HCL Tech disappoints with weak earnings quality

Lower than expected revenue growth, non-core boost to bottom line, margin contraction hit stock

For a consecutive quarter, HCL Technologies’ revenue and Ebitda (earnings before interest, taxes, depreciation, and amortisation) margins were below the Street's expectations. Unfavourable cross-currency, softness in sequential revenue growth of top 20 clients and wage rises pulled down the September quarter numbers. On a sequential basis, revenues grew 3.7 per cent to Rs 8,735 crore and net profit grew 2.1 per cent to Rs 1,873 crore.

Regions other than the US and Europe were largely responsible for the muted top line growth. The US grew 5.7 per cent sequentially, followed by 2.7 per cent in Europe. The rest of the world posted a fall of 6.4 per cent sequentially in revenue, partly due to weakness in Indian markets. HCL’s two key revenue verticals, BFSI and manufacturing, grew three per cent and 5.3 per cent sequentially, respectively. Life sciences/health care and public services revenues fell 1.7 per cent and 5.6 per cent, respectively.

“Softness in public services is more of a quarterly phenomenon and should improve from here on. However, life sciences/health care and BFSI are witnessing vendor consolidation and could take some time to improve,” says Anil Chanana, chief financial officer.

Infrastructure management services saw two per cent growth but should pick up in calendar year 2015.

Ebitda margin also took a hit. It contracted 120 basis points (bps) sequentially to 25.1 per cent. The decline was also higher than analysts’ expectations of a 90-100 bps fall. The management expects a further impact of 130 bps in the December quarter and 9-10 bps each in the March and June 2015 quarters.

While net profit beat consensus Bloomberg expectations of Rs 1,753 crore, it was largely volatile, non-core and unsustainable other income which grew 70 per cent sequentially to Rs 358 crore.

It is thus not surprising the Street was disappointed. Intra-day, the stock fell 9.6 per cent on Friday to close at Rs 1,506, where it now trades at 12.6 times FY16 (follows June-end) estimated earnings.

Though valuations are at a huge 35 per cent discount to larger peer TCS (19.4 times FY16 estimated earnings) and a 19 per cent discount to Infosys (15.6 times FY16 estimated earnings), it is unlikely to narrow down soon. Analysts believe, apart from smaller size relative to these two companies, HCL would also have to show consistent all-round financial performance to warrant a re-rating.

HCL continues to invest in infrastructure, engineering and digitisation technologies to drive growth. Analysts believe its long-term prospects remain good, which stems from management confidence of future growth and a strong deal pipeline. HCL won contracts worth $1 billion in the quarter, which along with 4,000 employee addition signals medium-term prospects remain healthy.