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HCL Tech: Core concerns remain! - Views on News from Equitymaster
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  • Oct 26, 2004

    HCL Tech: Core concerns remain!

    Performance Summary
    HCL Technologies has announced poor results for the first quarter of FY05. The company has reported a sequential decline in profits on the back of a marginal growth in the topline. Lower other income and high tax outgo has dented the company’s profits in the quarter. Operating margins have remained steady.

    Financial performance (US GAAP consolidated): A snapshot…
    Rs m 4QFY04 1QFY05 Change
    Sales 7,386 7,822 5.9%
    Expenditure 5,674 6,009 5.9%
    Operating profit (EBDIT) 1,712 1,813 5.9%
    Operating profit margin (%) 23.2% 23.2%  
    Other income 1,121 573 -48.9%
    Depreciation 334 316 -5.4%
    Profit before tax 2,499 2,070 -17.2%
    Stock-based sales incentive (4) (3)  
    Tax 35 210 497.7%
    Minority interest & income of equity investee (372) (239)  
    Profit after tax/(loss) 2,088 1,617 -22.5%
    Net profit margin (%) 28.3% 20.7%  
    No. of shares 285.4 296.5  
    Diluted earnings per share* (Rs) 28.2 21.8  
    P/E ratio (x)   17.1  
    (* annualised)      

    What is the company’s business?
    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 (39%), ITES (12%) and infrastructure services (8%). 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 2QFY05?
    Lacklustre growth in software services and BPO: Relatively sedate sequential growth in both software (80% of revenues) and BPO (12%) services led to this lackluster growth in the topline for 2QFY05. While the former grew QoQ by 6% (15% QoQ in 4QFY04), the growth in the latter was 10% (21% QoQ in 4QFY04). The third business segment of the company, infrastructure services, in fact witnessed a sequential revenue decline of 14%. Overall, this is a poor show from HCL Tech considering the fact that its peers in the Indian software industry have managed to maintaining their growth momentum and have reported double digits growth in software services revenues.

    Growth in software services revenues is a result of 6.9% and 0.3% QoQ growth in onsite and offshore volumes combined with a 0.6% rise in onsite billing rates. However, rates for offshore services declined by 0.2% on a sequential basis. The addition of 2,116 employees was one of the fastest in recent times. Out of these, while 1,582 were added in the software services business, 406 came in on the BPO front. The company added 16 new clients in the quarter.

    Improvement in BPO margins: Despite a sluggish sequential growth in the topline, HCL Tech managed to maintain its overall operating margins in 1QFY05 mainly due to steady margins for software services and a 430 basis points expansion in BPO margins. Reduction in direct and SG&A costs, as percentage of sales, led to this improvement in margins for the BPO business.

    Lower other income and higher taxes dent profits: The effect of a one-time other income in 4QFY04, on account of adjustments on the investments front, has led to a 49% QoQ decline on this front in this quarter. The management, in the conference call, has indicated that other income is likely to be lower in the next few quarters as well. This will be a result of changes in US GAAP regulations, as per which interest received on debt (treasury investments) will be credited to profit and loss account only at the time of redemption. As a matter of fact, HCL Tech had Rs 20.3 bn invested in treasury investments as on September 30 2004. On the tax front, a lower tax outgo in the previous quarter has led to taxes in this quarter appear higher.

    Performance in the recent past…
      2QFY04 3QFY04 4QFY04 1QFY05
    Sales (QoQ growth, %) 11.0 4.0 14.1 5.9
    Operating margins (%) 19.6 20.0 23.2 23.2
    Profits (QoQ growth, %) 271.4 (64.2) 66.0 (22.5)
    Employees (Nos.) 13,065 14,783 16,358 18,474

    What to expect?
    At the current price of Rs 373, the stock is trading at a P/E multiple of 17.1 times annualised 1QFY05 earnings. The company board has recommended an interim dividend of Rs 4 per share (200%). In this quarter, while net profit growth has been impacted on account of accounting adjustments on the other income and taxation fronts, what concerns us more is the volatile growth in the company’s topline. Also, if one were to consider the past four quarters (see table above), the company’s performance has been anything but enthusing.

    In this regard, and also considering valuations that are at the higher side of the spectrum, we believe that there are better stocks to choose from the software sector.



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