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HCL Technologies' margins surprise, but sustenance key to further re-rating

Strong deal wins were supported by healthy margins in Sept quarter but full impact of wage rises suggest margins could be impacted

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Unlike its larger peer, , which disappointed the Street by issuing a muted outlook last Friday, delivered on all three fronts – namely, volumes, profitability and deal pipeline. Its net profit at Rs 885 crore (up four per cent sequentially) came in ahead of Street estimates of Rs 780-800 crore.

The higher profit growth was largely driven by stable operating margins and lower-than-expected forex losses. Revenue, which grew by 2.9 per cent sequentially to Rs 6,091 crore due to strong volume growth of 4.5 per cent, though was slightly below estimates. Notably, while it bagged 12 large deals in the quarter gone by, the deal pipeline also remains robust, which indicates good visibility.

Reacting to the results, the HCL Tech scrip rallied 3.8 per cent to make a new 12-year high of Rs 606.9 in morning trade. However, it gave up gains later to close lower by 0.7 per cent, which can be partly attributed to some profit booking. Between October 8 and 16, HCL Tech stock rose nearly four per cent against a one-five per cent fall reported by and Infosys stocks, adding to its significant outperformance versus the since the start of 2012.

MARGIN CONCERNS
In Rs crore Q1FY13* FY13E
Revenues 6,091 25,716
% chg y-o-y 31.0 22.3
% chg q-o-q 2.9 NA
Ebitda margin (%) 22.2 18.0
Bps chg y-o-y 510 -70
Bps chg q-o-q 20 NA
Net profit 885 2,769
% chg y-o-y 78.1 12.8
% chg q-o-q 3.6 NA
EPS (Rs) 50.3 46.3
P/E (x) - 12.5
Volume growth (%) 4.5 13.9
E: Estimates
Source: Company, analyst reports
* HCL Tech follows July-June accounting period;
September quarter is thus the first quarter

The management also said margins could be impacted in the current quarter.

Nevertheless, at Rs 580 (PE of 14.3 based on FY13 estimated earnings) most analysts remain bullish given HCL’s strong deal pipeline, which provides higher visibility for future growth. The company’s aggressive go-to-market strategy is also making it a key beneficiary of the on-going vendor consolidation – also reflecting in a confident management outlook.

, research analyst at , says, “HCL Tech, with end-to-end IT capabilities and a strong client mining ability, is clearly emerging as a front runner and outperforming many of its peers companies. HCL Tech is one of our preferred picks in the Tier-I IT pack. HCL Tech is strongly positioned in the and verticals, which places it well for short-term as well as long-term growth.”

Margin gains difficult to sustain
A slight uptick in HCL’s earnings before interest, taxes, depreciation and amortisation (Ebitda) margins came in as a welcome surprise, given that wages were hiked in the September quarter. Most analysts were expecting Ebitda margins to shrink by 150-200 basis points. Among reasons for the margin gain is that the blended employee utilisation improved by 170 basis points sequentially to 81.4 per cent. Interestingly, HCL’s Ebitda margins have been expanding in the last three-four quarters, from 16.7 per cent levels in the September 2011 quarter to 22.2 per cent in the June quarter.

Still, it has to catch up with peers such as TCS and Infosys, which enjoy margins of 28-30 per cent. Notably, HCL’s relatively lower margins have been a key overhang on the stock and any sustained improvement in this metric could lead to further re-rating of the stock, believe analysts.

This, however, looks difficult at the moment. , chief financial officer, HCL Technologies, says, “We are committed to keep our Ebitda margin above the 16.5 per cent level on a full-year basis. Salary hikes impacted in the September quarter, hitting the Ebitda margin by 80 basis points. The impact of our October cycle wage hikes should be visible in the December quarter and lower margins by about 100 basis points.”

Thus, for now, analysts are projecting margins to be lower for the year ending June 2013.

Strong traction in key verticals
While lower-than-expected forex losses of Rs 61 crore (expectations of Rs 90 crore) partially aided HCL’s bottom line growth, the company’s core operations saw healthy growth.

Business growth was driven by healthcare, retail and infrastructure verticals, which grew by 10-15 per cent sequentially. Its BPO business also grew by 5.2 per cent sequentially.

The company’s strategy, which has been focusing all its energies on two key markets, namely, the US and Europe, has paid off well. While revenues from the rest of the world have shrunk in line with expectations, these two regions saw revenues grow four per cent and 2.8 per cent sequentially, a trend likely to sustain in the near term.

On the client side, growth was largely driven by the non-top 10 clients given that top 10 clients grew by just two per cent on a sequential basis. The company added four new clients in the $100-million plus revenue category; it also bagged 12 large deals.

These are positive, given the challenging environment, which has impacted HCL’s Enterprise Application business – down two per cent sequentially due to continued stress in discretionary spending. Pricing also remained flat and the management hopes to keep it stable. Infosys, in contrast, had seen pricing slip, albeit marginally by 0.2 per cent.

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