HCL Tech's core business continues to struggle in Q1

Changing business mix, new deal wins of over $1 billion every quarter are expected to drive future growth

The business of technology outsourcing is changing rapidly and HCL Tech's September quarter numbers clearly point to a shift. Like most other IT companies, HCL Tech's vanilla numbers too look good, with the company reporting a 3.5% growth in dollar revenues quarter on quarter and a 300 basis point expansion in margin. However, what is worth noting are the nine new transformational deals (total contract value over $1 billion), the company has signed during the quarter. The company has managed to keep its TCV (total contract value) of new deals at this level for the past several quarters. Standard Chartered Equity Research believes large deals (contract size of $25mn+) are the key growth drivers for Indian IT services companies.

 

So even as the 3.5% sequential growth in dollar revenues may be marginally below the market's expectations, HCL's changing business mix, stronger operating metrics, high return on equity (34% in September quarter) and robust deal pipeline are more relevant for future valuations.  Investors need to start looking at the business mix and not just revenue growth and margin expansion. Outsourcing clients are no longer looking to automate their businesses nor are they looking to cut costs alone. The importance of the traditionally strong time & material business is waning, which means that risks are increasing for players like Infosys and Wipro. 

 

Going beyond the vanilla numbers, HCL Tech's performance suggests that the traditional model of outsourcing is history. The shift in business is clearly evident as HCL's growth in the September quarter has been led by a robust 8% growth in infrastructure services, while application services (bread and butter business) have grown by 1.1%. Ankita Somani of Angel Broking says Excluding IMS, revenue growth was subdued at 1% sequentially.  

 

Another interesting development during the quarter has been the change in its business mix, with the share of time and material contracts in overall revenues falling to 46.9% and managed services & fixed price projects accounting for 53.1% of revenues. The company is seeing clients want large deals to bundle together both application maintenance and infrastructure management services. 
 

This could mean bad news for players which are not in a position to offer such bundled services. 

 

While analysts are worried about the soft growth in the core business, Anil Chanana, chief financial officer at HCL Tech, says given the integrated nature of deals, the lines are blurring between different service lines. However, he says that over the next few quarters, even the application segment will see higher growth.