularly on the profits front. The management has indicated that it expects BPO, infrastructure management and ERP to be the major growth drivers for the company, going forward. With some big order wins, like the order for implementation of a surveillance system for SEBI across market segments, including equities and derivatives, the company does seem to have gained better traction in the software services segment, which, being the major contributor to revenues, will certainly help the company show greater stability in its future performances and post performances that will rival those of its peers.

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