HCL Tech: Other income boost

Introduction to results

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HCL Technologies has announced strong results for the fourth quarter and full year ended June 2004. While FY04 revenue growth is in line with our projections, the profit growth varies on account of a one time large other income. Cost control measures have helped the company improve margins for both the quarter and the full year.

Financial performance (Consolidated): A snapshot...

Rs m	3QFY04	4QFY04	Change	FY03	FY04	Change
Sales	6,472	7,386	14.1%	19,308	26,136	35.4%
Other income	430	1,121	160.8%	499	4,630	828.5%
Expenditure	5,179	5,674	9.6%	15,654	20,843	33.1%
Operating profit (EBDIT)	1,293	1,712	32.4%	3,654	5,293	44.9%
Operating profit margin (%)	20.0%	23.2%		18.9%	20.3%
Depreciation	268	334	24.8%	880	1,157	31.4%
Profit before tax	1,455	2,499	71.7%	3,272	8,766	167.9%
Stock-based sales incentive	35	(4)		(17)	(7)
Tax	77	35	-54.2%	309	407	31.6%
Minority interest & income of equity investee	(155)	(372)		(251)	(438)
Profit after tax/(loss)	1,258	2,088	66.0%	2,695	7,914	193.7%
Net profit margin (%)	19.4%	28.3%		14.0%	30.3%
No. of shares	285.4	285.4		285.4	285.4
Diluted earnings per share* (Rs)	17.6	29.3		9.4	27.7
P/E ratio (x)		12.0			12.7
(* annualised)

What is the company's business?

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HCL Technologies is the fifth-largest software exporter from the country and is focused on research and development (R&D) outsourcing. Its service offerings include technology development (24% of revenues), product engineering (17%), application development (38%), ITES (12%) and infrastructure services (9%). Over the past four quarters, HCL Tech has witnessed volatility in its core business but 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 others.

What has driven performance in 1QFY05?

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Sales: Growth in 4QFY04 sales was largely a result of 12% and 21% QoQ growth in revenues from software services (77% of revenues) and BPO services (11%) respectively. The decent QoQ growth in software services in this quarter comes after a streak of volatile performances over the past seven quarters (since 1QFY03). This seems a result of 6.2% and 4.1% QoQ growth in onsite and offshore volumes combined with a 1.4% rise in onsite billing rates. Rates for offshore services, however, declined by 0.5% sequentially. On the BPO front, strong growth in revenues seems a result of a large addition to the employee base combined with almost stable billing rates. As a matter of fact, out of the 1,575 employees added in 4QFY04, over 600 came in the BPO division.

Operating margins: Improvement in fourth quarter operating margins for HCL Tech is a result of 210 basis points rise in margins of software services while those for BPO services witnessed a marginal decline. Reduction in direct costs (as percentage of sales) led to this improvement in margins for software services in the quarter.

Net profits: While the net profits have witnessed strong growth in both 4QFY04 and FY04, investors need to note that this is a result of a one-time other income due to adjustments on the investments front. The company has stated in its conference call that this one time spike in other income is a result of some mutual fund investments being shifted from growth plans to dividend plans. Excluding other income, net profit for FY04 has grown YoY by 22%.

Performance in the recent past...

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As seen for the table below, HCL Tech's performance has been very volatile in the last four quarters. This has been mainly on account of the sloppy performance of the company's organic business while inorganic businesses continue to witness strong growth. However, on account of improvement in BPO margins, the company has managed to improve overall margins during this period. While employee additions have been strong, they do not match the aggressiveness shown by the company's peers like Infosys, Wipro and Satyam.

Performance in the recent past

	1QFY04	2QFY04	3QFY04	4QFY04
Sales (QoQ growth, %)	19.1	11.0	4.0	14.1
Operating margins (%)	17.4	19.6	20.0	23.2
Profits (QoQ growth, %)	(1.2)	271.4	(64.2)	66.0
Employees (Nos.)	12,003	13,065	14,783	16,358
Revenue per employee (Rs m)	0.5	0.5	0.4	0.5

What to expect?

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At the current price of Rs 351, the stock is trading at a P/E multiple of 26.5x FY04 earnings (excluding the effect of one time increase in other income). The board of the company has recommended a final dividend of Rs 4 per share (200%). This takes the total dividend for FY04 to Rs 10 per share. While HCL Tech continues to perform strongly in its BPO business, the volatile growth of the software services business is a concerning factor. Also, a continued rise in the BPO segment revenues are likely to cast pressure on the overall margins of the company and would also reduce the quality of earnings (as BPO is a low value-added business than software services). Also, considering the fact that valuations are at the higher end of the spectrum, we would advice investors to exercise caution.