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HCL Tech: Forex pains - Views on News from Equitymaster

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HCL Tech: Forex pains

Oct 17, 2007

Performance summary
  • Topline grows by 6% QoQ for 1QFY08, driven by 7% QoQ growth in core software, infrastructure management service (IMS). BPO revenues flat on QoQ basis.

  • Operating margins contract by 0.3% largely due to higher direct costs in the core software and higher SG&A in IMS.

  • Bottomline contracts by 37% QoQ, mainly due to lower other income.

  • Declares interim dividend of Rs 2 per share (dividend yield of 0.7%).

Financial performance: A snapshot…
(Rs m) 4QFY07 1QFY08 Change
Sales 16,120 17,092 6.0%
Expenditure 12,646 13,453 6.4%
Operating profit (EBDIT) 3,474 3,639 4.7%
Operating profit margin (%) 21.6% 21.3%  
Other income 2,873 504 -82.5%
Depreciation 693 686 -1.0%
Profit before tax 5,654 3,457 -38.9%
Tax 777 346 -55.5%
Minority interest & income of equity investee 10 28 180.0%
Profit after tax/(loss) 4,867 3,083 -36.7%
Net profit margin (%) 30.2% 18.0%  
No. of shares (m)   681.0  
Diluted earnings per share (Rs)   20.7  
P/E ratio (x)   14.1  

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 (12% of revenues), engineering and R&D services (24%), industry solutions (36%), infrastructure services (15%) and BPO services (13%). While the company has witnessed stable growth in its core business, it has done well to grow its inorganic businesses in the past few quarters. HCL Tech’s focus on Engineering and R&D outsourcing and its experience in technology development services gives it a competitive edge over its peers. The company’s strategy to move up the value chain and improving operational efficiencies is paying off as well.

What has driven performance in 1QFY08?
Core software and IMS drives topline: HCL Tech’s topline recorded a 7% QoQ growth during 1QFY08, led by the core software and IMS segments. Growth of the BPO business was flat. The company is building domain expertise in some selective verticals across the core software segment namely life sciences and healthcare and plans to focus more on medical devices space. In the IMS space, it is already an industry leader and generates more than 15% of revenues from this service. While other players are trying to get a foothold in IMS across different business verticals, we believe that HCL Tech’s investments in IMS at a very early stage are paying off well.

In terms of geographies, HCL Tech is one of the few companies which in not highly dependent on the US for its business. This is good sign in wake of the Rupee’s appreciation against the US dollar. While the share of US has remained stable at a little over 55%, Europe recorded a 30 basis points expansion in its share, which was equally offset by decline in Asia Pacific contribution.

In terms of business verticals, life sciences recorded a 13% QoQ growth and manufacturing recorded 11% QoQ growth. While the share of other verticals and their growth in the current quarter has been more or less stable, the life sciences and manufacturing segments’ share in total revenues increased by 0.3% QoQ and 1.3% QoQ respectively.

HCL Tech added a net of 3,625 employees during the quarter and the attrition rate dropped considerably. This is encouraging as other IT companies are facing problems with their attrition levels. On the client side, it added 2 new clients during 1QFY08 and signed its third US$ 250 m deals in last 24 months.

Segmental performance
(Rs m) 4QFY07 1QFY08
Core Software    
Revenue 11,505 12,316
% of revenues 71.4% 72.1%
EBITDA margins 21.8% 21.4%
EBIT margins 18.2% 18.0%
Infrastructure Services    
Revenue 2,417 2,580
% of revenues 15.0% 15.1%
EBITDA margins 16.7% 16.8%
EBIT margins 11.2% 11.8%
BPO Services    
Revenue 2,198 2,198
% of revenues 13.6% 12.9%
EBITDA margins 25.7% 26.0%
EBIT margins 19.1% 19.8%

Operating margins contract marginally: HCL Tech’s operating profits grew by 5% QoQ in 1QFY08. The operating margins however, declined by 0.3% mainly due to higher direct costs in the core software and higher SG&A in IMS business. While in case of BPO, the direct costs have risen by only 0.6% QoQ, these were set off by decline of 1.0% QoQ in SG&A costs thereby leading to a 0.4% expansion in the segment’s EBITDA margins.

Lower other income dents bottomline: HCL Tech recorded a decline of 37% QoQ in bottomline mainly due to lower other income. The decline in other income was mainly due to two reasons. First, during 4QFY07 (April to June quarter for the company), the Rupee appreciated by 6.4% against the US dollar resulting in huge gain of US$ 1.15 bn for forward cover. Since the currency has not appreciated much in 1QFY08, the resulting other income is low. Secondly from 1st July 2007, the company has chosen forward contracts associated with forward transactions as cash flow hedges and due to this the change in fair value of such contracts has been accounted in balance sheet as Other Comprehensive Income (OCI) under shareholders’ fund.

Performance in the recent past…
  2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07 1QFY08
Sales (QoQ growth, %) 8.6 6.4 11.7 10.0 6.2 7.6 2.2 6.0
Operating margins (%) 22.5 22.3 22.5 21.7 22.1 23.3 21.6 21.3
Profits (QoQ growth, %) 8.2 6.5 20.8 7.4 6.4 15.9 46.7 (36.7)
Employees (Nos.) 28,182 29,948 32,626 36,452 38,317 40,149 42,017 45,642

What to expect?
At the current price of 299, the stock is trading at a multiple of 12.5 times our estimated FY09 earnings. The company, over the past six quarters, has posted a growth of 8% CQGR and has been able to mitigate the risk of currency appreciation in a very stable manner. More importantly, the attrition level has dropped considerably over the past few quarter indicating good human resource policies put forward by the management.

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