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HCL Infosys: Growth momentum continues - Views on News from Equitymaster
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HCL Infosys: Growth momentum continues
Dec 27, 2005

Performance summary
HCL Infosystems announced its results for the first quarter ending September 2005 (the company’s financial year ends in June). Yet again, the main growth driver for the topline was the Office Automation and Telecommunications (OA&T) segment. However, as has been the case in the past, margins remained fairly low, albeit a marginal expansion was witnessed. The bottomline grew at a good pace, at almost the same pace as the topline, a welcome change from the past.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY05 1QFY06 Change
Sales 15,653 22,781 45.5%
Expenditure 15,148 22,027 45.4%
Operating profit (EBDIT) 506 754 49.0%
Operating profit margin (%) 3.2% 3.3%  
Other income 85 97 13.7%
Interest 2 (9)  
Depreciation 35 40 13.7%
Profit before tax 554 820 48.1%
Tax 122 199 63.0%
Extraordinary items      
Profit after tax/(loss) 432 621 43.9%
Net profit margin (%) 2.8% 2.7%  
No. of shares (m) 165.0 186.5  
Diluted earnings per share* (Rs) 9.3 13.3  
P/E ratio (x)   19.5  
(* annualised)      

India’s largest PC maker
HCL Infosystems, India’s largest personal computer (PC) maker, is primarily engaged in the information technology related hardware business. Its other interests (apart from PCs) in hardware include trading and assembling of equipments like printers, scanners, photocopiers, cellular phones and EPABX systems. It is one of the largest distributors of Nokia cell phones in the country. The meager levels of PC and mobile penetration in the country present a big opportunity for higher growth for HCL Infosys going forward. Its number one position in the industry is, however, under threat due to low barriers to entry in this business.

What has driven performance in 1QFY06?
It’s the OA&T business again: HCL Infosystems’ topline witnessed an impressive 45.5% YoY growth. This was driven again by the office automation & telecommunications (OA&T) business (78.5% of 1QFY06 consolidated revenues). This has been the case over the past few quarters and given the strong growth in the Indian handset market due to the relative under-penetration, the segment continues to be the key driver for revenues for HCL. During 1QFY06, the OA&T segment grew at 52.5% YoY.

We believe that given low cellular teledensity in India compared to international standards and increasing competition that is driving affordability, there appears to be tremendous scope for growth.

Segmental break-up…*
  1QFY05 Share 1QFY06 Share Change
Computer Systems & Other Related Products 3,806 24.3% 4,803 21.1% 26.2%
Office Automation & Telecommunication 11,747 75.0% 17,912 78.5% 52.5%
Internet & Related Services 119 0.8% 97 0.4% -19.0%
Total 15,672   22,811   45.6%
* Includes inter-segment revenue

The second-largest business stream of the company, computer systems & other related products, also clocked in a decent YoY growth of 26.2% during 1QFY06. The contribution of this business to revenues continues to decline from 24.2% in 1QFY05 to 21.1% in 1QFY06. During the quarter, HCL launched a sub-Rs 10,000 PC, aimed at the common man and this is expected to herald the next phase of growth for PCs in the country. Given that PC penetration in India continues to remain at abysmal levels, this could bring in the next wave of growth for the PC industry in particular and HCL Infosystems in general. The company is in the process of upgrading its manufacturing facilities for PCs from the current 0.6 m units to 1 m units by the end of calendar year 2005. However, revenues from the third segment, Internet and related services, continue to remain lacklustre, declining by 19.0% YoY during 1QFY06.

Margins witness a slight up-tick: A slight fall in the total cost of sales as a percentage of total net revenues has resulted in HCL Infosystems witnessing a marginal 8 basis points margin expansion during the quarter. However, we believe that given the intensely competitive nature of the PC industry in India, the company’s margins will continue to remain under pressure in the foreseeable future. The fact that operating margins are in low single digits is a clear reflection of the high-volume-low-margin nature of HCL Infosystems’ business.

It trickles down to the bottomline: The strong growth in operating profits, coupled with a lower-than-proportionate rise in depreciation charges, led to the bottomline growing at virtually the same pace as the topline, despite a higher effective tax rate. This is a heartening feature of this quarter’s performance, as the topline has usually grown ahead of the bottomline. During 1QFY06, HCL Infosystems incurred Rs 7.9 m on the payment of fringe benefits tax (FBT).

Performance in the recent past…
  2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (YoY growth, %) 95.9 68.7 69.2 45.5
Operating margins 3.5 4.0 3.1 3.3
Profits (YoY growth, %) 44.5 17.9 28.8 43.9

What to expect?
At the current price of Rs 260, the stock is trading at a price to earnings multiple of 19.5 times annualised 1QFY06 earnings. The company has recommended an interim dividend of Rs 2 per share (100% of face value and dividend yield of 0.8%).

HCL Infosystems has managed to outperform the industry growth rates in the past due mainly to its strong, countrywide distribution network. The company has direct customer service contacts at 300+ locations around the country. It has also benefited from a rapid growth in demand for GSM handsets. We believe that, going forward, as income levels rise and consequently the demand for desktop PCs and cellular handsets, strong growth is likely to continue. Potentially larger investments in hardware from Indian corporates also promise strong times ahead.

However, we believe that given the intensely competitive nature of the PC industry in India, going forward, it will be a volume game rather than a margin game. Therefore, margins are likely to remain under pressure over the medium term. This is the key factor that investors need to take into account while considering a company like HCL Infosystems. Any inability to control its costs could adversely impact HCL’s profitability. Considering these factors, and that valuations are at the higher end of our spectrum, we would advise investors to remain cautious.

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