HCL Q1FY15: Revenue below estimate on lower IMS growth; buy

31 July 2014

1QFY15 Results Update | Sector: Technology

HCL Technologies

Ashish Chopra ([email protected]); +91 22 3982 5424

Siddharth Vora ([email protected]); +91 22 3982 5585

BSE SENSEX S&P CNX CMP: INR1,555 TP: INR1,750 Buy 25,895 7,721

Bloomberg HCLT IN

Equity Shares (m) 700.1 M.Cap. (INR b) / (USD b)

1,129.0/18.8

52-Week Range (INR) 1,624/838

1, 6, 12 Rel. Per (%) 2/-20/32

Financials & Valuation (INR Billion)

Y/E June 2015E 2016E 2017E

Sales 363.2 412.7 461.7

EBITDA 91.4 101.4 109.1

PAT 71.5 81.7 88.8

EPS (INR) 100.5 114.1 123.8

EPS Gr. (%) 11.5 13.5 8.5

BV/Sh.(INR) 370.1 458.2 556.1

RoE (%) 35.6 31.4 27.5

RoCE (%) 30.2 27.6 24.6

P/E (x) 15.5 13.6 12.6

EV/EBITDA

10.4 8.9 7.7

Revenue below estimate on lower IMS growth: HCL Tech’s 4QFY14 USD revenues grew 3.4% QoQ to USD1,407m (marginally below estimate of 4.3% QoQ growth to USD1,419m). In constant currency, revenue grew 2.8% QoQ, v/s estimate of 3.8% QoQ. EBITDA margin was 26.3%, -40bp QoQ (in line with estimate of 26%, -70bp QoQ) – as lower gross margin (38.1% v/s estimate of 38.6%) was offset by SGA (at 11.8% v/s estimate of 12.6%). PAT at INR18.34b grew 13.1% QoQ, above estimate of INR16.4b, +1% QoQ), due to lower tax rate of 16.5%, v/s estimate of 22%, and also higher other income (INR1.6b including forex loss, v/s estimate of INR0.85b).

Healthy growth in deal signings YoY: HCLT has signed 50+ transformational engagements totaling over USD 5b in TCV in FY14. This compares with USD3b+ in FY13, lending healthy visibility on revenue growth acceleration.

Peers catch up on IMS growth, expect Software Services growth to improve: Acceleration at peers and deceleration at HCLT in IMS have meant that the growth rates are now similar (QE June 2014 YoY – TCS: +24%, INFO: +21%, HCLT: +26%). However, HCLT guided for software services growth to get stronger in FY15 facilitated by ramp ups in the deals won during the year.

Growth visibility intact, Maintain BUY: We retain our estimates post the results, and expect HCLT to accelerate growth on the back of continued traction in deal wins. While the profitability for the company may cool off going forward, our FY16E EBIT margin estimate of 22.4% is 170bp lower than FY14, building cushion for multiple headwinds. We expect HCLT to grow its USD revenues at a CAGR of 15% over FY14-16E and EPS at a CAGR of 13% during this period. Our target price of INR1,750 discounts FY16E by 15x. Buy.

Investors are advised to refer through disclosures made at the end of the Research Report.

31 July 2014 2

HCL Technologies

4QFY14: Revenue below estimate on lower IMS growth HCL Tech’s 3QFY14 USD revenues grew 3.4% QoQ to USD 1,407m below our

estimate of USD1,419m; 4.3% QoQ. In CC terms revenue grew 2.8% QoQ v/s our estimate of 3.8% QoQ.

Revenues in software services grew to USD850m, +2.2%% (v/s estimate of 3.0% QoQ growth to USD857m). This was third consecutive quarter of 2%+ sequential growth in Software Services.

IMS grew 3.7% QoQ to USD485m (v/s estimate of +6.6% QoQ growth to USD499m). Growth in IMS decelerated for the third consecutive quarter.

BPO business was up 17.7% QoQ to USD72m (v/s estimate of 2.6% QoQ growth to USD62.3m)

Revenues grew 3.4% below our estimate of 4.3%

Source: Company, MOSL

Growth in BPO was a surprise while IMS was below estimate


EBITDA margin was 26.3%, -40bp QoQ (v/s estimate of 26%, -70bp QoQ). This

was primarily due to SGA at 11.8%, -30bp QoQ (v/s our estimate of 12.6%, +50bp QoQ). Gross margin was 38.1% (-80bp QoQ), below our estimate of 38.6%

Reduction in SG&A continue to help margin in 26% range


Highest quarterly gross addition since 1QFY12


PAT was INR18.34b, +13.1% QoQ, above our estimate of INR16.4b. PAT beat was on

account of lower tax rate of 16.5%, v/s our estimate of 22%, and also lower forex loss of INR530m v/s estimated loss of INR751m.

31 July 2014 3

HCL Technologies

Segment-wise performance: BFSI, Telecom/Media, Europe and BPO drive growth Growth was the highest in BPO during the quarter at 17.7% QoQ and 16.8% in

CC terms. While IMS continued to grow at a healthy rate it was not the dominating growth driver, it has now seen a growth deceleration for the third consecutive quarter. It grew at 3.7% QoQ and 3.1% in CC terms.

BPO supported growth on lower than expected IMS performance

Services Contr. to

rev. (%) QoQ

Gr. (%) Contr. to

Incr. rev. (%) 4 Qtr

CQGR (%) EAS 16.8 0.5 2.4 2.0 Engg and R&D Services 27.4 3.8 17.6 1.8 ADM 16.2 2.2 17.8 1.8 IMS 34.5 3.7 36.8 5.9 BPO 5.1 17.7 22.8 7.9


Among verticals, growth was driven by Financial Services (+8.2% QoQ CC),

Telecom Media Publishing & Entertainment (+9.5% QoQ CC) and Retail & CPG (+2.4% QoQ CC). 4-quarter CQGR across verticals shows that the key contributors to the company’s growth are Public Services, Financial Services and Retail & CPG.

BFSI and Media were the best performing verticals during the quarter

Verticals Contr. to rev. (%) QoQ Gr. (%) Contr to inc

rev. (%) 4 Qtr CQGR

(%) Financial Services 28.4 9.3 74.4 6.5 Manufacturing 31.6 (2.1) (20.9) 2.6 Retail & CPG 8.5 2.9 8.5 3.2 Telecom MP&E 8.9 9.5 23.8 0.2 Life Sciences & Healthcare 10.2 1.4 4.2 0.9 Public Services 10.1 2.8 8.5 9.7 Others 2.3 2.1 1.4 (9.9)


Among geographies, Europe grew fastest (+6.5% QoQ CC), followed by Americas

(+1.3% QoQ CC). Europe continues to be key growth driver in the recent quarters, with 4-quarter CQGR of 5.6%.

Europe dominated growth among geographies

Geographies Contr. to rev. (%) QoQ Gr. (%) Contr to inc

rev. (%) 4 Qtr CQGR

(%) US 54.3 1.3 21.5 2.3 Europe 33.0 7.4 70.3 5.6 ROW 12.7 2.2 8.2 3.4


31 July 2014 4

HCL Technologies

Growth Comparison Matrix HCLT WPRO TCS INFY

Geography

North America 1.3 0.8 5.5 3.7

Europe 7.4 -0.3 4.8 -0.9

ROW 2.5 4.2 6.6 -0.1

Industry

BFSI 9.3 0.7 2.5 1.8

Manufacturing -2.1 2.3 5.5 2.6

Retail 2.9 -2.3 7.8 2.1

Energy and Utilities 2.8 0.1 8.2 1.6

Services

Custom application 2.2 -4.7 4.9 0.8

IMS 3.7 5.0 10.7 11.9

BPO 17.7 2.8 3.7 -1.7

EAS / Pkg Implementation / Consulting 0.5 - 6.8 1.3

Engineering Services 3.8 - -1.1 2.0

Source: Company, MOSL Peer group has caught up with HCLT on IMS growth (ex-WPRO) Acceleration at peers and deceleration at HCLT in IMS have meant that the

growth rates are now similar. While for HCLT the rates are cooling off, larger peers are catching up in growth (ex-Wipro) and are at a similar scale (ex-Infosys).

HCLT’s growth at bread-n-butter software services business (~60% of revenues) has remained in single digits YoY in the last 8 quarters, though improving every quarter since the last four. The company expects this to pick up significantly, as the deal wins in Application Services ramp up gradually through FY15.

While growth has picked up across peers, Wipro and TCS have comparable size as well


Deal signings a positive A key positive in the HCL Tech’s disclosures is the intact visibility on revenue

growth - signed 50+ transformational engagements with more than USD 5b in TCV in FY14. Had announced deals of more than USD3b in FY13. We expect USD revenue growth to accelerate in FY15 on the back of the same.

31 July 2014 5

HCL Technologies

Deal signings give higher growth visibility

Source: MOSL, Company

Takeaways from Management Commentary IMS growth outlook: While growth in IMS has relatively dropped in recent

quarters, HCLT remains confident of significant revenue growth in the segment. Encouragingly, HCLT is being invited for more and more complex and larger sized deals, and cited 3 very large deals it won in FY14. Pipeline is very strong in both re-bid markets as well as first-time outsourcing in regions like ANZ. There has been a marginal increase by ISG in the re-bid market, which is now up to USD56-58b. 40% of that is addressable market for HCLT.

Software Services outlook: HCLT has won a number of large deals in Application Services. The steady state revenues will be reflected in quarters to come. Core software services should trickle in significant growth for the company in FY15.

To invest in building capabilities: 5 umbrella themes of HCL Tech, viz. Enterprise of Future, Engineering outsourcing, ALT ASM, Enterprise Function as a Service and Digital System are all gaining traction in the marketplace. However, each offering is at different stage of adoption and these will see increased investments going forward towards capabilities building.

Deal signings: The mega deals won in 1HCY14 are both USD300m+. Both involve complex transformation and then continue into ongoing operations. The margin profile is very similar to current profile. However, in the mega deals, the ramp ups are slower than the normal 6-8 months period.

Intact visibility on growth, Maintain buy We retain our revenue estimates post the results, and expect HCLT to accelerate

growth on the back of continued traction in deal wins. We model 23.1% EBIT margin for FY15 and 22.4% for FY16, which compare with 24.1% in FY14, due to our assumed currency rates of INR58.7in FY15 and INR58 in FY16 (compared to INR61.4 in FY14).

Continued closure of orders keeps prospects of revenue growth at HCLT sanguine. While the profitability for the company may cool off going forward, execution towards extracting efficiencies has been continued to drive outperformance to sustain healthy profitability. Secondly, with greater proportion of locals at onsite, the sensitivity of margins to currency has come down too, reducing the risk to margins in the event of INR appreciation. Our FY16E EBIT margin estimate of 22.4% is 170bp lower than that in FY14, building enough cushion for factors like wage hikes and appreciation in INR. We expect

31 July 2014 6

HCL Technologies

HCLT to grow its USD revenues at a CAGR of 15% over FY14-16E and EPS at a CAGR of 13% during this period. Our target price of INR1,750 discounts FY16E by 15x. Maintain Buy. Narrowing of growth delta to peers amid increasing competitive intensity in IMS is a key risk to our thesis.

Change in estimates Revised Earlier Change

FY15E FY16E FY15E FY16E FY15E FY16E

INR/USD 58.7 58.0 58.7 57.9 0.0% 0.2%

USD Revenue - m 6,184 7,115 6,192 7,121 -0.1% -0.1%

USD revenue growth 15.4% 15.1% 15.3% 15.0% 11bp 5bp

EBIT Margin 23.1% 22.4% 22.9% 22.1% 15bp 30bp

EPS - INR 100.5 114.1 99.6 111.7 0.9% 2.2%

EPS Growth 11.5% 13.5% 14.1% 12.2%


Other result highlights Overall headcount increased by 1,501 employees during the quarter to 91,691

employees. Gross additions during the quarter of 8,442. Blended utilization for the quarter was 84.5%, +30bp QoQ. The company signed deals in excess of USD5bn in TCV in FY14. Company had

signed more than USD1b of deal TCV in prior three quarters. Attrition rate in IT Services was 16.9%, v/s 16.9% in 3QFY14. Billed receivables increased to 60 days (v/s 58 in 3QFY14). Revenue proportion from Fixed Price contracts increased 80bp QoQ to 56.5%. Total hedges amount to USD1.15b, USD825m of which is cash flow hedges and

USD325m are Balance Sheet hedges. The hedges are at an average rate of INR62.61.

31 July 2014 7

HCL Technologies

Story in Charts

ISG upgraded the opportunity in the churn markets…


… HCLT continues to reap its benefits through deal wins…


..reflected in IMS being a key growth driver for HCLT


Uptick in software services growth improves the growth mix


Growth and scale have driven Continued OPM surprise...


…and 4th consecutive year of spectacular PAT growth


31 July 2014 8

HCL Technologies

Operating Metrics

1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14

Service Line wise (%)

Enterprise application services 19.9 19.0 19.0 17.3 17.3 17.1 17.2 16.8

Engineering and R&D Services 18.1 17.6 17.1 17.3 16.9 16.6 16.1 16.2

Custom Application 31.0 30.6 29.7 29.2 28.4 28.0 27.7 27.4

Infrastructure Services 26.6 28.4 29.9 31.5 33.1 33.7 34.4 34.5

BPO Services 4.5 4.4 4.3 4.3 4.3 4.6 4.5 5.1

Vertical wise (%)

BFSI 24.1 25.8 25.0 25.3 26.0 25.9 26.9 28.4

Manufacturing 31.6 31.0 28.4 32.7 33.3 33.6 33.3 31.6

Retail & CPG 9.2 9.0 8.9 8.6 8.3 8.6 8.5 8.5

Telecom MP&E 10.4 10.3 6.7 10.1 9.1 8.9 8.4 8.9

Life Sciences 12.0 11.9 11.3 11.3 11.6 10.8 10.4 10.2

Public Services 6.9 7.0 7.7 8.0 7.8 9.2 10.1 10.1

Others 5.8 4.8 4.8 4.0 3.9 3.1 2.3 2.3

Geography wise (%)

US 57.0 56.9 57.1 57.0 57.2 56.9 55.4 54.3

Europe 27.9 28.5 28.9 30.5 30.2 31.3 31.8 33.0

ROW 15.1 14.6 14.0 12.5 12.6 11.8 12.8 12.7

Client wise (%)

Top 5 clients 16.2 15.7 15.4 15.4 15.1 14.8 15.0 14.7

Top 10 clients 24.5 24.2 24.0 23.8 23.8 23.8 24.1 23.7

Top 20 clients 33.6 33.3 32.8 33.0 33.2 33.6 34.2 33.7

QoQ Growth (%)

Service Line wise

Enterprise application services -1.3 -1.1 3.2 -6.1 1.2 2.5 4.0 0.5

Engineering and R&D Services 0.4 0.8 0.2 4.3 1.4 2.1 0.1 3.8

Custom Application 2.2 2.3 0.1 1.4 0.6 2.4 2.2 2.2

Infrastructure Services 10.7 10.6 8.6 8.6 8.7 6.0 5.1 3.7

BPO Services 5.5 1.3 0.8 3.1 1.9 13.7 -0.7 17.7

Vertical wise

BFSI 4.5 10.9 0.0 4.3 6.2 3.8 6.8 9.3

Manufacturing 14.8 1.7 -5.5 18.7 5.6 5.0 2.0 -2.1

Retail & CPG 10.4 1.4 2.0 -0.4 -0.7 7.5 2.8 2.9

Telecom MP&E 60.1 2.6 -32.9 55.4 -6.4 1.2 -2.6 9.5

Life Sciences 14.6 2.8 -2.0 3.1 6.8 -3.8 -0.7 1.4

Public Services -1.1 5.1 13.5 7.1 1.5 21.8 13.9 2.8

Others -6.5 -14.2 3.2 -14.1 -2.6 -16.9 -20.4 2.1

Geography wise

US 3.9 3.5 3.5 2.9 4.0 3.4 0.4 1.3

Europe 2.8 5.9 4.6 8.8 2.6 7.8 4.8 7.4

ROW 1.2 0.2 -1.1 -8.0 3.2 -2.3 11.0 2.2

Client wise

Top 5 clients 1.9 0.4 1.2 3.1 1.5 1.9 4.4 1.3

Top 10 clients 2.3 2.4 2.3 2.2 3.5 4.0 4.3 1.6

Top 20 clients 1.7 2.7 1.6 3.7 4.1 5.3 4.9 1.8


31 July 2014 9

HCL Technologies

HCL Technologies: an investment profile Company description HCL Technologies is one of the largest IT services companies in India, employing over 91,000 people. It is a leader in remote infrastructure management, engineering and R&D services and has sizeable BPO, Enterprise Solutions and ADM practices. Key investment arguments Healthy strike rate in large deal wins have

ascertained the company’s prowess in the RTB space.

Fastest growth trajectory in the infrastructure management space, the strongest growth segment for Indian IT.

A comprehensive IT services company with a wide portfolio of services including R&D, Enterprise, BPO, Infrastructure Management and Enterprise Application services.

Key investment risks Risk-pricing in FPP contracts could go wrong. Slower than anticipated ramp-up in large deals

leading to moderation in revenue growth. Appreciation of the rupee and cross currency

movements could hamper profitability.

Recent developments HCLT signed 50+ transformational engagements with

more than USD5b of TCV in FY14. HCLT was selected by Norway’s leading financial

services institution for IT infrastructure Services and Application Operations for its non-mainframe platforms and end user services.

Valuation and view We expect USD revenues to grow at a CAGR of 15.2%

over FY14-16 and EPS CAGR to be 12.5%. The stock trades at 15.5x FY15E and 13.6x FY16E EPS.

Maintain Buy, with a target price of INR1,750, which discounts our FY16E EPS by 15x.

Sector view With strengthening demand in the US and large deals

traction in traditional services in Europe, industry growth in FY15 should be better than FY14.

Digital technologies/SMAC may not be a needle mover right now but are increasingly seeing traction and can potentially drive downstream opportunity.

We see better risk-reward in Tier-I v/s Tier-II. Currency is a key risk to valuations, and Tier-II has a

higher sensitivity to the same v/s Tier-I

Comparative valuations HCLT TCS WPRO P/E (x) FY15E 15.5 23.3 15.5 FY16E 13.6 20.2 13.8 P/BV (x) FY15E 4.2 7.2 3.3 FY16E 3.4 5.9 2.8 EV/Sales (x) FY15E 3.0 5.9 2.8 FY16E 2.6 5.0 2.5 EV/EBITDA (x) FY15E 10.4 17.1 10.8

FY16E 8.9 14.8 9.4

EPS: MOSL forecast v/s consensus (INR) MOSL

Forecast Consensus

Forecast Variation

(%) FY14 100.5 99.2 1.3 FY15 114.1 111.3 2.6 Target price and recommendation

Current Price (INR)

Target Price (INR)

Upside (%)

Reco

1,550 1,750 12.5 Buy

Shareholding pattern (%) Jun-14 Mar-14 Jun-13

Promoter 61.7 61.7 61.9

DII 3.7 3.7 6.5

FII 28.9 28.6 24.5

Others 5.8 6.0 7.1

Notes: FII includes depository receipts

Stock performance (1-year)

31 July 2014 10

HCL Technologies

Financials and valuation

Income Statement (INR Million)Y/E June 2014 2015E 2016E 2017ESales 329,180 363,226 412,673 461,734 Change (%) 27.9 10.3 13.6 11.9Cost of Goods Sold 202,160 227,660 262,894 299,565Gross Profit 127,020 135,566 149,780 162,169Sel l ing & Admin Exp. 40,350 44,193 48,349 53,043EBITDA 86,670 91,373 101,431 109,126 % of Net Sa les 26.3 25.2 24.6 23.6Depreciation 7,320 7,632 8,866 9,920EBIT 79,350 83,741 92,565 99,206Forex Gain -5,890 -734 2,769 2,281Other Income 5,730 7,493 8,118 10,919PBT 79,190 90,500 103,451 112,406Tax 15,480 19,005 21,725 23,605 Rate (%) 19.5 21.0 21.0 21.0

PAT 63,710 71,495 81,727 88,801Net Income 63,710 71,495 81,727 88,801 Change (%) 58.3 12.2 14.3 8.7

Balance Sheet (INR Million)Y/E June 2014 2015E 2016E 2017EShare Capita l 1,396 1,398 1,400 1,401Other Reserves 199,418 257,365 319,299 388,196Net Worth 200,814 258,764 320,698 389,597Loans 7,509 6,329 6,329 6,329Capital Employed 208,323 265,093 327,027 395,926

Gross Block 78,595 92,695 97,750 101,509Less : Depreciation 47,130 54,762 54,762 54,762Net Block 31,465 37,933 42,988 46,747Intangibles 74,954 77,848 81,746 85,114Investments 89,948 89,948 89,948 89,948Curr. Assets 108,537 162,833 230,334 307,198Debtors 77,086 85,059 96,638 108,127Cash & Bank Ba lance 10,206 53,908 106,301 168,626Loans & Advances 21,245 23,866 27,395 30,445Current Liab. & Prov 96,581 103,469 117,989 133,082Current Liabi l i ties 81,966 87,051 99,143 112,138Provis ions 14,615 16,418 18,846 20,944Net Current Assets 11,956 59,363 112,346 174,116

Application of Funds 208,323 265,093 327,027 395,926E: MOSL Estimates

RatiosY/E June 2014 2015E 2016E 2017EDiluted (INR)EPS after ESOP chg 90.2 100.5 114.1 123.8Cash EPS 100.5 111.2 126.5 137.6Book Value 287.6 370.1 458.2 556.1DPS 22.0 16.6 24.2 24.3Payout % 24.4 16.5 21.2 19.6

Valuation (x)P/E a fter ESOP chg 17.2 15.5 13.6 12.6Cash P/E 15.5 14.0 12.3 11.3EV/EBITDA 11.5 10.4 8.9 7.7EV/Sales 3.0 2.6 2.2 1.8Price/Book Value 5.4 4.2 3.4 2.8Dividend Yield (%) 1.4 1.1 1.6 1.6

Profitability Ratios (%)RoE 42.4 35.6 31.4 27.5RoCE 35.6 30.2 27.6 24.6

Turnover RatiosDebtors (Days) 77 81 80 81Asset Turnover (x) 11.2 10.5 10.2 10.3

Leverage RatioDebt/Equity (x) 0.0 0.0 0.0 0.0

Cash Flow Statement (INR Million)Y/E June 2014 2015E 2016E 2017ECF from Operations 71,030 79,127 90,592 98,721Chg. in Working Capita l -1,486 -3,705 -589 554Net Operating CF 69,544 75,422 90,003 99,275

Net Purchase of FA -14,410 -16,994 -17,818 -17,049Net Purchase of Invest. -46,957 0 0 0Net Cash from Inv. -61,367 -16,994 -17,818 -17,049

Is sue of shares/other adj 12,155 11 25 19Proceeds from LTB/STB 549 -1,180 0 0Dividend Payments -17,995 -13,556 -19,816 -19,921Net CF from Finan. -5,292 -14,725 -19,792 -19,901

Free Cash Flow 55,134 58,427 72,185 82,226Net Cash Flow 2,885 43,702 52,394 62,325

Opening Cash Balance 7,322 10,207 53,909 106,303Closing CashBalance 10,207 53,909 106,303 168,628E: MOSL Estimates

31 July 2014 11

HCL Technologies

N O T E S

31 July 2014 12

HCL Technologies

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Disclosure of Interest Statement HCL TECHNOLOGIES LTD Analyst ownership of the stock No

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Economy & Finance

HCL Q1FY15: Revenue below estimate on lower IMS growth; buy