HCL: Pick-up in software services key to re-rating

The overall deal pipeline has also gained momentum while the prospects for IMS remain good

For three days, the HCL Technologies stock has been scaling new highs. It saw a strong run at the bourses and outperformed both the S&P BSE Sensex and the S&P BSE IT index through the past month, as well as the past three months.

This is significant because the run-up is despite the move from defensive sectors towards cyclical stocks, and suggests the market seems to have sensed the expected improvement in the company’s prospects. The outlook for its core software services business (which accounts for 62 per cent of consolidated revenues) has improved and the management expects better growth in this segment this financial year.

Analysts believe the company’s cash-generation, too, is likely to improve. “We believe HCL Tech will continue to be among the fastest-growing Indian IT companies. Valuations are the cheapest among larger IT vendors. Its cash-generation continues to improve due to tight working capital management,” says Sandeep Muthangi, IT analyst at IIFL.

However, despite the run-up, its stock continues to trade at a discount to those of its peers such as TCS, Infosys and Wipro.

While the HCL Technologies stock is being traded at the FY14 estimated price/earnings ratio of about 14 times, Infosys and TCS stand at 19 times and 22 times, respectively. Wipro is being traded at a higher valuation of 16.7 times the FY14 estimated earnings. Given HCL Technologies’ improving prospects, this valuation discount should fall.

Of the nine analysts polled by Bloomberg in December so far, seven have ‘buy’ ratings; the rest have ‘sell’ ratings. Their average target price stands at Rs 1,261 a share, an upside of six-seven per cent from the current Rs 1,186. However, this figure could inch up if the company displays all-round growth.

Revival of core software growth key catalyst
While HCL Tech’s IMS (infrastructure management services business, which accounts for 33 per cent of consolidated revenues) continues to grow at a robust pace, the core software services business has recorded subdued single-digit growth through the past few quarters. The management, however, expects the growth in core software services business to be better than in FY13 (the company follows the financial year ending June). This could trigger a re-rating of the stock, as the company starts witnessing all-round growth.

“We believe core software growth could surprise positively. Last year, HCL Tech posted growth of 5.3 per cent in core software; for it to achieve similar growth, it would require a CQGR (compounded quarterly growth rate) of two per cent in this segment through the next three quarters. This is better than the 0.8 per cent CQGR in this segment over the last five quarters,” says Ashwin Mehta, IT analyst at Nomura.

The company has witnessed improved deal flow in the core software services segment, especially from engineering services and custom application development services. On the whole, it has bagged deals worth over $4 billion in the last 12 months. It has also witnessed an uptick in offshoring activity in engineering services, especially in Europe. Custom application development stands to gain from improved multi-service deal flow through the last three quarters. The company is also positive on ALT ASM offerings, which bundle IMS along with ADM (application development and maintenance).

“Since its launch in early 2013, ALT ASM has had 13 deal wins. Of the nine large deal wins in the September quarter, a significant component share came from ALT ASM. I think we should be tracking at least better than what we did last year in the software services business,” Anant Gupta, president & chief executive, HCL Technologies, told analysts in a recent call.

Road ahead
Analysts expect the company to post compounded annual growth of 20 per cent in revenues and 25 per cent in net profit during FY13-15.

Most analysts expect the company’s earnings before interest, tax, depreciation and amortisation margin to rise to 25 per cent in FY14 from 22.3 per cent in FY13, led by a weaker rupee. The management says it will reinvest some rupee-driven gains to drive growth. It will record a 60-70-basis-point sequential impact on margins, as the company implements residual wage hikes in the December 2013 quarter.