HCL Tech's core business continues to struggle

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

The business of technology outsourcing is changing rapidly and HCL Tech's September quarter numbers point to a shift. Like most other information technology (IT) companies, its basic numbers look good. The company reported a 3.5 per cent growth in dollar revenue quarter-on-quarter (q-o-q) and a 300 basis point expansion in margin.

What is worth noting are the nine new transformational deals (total contract value over $1 billion), it signed during the quarter. The company has managed to keep its total contract value of new deals at this level for several quarters. Standard Chartered Equity Research believes large deals (with contract size above $25 million) are the key growth drivers for Indian IT services companies. So, while the 3.5 per cent sequential growth in dollar revenue is marginally below market expectations, HCL's changing business mix, stronger operating metrics, high return on equity (34 per cent in the September quarter) and robust deal pipeline are more relevant for valuations. Investors need to start looking at the business mix and not only revenue growth and margin expansion. Outsourcing clients are no longer looking to automate their businesses to cut costs alone. The importance of the traditionally strong time and material business is waning, which means risks are increasing for players such as Infosys and Wipro.

Going beyond the basic numbers, HCL Tech's performance suggests the traditional model of outsourcing is history. The shift is evident, as growth in the quarter has been led by a robust eight per cent growth in infrastructure services, while application services (the bread and butter business) have grown 1.1 per cent. Ankita Somani of Angel Broking says excluding infrastructure management services (IMS), revenue growth was subdued at one per cent sequentially.

Another interesting development has been the change in business mix, with the share of time and material contracts in overall revenue falling to 46.9 per cent, and managed services and fixed price projects accounting for the rest. Notably, clients want large deals to bundle both application maintenance and IMS. This could mean bad news for those not in a position to offer such bundled services. While analysts are worried about soft growth in the core business, Anil Chanana, chief financial officer at HCL Tech, says given the integrated nature of deals, the lines between different service lines are blurring. However, he says over the next few quarters, even the application segment will see higher growth.