HCL chasing growth over margins not working

Results short of estimates; pressure in financials, application services could continue as overhang

Following the footsteps of its closest peer Wipro, HCL Technologies posted weak numbers for the March quarter. The company's constant currency revenues grew 1.7 per cent sequentially and missed Street expectations of 2.5-three per cent. (The use of constant currencies allows companies to show performance unaffected by currency fluctuations.) This is the fifth quarter in a row where this metric has grown below three per cent. The lower constant currency revenue growth is also out of line with the management's consistent commentary of a strong deals kitty. This quarter as well, the management has signed seven large deals with a total contract value (TCV) of $2 billion, taking the first nine months' figure to $4 billion for 25 deals. Weakness in application services (40 per cent of revenues) as well as manufacturing and financials verticals (together contribute 56 per cent to consolidated revenues) pulled down HCL Technologies' results in the quarter.

The management expects the financials and application services businesses to remain weak. These segments could continue to grow in low to mid-single digits year-on-year. The Volvo deal will aid double-digit revenue growth in the manufacturing vertical (31.5 per cent of revenues) from the June quarter onwards and provide some support to overall performance, but it will impact margins.

While HCL's Ebit (earnings before interest and tax) margins grew 73 basis points sequentially to 20.8 per cent in the March quarter, the Volvo acquisition will pressure this metric. Anil Chanana, financial chief, HCL Technologies, says "We want to retain the flexibility to make all investment needed to boost our business. As a result, we have decided not to stick to any margin range."

While client budgets will be flat in FY17, Chanana believes telecom, life sciences, and health care, and oil and gas verticals look promising.

The lower margin (relative to peers) is a key reason HCL Technologies' stock trades at a discount to most of its peers. In fact, for the last one year, HCL's stock has lagged its peers, including TCS, Infosys, and Wipro.

At current levels of Rs 804 (down four per cent on Thursday), it trades at 14 times the FY17 estimated earnings, same as Wipro but lower than the 18-19 times multiple that TCS and Infosys trade at. Ashish Chopra, analyst, Motilal Oswal Securities, says, "We believe acquisitions could put HCL Technologies' margins at risk. The stock will not see meaningful upsides until the management addresses growth concerns as well, as there is better visibility on margins."