What is ailing HCL Tech?

Among its peer group, as maintained by Business Standard, HCL Tech is the cheapest stock is the group. The stock trades at a price to earnings of 13.5 as compared to 21.85 times of sector leader TCS. It is also the only company among the top players to trade near its 52-week-low level and trades at a discount to smaller players in the sector like Tech Mahindra and Hexaware.

So what is plaguing the company?

A report in Mint highlights all that is wrong in HCL Tech. The report says the IT firm has lost at least $1.5 billion worth of contracts that had come up for rebid over the last two years. The report points out that for a company with revenue of $6.23 billion, a loss of $1.5 billion in contracts is big.

Analysts were already aware about the issue and had been cautious on the stock for some time now. IIFL in its report on the company has pointed out the company has lost investor’s confidence but not that of its clients. A key investor concern is about a structural slowdown in HCLT’s IMS (infrastructure management system) business, due to increasing competition and a shift towards cloud. On top of it, the company decided not to provide margin guidance, which IIFL feels is a case of poor judgement by the management.

HSBC in its report on the company says that HCL Tech’s recent weak revenue growth has perplexed investors. Though the company has been bagging orders, they are not translating into revenues. HSBC has provided a detailed analysis of why it believes the company’s growth rate is affected.

The HSBC report says that in the past 4-5 years, HCL Tech has signed $5bn worth of contracts each year and added around $650m in revenues annually. This is roughly 12-13% of the contracts signed every year. Usually, 20-25% of contracts should convert to revenues each year (assuming 4-5 years of deal duration). However, HSBC feels there is a genuine reason for the lower revenue growth for HCL Tech.

HCLT Tech shows some element of hardware purchase in the deal, especially in IMS which involves hardware, bandwidth/WAN purchase, data centre, etc. and can account for up to 40% of the contract value that does not pass-through P&L.

HCL Tech’s growth issue is expected to continue for some more time. HCL Tech, according to HSBC, started participating in and winning large Infra contracts from FY09/10.  Based on publically available information, the company is going through peak renewals in FY16/17, which will put further pressure on growth and margins.

Though the company said its retention is around 98% and HSBC has assumed 95%, these numbers are much higher than the western players who have a retention rate of 80%. Renewed business, feels HSBC will experience lower pricing. This adds to the slowing growth for HCLT in FY16, including the impact on profitability, as these well-established deals were running at high efficiency.

However, Prabhudas Lilladher’s analysts who recently met with the management pointed out that in their interaction, the management has clarified that EBIT (earnings before interest and tax) of the core business will remain stable. Volvo and Geometric acquisitions will impact margins and the Volvo large deal will reach steady state margins in 6?8 quarter period.

HSBC agrees that the worst is behind the company. Peak renewals in FY16 are now complete and the extent of margin and growth headwinds to recede. However, dependence on only Infra for growth and relative weakness of HCLT in the digital deals remain concerns. The company’s officials agree that it has been losing clients on account of newer technology.

Another headwind which will impact HCL Tech the most is Brexit. Among the top four players, contribution from Europe is the most for HCL Tech at 31% compared to 26.8% for TCS, 23% for Infosys and 25% for Wipro. The cross currency impact alone on EPS is expected to be a hit of 6.4% for HCL Tech according to a report on the event by Jefferies. Other issues like volume impact and immigration have not been considered in this calculation.

HCL Tech’s slow reaction to the changing times and higher dependence on one of the most volatile places in the world is costing it dear. Just when it was about to come out of the growth issues, Brexit might pull it back in.