As a top-tier IT service player that has consistently grown faster than the industry and, yet available at a reasonable valuation, HCL Technologies is an attractive bet for long-term investors.
Despite growing consistently at double-digits in dollar terms — it displaced Wipro to become the third-largest IT player in India in FY19 — over the past several years, the stock is at a discount to peers in the space.
HCL Tech now trades at a trailing 12-month price-earnings multiple of 14 times, which is below that of most of its peers like Tata Consultancy Services, Infosys and Wipro (16-25 times). This discount makes it a solid proposition for investors with a two-year horizon.
Robust traction in five of its seven verticals of operation, large-sized client additions and a good show in metrics such as utilisation are positives for the company. In FY19, HCL Tech’s revenue grew at a robust 11.8 per cent over the previous fiscal in dollar terms, which was higher than almost all top-tier peers and the industry as well. The company’s EBIT margin has remained stable at around 19.5 per cent.
Digital in progress
In FY19, verticals such as technology and services, retail & CPG, life sciences and telecom grew at 16.8-30.7 per cent over the previous fiscal. This growth suggests broad-based traction across segments.
For the full financial year 2018-19, the net profit rose 15.3 per cent to 10,123 crore Y-o-Y, while revenue rose 19.5 per cent to ₹60,427 crore. HCL Tech’s earnings before interest and tax margins came in at 19.5 per cent. The company managed to beat its guidance for revenue, and margins were within the guided range.
Three years ago, HCL Tech announced a strategic blueprint called Mode-1,2 and 3. Mode 1 includes traditional services-related businesses such as infrastructure management services, application services and BPO services. Mostly its core services offering, Mode 2 comprises cloud and security services and digital services. Mode 3 is HCL Tech’s effort to build products and platforms to create its own ecosystem of products and includes its intellectual property partnerships for products of other companies.
At the end of FY19, Mode 1 makes up 71.6 per cent of its total revenue, while Mode 2 and 3 together make up 28.4 per cent. Three years ago, the proportion of revenues was 81.4 per cent and 18.6 per cent for Mode 1, and Mode 2-3 together, respectively.
Mode 2 and 3 are high-growth businesses that earn HCL Tech higher margins. The increased investments in new growth opportunities have weighed on margins.
In FY19, in three out of four quarters, the company bagged the highest deals for a quarter, showing a decent deal pipeline. During the year, the company added two customers in the $100-million contract value category, four in the $50-million bucket, four in the $40-million band and 13 in the $10-million zone.
The utilisation rate for HCL Tech is quite healthy at over 85 per cent, among the highest in the industry. Attrition, after increasing in the previous quarters, is showing signs of stabilising, though, at over 17 per cent, it is still a concern.
Guided range
HCL Tech’s 2019-20 revenue growth guidance is 14-16 per cent in constant currency terms, while margins are expected to be in the 18.5-19.5 per cent range, lower than that of FY19.
The company expects to take a hit in its margins during the Q1FY20 due to process-related expenses for IBM product acquisitions.
In December 2018, HCL Tech announced the purchase of seven of IBM’s products for nearly $1.8 billion. It already had intellectual partnership with IBM for five out of seven of these products. The company expects to rejuvenate these product lines and use them as an entry point to push its other products and services to existing customers.
This deal is expected to be completed by end- May 2019. HCL Tech expects an additional $650 million in revenue from the second year. The incremental annual revenue in FY20 is expected to be $625 million. This deal, the company expects, will add 15 per cent to its earnings per share.
Embedded risks
Inorganic growth in revenues (from companies HCL Tech has acquired) helps the company post industry leading revenue growth. The dependence on acquisitions to push revenue growth would mean each acquisition must add to the top-line growth from the get-go. If the new businesses acquired falter, then revenue growth might be hit.
Then comes the risk from the current US-China trade war. This could lead to clients curtailing their IT spends. Foreign currency fluctuations can curtail its ability to meet the guided numbers. This includes headwinds due to uncertainty on Brexit.
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