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HCL Tech: Conference call excerpts
Nov 7, 2005

HCL Technologies, India’s fifth-largest software services company, recently announced its FY05 results (the company’s financial year ends in June). Post-results, we had a conference call with the management of the company in order to understand it’s long-term growth strategy, the competition and future growth drivers. The following are the excerpts of the same.

Conference call excerpts
View on the industry: The company is of the opinion that growth in global IT spending, the key metric for IT companies, will be in a range of around 5%. A greater number of HCL Tech’s clients’ IT spends have been largely flat-to-negative. However, the company is experiencing the proportion of offshore increasing in overall IT spends. Over the medium-to-long term, volume growth is expected to be the major driver of growth, with billing rates remaining relatively flat.

Business segments: HCL Tech has three major business segments: Software services, BPO and Infrastructure management. The company is strong in BPO, with the latest NASSCOM rankings showing it to be the third-largest third-party services provider. Infrastructure management is another good growth area, with around two-thirds of revenue of the segment coming from the domestic market.

Software services: This segment has shown a fair amount of inconsistency and volatility in the past. Considering that it accounts for over 75% of HCL Tech’s revenues, this has affected the company’s overall performance. The company expects another year of volatile performance in this segment, as it seeks to continue building traction in it. The company’s enterprise consulting business, part of this segment, is expected to be the major driver of growth with around 3,000 people working in it.

The recent performances of nearly double-digit sequential growth in the segment are not sustainable and, over the longer term, enterprise consulting and Application Development and Maintenance (ADM) are expected to lend stability to the business, as enterprise consulting results in a greater amount of downstream ADM work. However, the sales cycles are also longer, resulting in the expected volatility.

BPO: This segment is expected to be the major growth driver for the company over the medium term. HCL Tech is witnessing good sign-ups from existing clients and also expects strong ramp-ups from December. The fourth quarter last fiscal witnessed flat growth for the segment, but the company believes that this was only an aberration and in the long-term, the growth will be strong.

The segment currently has a 70:30 mix of voice:non-voice business. The company expects to grow this business through a mixture of organic and inorganic growth. The main focus of the company will be maintaining profitability, with margins stable at around 24%. Over the longer term, the voice:non-voice mix is expected to become around 50:50.

Infrastructure management: This segment, as mentioned above, is mainly domestic, with nearly 70% business coming from India. Margins in this business tend to be sub-optimal, due to the domestic concentration. The business model is a mix of services and box selling (hardware). Going forward, the company intends to increase its focus on services, as margins are higher. The global component of revenues is also expected to increase. This combination will result in better margins for the business. A number of global clients have already signed up and the increasing proportion of exports in the business will be a factor of the ramp-ups that these clients witness.

Capex plans: HCL Tech expects to spend around US$ 85 m in FY06 on capital expenditure. The main expenses will be on building new campuses and adding around 2,000-odd seats in the BPO business.

Billing rates: HCL Tech expects billing rates to remain stable, by and large. Higher rates are being witnessed for new clients, but for existing clients, it remains a challenge. Although there are no specific downward pressures on billing rates, if the company’s cost pressures become acute, then it will have to be more aggressive with respect to getting rate increases from clients.

The margin picture: As regards margins, the company expects to maintain its margins over the medium term. Major growth drivers for a possible upside surprise to margins are expected to be BPO and infrastructure management. In BPO, an increase in the offshore component and in infrastructure management, an increase in the global component of revenues, are expected to be margin triggers.

Exchange rates: HCL Tech has hedged its net inflows in dollar terms to the extent of US$ 300 m, which covers all net inflows in dollars for the next 12 to 14 months.

Onsite-offshore mix: HCL Tech has as much as 86% of its revenues coming from offshore services. However, one must take into account the fact that the way HCL Tech classifies offshore is slightly different from industry norms, as employees who go offshore even for a short period of time are also classified as offshore services. If we take the industry definition, around 75% of revenues are offshore.

But going forward, the company has said that it expects a greater proportion of revenues to come from onsite services. This limits the possibility of any margin upside on this front, as margins are higher in offshore services. The company has recently re-classified its onsite and offshore revenues as per the industry classification and its service lines have also been re-classified.

Subsidiaries: HCL Tech has a number of subsidiaries that it acquired either by direct acquisition or by buying out its partners’ stakes in their joint ventures. Going forward, the company will continue to acquire the companies/JVs in which it currently has minority stakes and merge these with itself. However, the front-end subsidiaries will continue to operate separately. Therefore, the subsidiary count will be pruned.

What to expect?
At the current market price of Rs 439, the stock trades at a price to earnings multiple of 23.3 times its FY05 EPS. In the past, the company has displayed a fair amount of volatility in its performance. The main software services division has clearly lagged its peers. Given that this division contributes to over three-fourths of HCL Tech’s revenues, it has adversely impacted the company’s performances. In the medium term, this division is expected to continue to under-perform its peers and as a result, the overall performance of the company will also be impacted.

HCL Tech has started to follow a conscious strategy of focussing only on large-sized deals and rationalising the number of clients. This will have the impact of increasing quarterly fluctuations. Though one, of course, must look more at the longer term rather than quarterly aberrations, the company is yet to prove the success of this strategy, the results of which would take at least two to three years to reflect. Overall, given their track record, consistency of performance and strong management quality and vision, we continue to prefer companies like Infosys and TCS from the large-sized software companies.

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