Margin headwinds may cap upsides for HCL Tech despite strong top line show

What works in favour are strong revenue growth, deal wins and attractive valuations

A muted margin outlook and cut in earnings estimates of IT major HCL Technologies led to a 5.9 per cent fall in its stock price, the highest drop among Sensex constituents. The company had declared its December quarter results after market hours on Friday. 
 
While the company did not disappoint on the growth front with a 7.6 per cent constant currency jump, which was at a 74-quarter high and best among the tier-1 companies thus far, the operational performance suffered. Margins at 19 per cent were flat on a sequential basis and missed estimates by 40-70 basis points (bps). 
 
The products and platforms business, which has been the laggard over the past quarters, did much better-than-expected supporting the topline growth as well as margins. The segment revenues were up 24.5 per cent, aided by deal spilling over from the September quarter, and it reported a growth after falling for three consecutive quarters on a sequential basis. In a seasonally weak quarter, the IT services business and the engineering research and development segment, too, reported strong growth beating expectations.

The strong topline performance did not percolate down to the margins. While products and platforms, which accounts for 13.5 per cent of revenues, saw its margins move up 12.5 percentage points, profitability for IT services (70 per cent of revenues) was down 220 basis points. Cost pressures especially on the employee front due to higher recruitment costs, salary hikes, retention and other investments dented margins. 

Though the company has retained its 19-21 per cent margin guidance for financial year 2021-22 (FY22), the management indicated that margins will be closer to the lower end of this range with a 10-20 bps downside risk. This factors in the performance over the last nine months, supply side inflation and planned investments across geographies, in digital capabilities and in boosting its leadership team. 

CLSA’s Pankaj Kapoor believes that supply side pressures appear to be affecting HCL more than peers. Higher attrition, aggressive M&A which is inflating transition costs and lack of leverage from the pyramid structure despite the company’s aggressive campus intake indicates that an early respite is unlikely. These headwinds had led to 70-100 basis points downward revision in margins for FY23 and FY24 by Jefferies.

Brokerages, however, are positive on the sales front, given double-digit dollar revenue growth guidance for FY22 and the 64 per cent year-on-year gain in new deal value at $2.1 billion. With valuations turning attractive (30 per cent discount to sector leaders), investors can consider the stock on dips from the longer-term viewpoint.