Strong revenue growth in enterprise application services and earnings stability could improve valuations for HCL Technologies
As India’s fourth-largest IT services company, HCL Technologies has a lot going for it, a part of which comes from having made the largest acquisition yet by any technology company in India. Still, the Noida-based tech company hasn’t quite enjoyed the investor adulation that the top three IT companies — Infosys, TCS and Wipro — have received. Not without reason. Even though HCL Tech has been able to match the top three in revenue growth, it has exhibited too much volatility in earnings. Forex losses, interest costs and amortisation costs (arising from an acquisition) have severely dented the company’s profitability. Even in the recently concluded December 2009 quarter, net profit took a hit
| | | | In the past two years, the company has signed deals worth $2.65 billion with clients such as Nokia, Xerox and Viacom | | | | |
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. HCL Tech posted a 20.5 per cent fall in consolidated net profit, hurt by forex losses, declining other income and higher costs. There’s also the issue of the company not being as transparent as the top three, in its disclosures. Combined, they’ve had a dampening effect on valuations.
The company’s December quarter numbers didn’t exactly set the markets on fire, as expectations were quite high post the stellar performances by Infosys, TCS and Wipro. So when HCL Tech reported flat sequential revenue growth, it got a thumbs down from the market. To be fair to HCL Tech, this performance comes off a relatively high base. Its growth was at the top end of the range among top-tier IT firms in the September quarter (3.8 per cent) and it was far ahead of the rest in the June quarter (7.6 per cent). It added revenues of around $466 million during the calendar year ending December 2009, the best among software services vendors, including TCS, Infosys, Wipro and Accenture and this is clearly evident in the revenue growth on a year-on-year basis. HCL Tech’s revenue growth in the last quarter was 22.8 per cent y-o-y. TCS’ revenue growth was just 5.1 per cent.
The company, which has transformed its business model by building a strong presence in niche high-growth areas, has been able to clinch a number of large deals over the past two years, fighting off competition from its larger domestic rivals and international companies. The company won 12 outsourcing deals in the October-December quarter, including two large deals in the financial services sector. It also recently bagged a $50 million (Rs 231 crore) deal from UK-based defence equipment maker Meggitt for providing engineering services. Analysts say these large deals and the growth potential in niche segments should keep the company’s revenues humming along nicely, but it will take a couple of quarters more for the volatility in earnings to smoothen out.
Driving growth
Clearly, HCL Tech’s infrastructure services, which primarily involves the management of a company’s IT infrastructure, has been the engine of growth, with large deals continuing to boost revenues. The business posted a double-digit jump in revenues in dollar terms — 26 per cent in the June 2009 quarter and 15 per cent in the September 2009 quarter. Despite a higher base, this segment still managed to deliver 8 per cent growth in the December quarter. Infrastructure service revenues have leaped by 10 times in the past five years. Its share in revenues has grown from 8 per cent in September 2005 to 20 per cent in September 2010. Operating margins have also improved from 10 per cent to 20 per cent during the same period.
Scaling up
Enterprise application services is expected to drive growth
Source: IIFL Research; Numbers are adjusted for noncash ESOP charges
Industry consultant Gartner predicts that the demand for infrastructure services will rise by 25-27 per cent over the next two years. For HCL Tech, in particular, a lot of deals in this area will come up for renewal in the next few years, which should feed revenues. The company anticipates that contracts worth about $60 billion will be renewed worldwide in the next 2-3 years, a significant portion of which will involve providing infrastructure services.
In the past two years, the company signed deals worth $2.65 billion with major clients such as Nokia,Xerox and Viacom. Most of these deals have been scaled up in recent months and will provide the necessary fuel to maintain growth momentum.
Another important focus area has been enterprise application services (EAS), which deals with automating a company’s entire operations, resulting in faster transactions and quicker response time. To buttress its presence here, HCL Tech completed its acquisition of UK-based Axon Group for £441 million in December 2008, making it the largest acquisition by any Indian tech company and outbidding rivals like Infosys Technologies. Axon is a consulting firm that offers services to companies that use SAP, an enterprise resource planning product which includes the implementation and management of the product.
Growth area
HCL Tech’s infrastructure services business has been the engine of growth
Source: HCL Technologies; BNP Paribas; Note: The company has fi nancial year ending June
The acquisition catapulted HCL Tech into the top 10 service providers in EAS, with a combined SAP consulting and support capability that is 60 per cent larger than TCS, its
closest Indian rival in this area. At that time, there were definite concerns that the deal would prove to be too much for HCL to handle, given that it happened in the middle of the global economic slowdown. HCL was, however, unfazed by the criticism, saying that it viewed Axon as a strategic acquisition, since it had identified EAS as one of the eight focus areas for growth. Indeed, the global market for SAP-related services is estimated at $26 billion, $7.5 billion of which is offshored. Yet, Indian companies only claim only about $1.5 billion of the offshore market, which indicates that there is plenty of opportunity to expand.
While the slowdown did hit revenues from this business, it looks like things are improving now. The EAS market is showing signs of an early recovery. (HCL Axon recently won an SAP implementation deal from drug giant GSK). In the December quarter, this business bounced back with a 4.6 per cent growth after a 5 per cent drop in revenues in the September quarter, putting all concerns about the integration of the acquired business to rest. Analysts say Axon will benefit from an increase in deals flow in the coming quarters. They estimate that Axon could haul in $400 million to HCL Tech’s revenues (nearly 15 per cent of the total) in 2010. Both companies are also increasingly cross-selling their services, which will lead to a deepening of their client base. Also, a large number from the senior management team of Satyam’s enterprise application services have moved to HCL Tech, boosting the company’s skills in this business. The high-end consulting capabilities resulting from the Axon acquisition, makes HCL Tech a formidable enterprise applications player.
Another business trying to find its groove is business process outsourcing (BPO). Client losses and a decline in the voice-based business have affected HCL Tech’s operations seriously in the BPO segment.
Rough ride
Currency fluctuation, amortisation of goodwill and higher interest expenses led to higher volatility in QoQ profit
Source: Company, IIFL Research
The chasm widens
The stock trades at a 42 per cent valuation discount to Infosys compared with the historical discount of 24 per cent
Source: Bloomberg, IIFL Research; *Note: Two-year rolling forward PER (Price earning ratio) considered due to the heavy impact of amortisation and forex charges during FY10
Till September 2008, the voice-based business accounted for all of BPO revenues. But today, it is just 65 per cent. The reduction is deliberate as the company is working on increasing its transaction-based services, which earn better margins. Consequently, revenues from voice-based services are likely to slip even further to 50 per cent in the next few years. The company says acquisitions will also be one of the growth drivers for this business. The company acquired US-based Control Point Solutions and UK-based Liberata Financial Services as part of this strategy. HCL has said that acquisitions will account for at least 55 per cent of its growth, while the rest would be derived through the organic route. The strategy seems to be working already. HCL landed a $200 million deal from UK-based Equitable Life. According to the management, the ongoing restructuring of the BPO business will keep its performance muted in the near term and a recovery is expected from the middle of next financial year.
Profit woes
While the company has been able to keep its nose ahead of its peers in revenue growth, profitability has been curtailed due to derivative losses, acquisition expenses and the amortisation of intangibles related to the Axon acquisition in 2009. HCL Tech took a $500 million foreign-currency loan to complete the acquisition in the September 2009 quarter. However, to mitigate the effect of foreign exchange rate volatility, the company converted $200 million of this into a rupee loan (of Rs 1,000 crore), with a coupon rate of 8 per cent. The company has managed to bring down its net debt from $220 million in September 2009 to $136 million in December 2009. At a post results press conference, chief financial officer Anil Chanana said that the company has already generated cash of $190 million in the first half of the current fiscal, as against $210 million in entire FY09. According to him, over the next two quarters the company will be debt-free and cash positive.
HCL Tech is doing its best to restore stability to earnings. For a start, it has significantly cut down its foreign-exchange cover. Outstanding hedges have come down to $645 million in December 2009 from $2.2 billion in March 2008. While losses on forex positions will continue, the good news is that the impact will no longer be as severe as it was a few quarters ago. Currency fluctuations and salary hikes have, nevertheless, put pressure on operating margins, currently at 16.6 per cent in the second quarter against 18 per cent in the September 2009 quarter. However, the company is hoping that there will be enough scope for improving profitability going forward. “We don’t want to be a low-margin vendor. We have only three quarters of bad news left, after that it will be only good news,” said Vineet Nayar, CEO, during the press conference to announce the December 2009 quarter results. For HCL Tech, rising revenues could offset some of the currency and salary-imposed pressures. Earnings are expected to stabilise in FY11. Even as amortisation costs and forex losses (both seen as non-recurring in FY11) keep profits subdued in 2010, analysts expect earnings to grow by 37 per cent in FY11. IIFL Research, however, expects a 58 per cent growth.
Although HCL Tech ranks among the top tier companies by revenues, it’s a different story with stock valuations, as its valuation is far lower than the top three. Analysts say this is because Infosys, Wipro and TCS have very high standards of transparency and corporate governance and on this front, HCL Tech has some catching up to do. No wonder then that the discount on HCL Tech’s valuations has widened to 30-45 per cent against that of its peers from the historical 17-25 per cent.
The management is confident that it will be able to match the revenue growth of its larger peers in dollar terms. While the top three companies may continue to do well, given the demand recovery, a chunk of the future gains already seem to be captured in their valuations. By getting its house in order, HCL Tech now seems ready to be a credible alternative to the top tier companies. While the valuation gap will continue to exist, it could narrow down in the coming quarters. At the current price of Rs 348, the stock trades at a P/E of 13 times its 2011 estimated earnings.