HCL Tech Ltd (Q1 F6/12)

CMP Rs401, Target Rs500, Upside 24.6% 

• Volume growth came in below expectation; Pricing up pleasantly by 1.2%; Twelve transformational deals signed
  

• Growth relatively narrow based across verticals; Enterprise Applications down 0.6% in constant currency
  

• Consolidated as well as core software OPM came in-line; BPO profitability improves
  

• Decent employee addition; Fresher ramp-up strong; IT Services attrition down sequentially 
  

• Volume miss a slight concern; Margin management commendable; Maintain BUY

Volume growth coming in below expectation; Pricing up pleasantly by 1.2%; Twelve transformational deals signed

HCLT's volume growth came in at 5.1% qoq and for its IT services business it came in at 5.4% qoq against our expectation of ~6% growth. Core Software reported dollar revenue growth also was ~1% below expectation coming in at 4.5% qoq with cross currency impact of 1% qoq. Infrastructure services grew markedly slower by 5.8% in constant currency vis-à-vis 9.3% growth in Q4 F6/11. Mix based pricing up-tick came in as pleasant surprise growing sequentially by 1.2%. On the BPO side, recovery continued with a fall of 1.3% qoq on constant currency terms as opposed to 5.7% fall last quarter. Company maintained its stance of capitalising on the restructuring/rebid of deals globally which is expected to come in Q2 F6/12. Company won 12 transformational deals in Q1 F6/12 (vis-à-vis 20 deals last quarter)

Growth relatively narrow based across verticals; Enterprise Applications down 0.6% in constant currency

HCLT’s operating matrix suggests a narrow based growth seen across verticals as well as geographies.  Within verticals only Retail & CPG and Manufacturing showed greater than company average growth (in constant currency) at 12% and 8.2% respectively. Financial services grew by a 2.1% qoq. Management indicated large transformation projects started few quarters back coming to an end leading the tepid growth in financial services. Telecom weakness continued to play out as seen in results of larger peers. Amongst geographies, RoW grew marginally by 0.7% as challenges in Japan and cyclical softness in India continued. Amongst services Engineering and R&D lead the pack with 8.6% constant currency growth followed by custom application (+7.3% qoq) and Infrastructure services (+5.8% qoq). A key dampener of the result was de-growth in strong hold service line of Enterprise applications (down 0.6% sequentially) indicating slower discretionary spending. Infrastructure services also grew more softly after a blistering 8.2% CQGR in last four quarters. Top 5/10/20 clients grew below company average as seen in Q4 F6/11.

Consolidated as well as core software OPM came in-line; BPO profitability improves

The operating margin performance in Q1 F6/12 was in-line our expectation falling by 138 bps to 17.1% on a consolidated basis. Core software services margin was also in-line with expectation coming in at 18% (down 153bps sequentially). OPM for Infrastructure services too fell by similar quantum to 18.1%. On the BPO front profitability improved posting an operating loss of Rs34mn as opposed to Rs41mn loss last quarter. The margin performance was largely impacted by salary hikes across the company (200bps impact), higher SG&A (53bps impact) and lower utilization (45bps impact) on the back of strong fresher addition. Operational efficiencies (+84bps) and rupee depreciation cushioned the margin fall. Higher forex loss of Rs179mn offset the higher other income of Rs238mn (Rs71mn last quarter) resulting in a 2.7% fall in reported PAT on a sequential basis.

Decent employee addition; Fresher ramp-up strong; IT Services attrition down sequentially

Decent employee additions continued for HCLT with ~9300 gross additions during the quarter. Net additions in the IT services continued to be decent at 3836 employees (5.7% of Q4 F6/11 base). Strong fresher additions in current as well as last quarter lead to trainee man-months to double sequentially and hence the consequent impact on utilization. BPO headcount came down sequentially by 362 on the back continued restructuring in that line of business. Attrition for IT Services reduced qoq to 15.9% on an LTM basis likely due to salary hikes. Company guided to about 2500 campus offers for the next quarter. 

Volume miss a slight concern; Margin management commendable; Maintain BUY

The volume miss against our expectation in the seasonally strong JAS quarter has come in as a slight disappointment. Growth softened a bit for the strong Infrastructure services (4.3% qoq dollar growth vis-a-vis 8.2% CQGR is previous four quarters). On the flip side, margin management was commendable considering the strong headwind of salary hikes. Management also remains confident (as previously communicated) on strong deal conversions as they come up for renewal/rebidding in the next quarter. Post factoring for the slower growth this quarter as well as weaker rupee, we expect 20+ revenue/earnings CAGR for the company over F6/12-13. Today’s strong correction in the stock appears to be largely unwarranted and we believe the valuations have again turned attractive for ~25% upside from current levels. Maintain BUY