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HCL Info: Strong growth, but...

Sep 26, 2005

HCL Infosystems, India's leading hardware company, has a direct presence in over 300 locations across India and a channel base of over 44,000 channel partners. The company is also the country's leading distributor of Nokia GSM phones. It seems that the company is operating in the right business at the right time. This is because there is tremendous potential in both of HCL's major businesses, that is, PCs and mobile phones. The penetration levels of both these products are very low in India compared to international standards. HCL Infosystems divides its business into three major segments - Computer Systems, Office Automation and Telecommunications (OA&T) and Internet & Related Services. However, the third segment does not contribute much to revenues (1% in FY05). The company clubs the first two segments into one big segment, Products and Related Services. In this write-up, we compare the performance of the company's two main segments, Computer Systems and OA&T over the past few years and see where the company is headed, going forward.

Computer Systems segment
As can be seen from the table below, the Computer Systems segment of the company has shown steady growth, increasing at a CAGR of 29.5% from FY02 to FY05. Over the years, it has steadily increased its market share in the PC segment.

Computer Systems: Steady growth
(Rs m) FY02 FY03 FY04 FY05 CAGR
Revenues 9,068 11,037 15,220 19,674 29.5%

As per International Data Corporation (IDC), HCL Infosystems had a market share of 15.1% in 1QCY05, the highest as compared to the 13.4% share of Hewlett-Packard (HP), its closest competitor. The fact that it has managed to increase its market share from 11.2% in CY03 in a highly competitive industry is a creditable job. To its credit, the company has been proactive in rolling out new products at different price points in order to cater to different customer segments. It recently launched a sub-Rs 10,000 PC in Chennai, which is expected to result in an explosion in the marketplace and increase PC penetration substantially. At the end of CY04, as per Forrester Research, Indian PC adoption hit 7.9 m units, a penetration level of less than 1%, reflecting the enormous growth potential.

It should be noted that the PC industry is highly competitive, with the top players not commanding a very significant share of the market. This is also because the unorganised segment constitutes a large chunk of the market. But their share has reduced over the years (45.3% of the market in 1QCY05 as compared to 63.7% in CY03).

Besides increasing affordability of PCs, government support is also a factor and a task force has been set up to suggest a road map of how to increase PC penetration in the country, of which Mr. Ajai Chowdhry, CMD of HCL Infosystems, is the Chairman. HCL Infosystems, being the market leader and having a strong brand name, is expected to be among the major beneficiaries.

However, on the flip side, given the intensely competitive business that PCs are, there is bound to be margin pressure. In fact, PBIT margins declined for this segment from 8.7% in FY04 to 7.1% in FY05. Undoubtedly, this is a volume business and if HCL Infosystems does slow down due to better performance from competitors, margins could be adversely affected.

OA&T segment
The OA&T segment has undoubtedly been the major driver of revenues for the company over the past three years. This segment has maintained an outstanding CAGR of 167.0% from FY02 to FY05. The main drivers of this strong growth have been huge potential of mobile phones due to low levels of penetration in India, ever-increasing affordability of the product, regular launches of new models and the large distribution network of HCL Infosystems. At the end of June 2005, the company had over 44,000 dealers and was present in over 3,600 towns.

OA&T: Scorching growth!
(Rs m) FY02 FY03 FY04 FY05 CAGR
Revenues 3,036 15,216 28,768 57,793 167.0%

HCL Infosystems has also followed a conscious strategy of following BSNL's footprint, the largest telecom company in India. The company's thrust is now on the rural areas in line with the operators' expansion plans. As per Gartner, India is set to clock a 62% growth in the sale of mobile phone units in CY05, with 34 m phones, compared to 21 m phones in CY04. As per sources, mobile penetration in the country is a mere 6.5% (66 m users for GSM and CDMA combined). However, for HCL Infosystems, it is the GSM number that matters, as it distributes only GSM phones of Nokia, while another distributor is responsible for CDMA. GSM subscribers account for 4.8% penetration. Therefore, as can be seen, the scope for growth is massive.

However, once again, the company earns low margins in this business. In FY05, PBIT margins declined from an already low 2.9% in FY04 to 2.5%. The company appears to be in a 'catch-22' situation here. While this business is really fast growing, margins are lower. However, it is this business that is driving revenues, thus, driving down overall margins. The Computer Systems segment, on the other hand, is growing at a strong pace of around 30%, with margins at over 7%. Thus, the company has to choose volume growth over margins, due to the competition in both the segments and huge potential for growth.

Conclusion
HCL Infosystems' business prospects appear fairly bright. As mentioned above, the company has been proactive in launching new models at different price points in order to improve penetration of the product. Going forward, the huge potential in PCs and mobile phones and HCL Infosystems' market leadership will help the company grow its revenues at a steady clip. We expect HCL to outpace the industry growth rate.

However, as mentioned above, the company will have to keep an eye on its margins. Undoubtedly, volume growth will be the priority in this business. But in case the company's competitors outpace it in growth, margins, which are already low, could come under further pressure. In FY05, net margins stood at 2.9%, compared to 4.1% in FY04. Therefore, it is imperative for HCL Infosystems to protect its margins. To that extent, there is a risk.

At the current market price of Rs 246, the stock trades at a price to earnings multiple of 19.1 times FY05 earnings. We shall update our research report on HCL Infosystems shortly.


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