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HCL Tech: No let-up in growth! - Views on News from Equitymaster
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HCL Tech: No let-up in growth!
Oct 17, 2006

Introduction to results
HCL Technologies announced its results for the first quarter ending September 2006 late yesterday evening (the company’s financial year ends in June). For 1QFY07, the company has recorded a strong performance, driven by all-round traction seen in al its major businesses. While it was the infrastructure management business that was the star performer this quarter, good traction seen in the core software business has been another major positive for the company. Margins, however, saw a contraction, due to the salary revisions carried out this quarter for 85% of the company’s staff. Nonetheless, considerably higher other income led to the net profit growing at a decent sequential pace, even as the company incurred higher taxes this quarter.

Financial performance (US GAAP consolidated): A snapshot…
(Rs m) 4QFY06 1QFY07 Change
Sales 12,538 13,795 10.0%
Expenditure 9,723 10,806 11.1%
Operating profit (EBDIT) 2,815 2,989 6.2%
Operating profit margin (%) 22.5% 21.7%  
Other income 54 290 437.0%
Depreciation 562 557 -0.9%
Profit before tax 2,307 2,722 18.0%
Tax (23) 219  
Minority interest & income of equity investee 1 1  
Profit after tax/(loss) 2,329 2,502 7.4%
Net profit margin (%) 18.6% 18.1%  
No. of shares (m) 323.4 370.0  
Diluted earnings per share (Rs)*   23.2  
P/E ratio (x)*   25.9  
* On a trailing 12-month basis.

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 enterprise application services (14% of revenues), engineering and R&D services (24%), industry solutions (36%), infrastructure services (13%) and BPO services (13%). 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 1QFY07?
‘Infrastructure’ engineers the topline: During 1QFY07, HCL Tech saw an impressive 10.0% QoQ growth in its topline. This was powered by across-the-board growth in all its major businesses, viz. core software, infrastructure services and BPO services. The infrastructure services business powered ahead by as much as 16.6% QoQ and 88.4% YoY. This service has been one of the major drivers of HCL Tech’s growth in the recent past. HCL Tech was amongst the first Indian software companies to launch this service and it has been a key contributor to topline growth and is expected to be amongst the fastest-growing services for the company in future as well. HCL Tech is focussing on increasing the share of exports in this business, which is more profitable.

On the other hand, HCL Tech’s BPO business grew at 5.4% QoQ. This business won a major Legal Process Outsourcing (LPO) deal during the quarter from a UK-based property services conglomerate. This is a positive, since such deals are higher-end and higher-margin deals, adding to the profitability of the business. However, a major positive this quarter is good traction seen in the core software business of HCL Tech, which clocked a 9.7% QoQ increase. This business contributes to 74.0% of the company’s revenues and in order to grow in a sustainable manner over the long-term, this business does have to show good growth rates.

During the quarter, in this business, offshore volumes grew at 5.0% QoQ, while onsite volumes grew at 7.0% QoQ. However, overall offshore and onsite revenues grew at 8.8% and 10.6% QoQ respectively, signifying that billing rates saw a strong up-tick, with offshore and onsite rates growing by 3.9% QoQ and 3.6% QoQ respectively. Revenues in dollar terms were slightly higher due to a lower rupee rate used for convenience translation. Clearly, HCL Tech appears to be seeing renewed traction in this business, and no pressure appears to be there on the pricing front, rather, the environment appears to be fairly positive. The major factor to watch out for will be the sustainability of this growth going forward

We believe that HCL Tech’s focus on large, multi-year, multi-service and multi-geographical deals, is paying off, as witnessed by the all-round growth seen in this quarter. The company has a strong portfolio of offerings. While the company may have had inconsistent performances in the core software business in the past, its strong positioning in the high-growth infrastructure services and BPO services businesses has helped it to win deals based on the overall strength of its offering, rather than just as standalone services. We believe that this is the way to go in the software industry in order to grow at a fast pace, and expect top-tier software companies to grow at rates superior to that of the industry.

Gross revenues by segment: Strong growth 'infrastructure'!
(Rs m) 4QFY06 1QFY07 Change
Core Software 9,301 10,206 9.7%
Infrastructure Services 1,565 1,825 16.6%
BPO Services 1,672 1,763 5.4%
Total 12,538 13,794 10.0%

As regards employee data, HCL Tech added a net of 3,826 employees this quarter. On a segment-wise basis, core software added 1,611 employees, while the corresponding figures for infrastructure services and BPO services were 446 and 1,769 respectively. On the client side, HCL Tech has 219 active clients as at September 30, 2006. As many as 143 clients give the company trailing 12-month revenues in excess of US$ 1 m (140 as on September 30, 2005), while 2 clients give it revenues in excess of US$ 50 m.

Salary hikes subdue margins: During 1QFY07, HCL Tech saw a 78 basis points decline in its EBIDTA margins. This was due to the salary hikes carried out by the company in this quarter. HCL Tech raised salaries for 85% of its employees by an average of 17%, and the raise will be similar for the balance 15% effective October. It should be noted that EBITDA margins at 21.7% are considerably lower than other top-tier peers like Infosys, which earns EBITDA margins that are at 27.9% (US GAAP).

Segmental performance…
(Rs m) Core Software Infrastructure Services BPO Services
4QFY06 1QFY07 4QFY06 1QFY07 4QFY06 1QFY07
Sales 9,301 10,206 1,565 1,825 1,672 1,763
Direct Costs 5,825 6,364 1,028 1,200 1,093 1,145
% of sales 62.6% 62.4% 65.7% 65.8% 65.4% 64.9%
Gross profit 3,476 3,842 537 625 579 618
Gross margins 37.4% 37.6% 34.3% 34.2% 34.6% 35.1%
SG&A 1,315 1,571 264 304 198 223
% of sales 14.1% 15.4% 16.9% 16.7% 11.8% 12.6%
OP 2,161 2,271 273 321 381 395
OPM 23.2% 22.3% 17.4% 17.6% 22.8% 22.4%
Depreciation & Amortisation 323 310 108 108 131 138
EBIT 1,838 1,961 165 213 250 257
EBIT margins 19.8% 19.2% 10.5% 11.7% 15.0% 14.6%

As regards segmental EBITDA margins, there was no major positive improvement in the EBITDA margins of any of the segments. In fact, the core software and BPO services division saw clear reduction in profitability. Going forward, it is clear that HCL Tech’s strength in the high potential infrastructure management business is expected to drive performance. Given the company’s focus on garnering more export revenues, margin expansion in this segment could be witnessed in future. If we take a YoY basis, this segment has witnessed a strong 516 basis points margin expansion, and on an absolute basis, EBITDA was up by as much as 166.1% YoY.

Higher other income aids the bottomline: HCL Tech saw a decent 7.4% QoQ growth in its net profits in 1QFY07. This was enabled due to considerably higher other income (up by as much as 437.0% QoQ), even as the company incurred taxes this quarter as compared to tax credits last quarter.

Performance in the recent past…
  2QFY06 3QFY05 4QFY06 1QFY07
Sales (QoQ growth, %) 8.6 6.4 11.7 10.0
Operating margins (%) 22.5 22.3 22.5 21.7
Profits (QoQ growth, %) 8.2 6.5 20.8 7.4
Employees (Nos.) 28,182 29,948 32,626 36,452

What to expect?
At the current price of Rs 600, the stock is trading at a price to earnings multiple of 25.9 times its trailing 12-month earnings. The company’s board has recommended an interim dividend of Rs 4 per share (dividend yield of 0.67%). The company has recorded a good performance this quarter, and a redeeming feature has been the good traction witnessed in the core software business, apart from continued traction in the infrastructure services business, where HCL Tech is amongst the leaders, along with Wipro. As we have mentioned above, the company is approaching clients with an integrated offering and is focusing more on multi-year, multi-service and multi-geography deals, which enable it to leverage its global deliver capabilities and offerings across various industries and service lines.

The company has significantly improved its disclosures this quarter, which we believe is a strong positive. More information on total clients, clients in different revenue buckets, greater detail about employees in different segments and information about revenue break-up from different verticals are notable additions to previous data sheets.

Going forward, we expect BPO, infrastructure management and ERP segments to be the major growth drivers for the company. While the improvement in performance this quarter and the significantly improved disclosure quality is encouraging, we would, nonetheless, wait to see how consistently the company is able to deliver vis-à-vis its other top-tier peers in the sector.

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