Addressing key investor concerns. Dec-09

Transcription

1 22 March 2011 Update Sector: IT BSE SENSEX S&P CNX 17,988 5,414 Rs452 HCL Technologies Buy Bloomberg HCLT IN Equity Shares (m) Week Range (Rs) 518/338 1,6,12 Rel. Perf. (%) 0/17/19 M.Cap. (Rs b) M.Cap. (US$ b) 7.0 Addressing key investor concerns High visibility on near-term margin expansion; working capital execution consistent with peers Despite faster than peer quarterly revenue growth over the period March 2009 to December 2010 (CQGR of 6.3% v/s 5.1% for Infosys and 5.9% for TCS), HCL trades at a one-year forward P/E of just 14.6x, lower than its five-year median P/E of 16.5x. We believe that HCL's subdued multiple reflects investor concerns around the following two issues, which we attempt to address in this report: Y/E June 2011E 2012E 2013E Sales (Rs b) EBITDA (Rs b) NP (Rs b) EPS (Rs) EPS Gr. (%) BV/Sh. (Rs) P/E (x) P/BV (x) EV/EBITDA (x) EV/Sales (x) RoE (%) RoCE (%) Shareholding pattern % (Dec-10) Domestic Inst, 5.8 Foreign, 23.3 Issue #1: Revenue growth/margin conundrum - can the twain meet?: Over the last five quarters, HCL has not been able to manage revenue growth and margin expansion/preservation concurrently. Its absolute EBITDA has declined from September 2009 levels, despite revenue growing ~30% over the period September December EBITDA margin has declined from 22.1% in September 2009 to 15.7% in December However, we believe that a part of the 640bp decline in EBIDTA margin was driven by transient factors rather than structural, prominent among them being: [1] significant employee additions ahead of demand, as reflected in utilization declining from 76% in 1QFY10 to 70% in 2QFY11, [2] higher proportion of lateral additions (~80% of gross adds in IT Services v/s 70% historically), and [3] significant investments in SGA to drive sustained growth. SGA increased by 110bp to 15.2% within five quarters. Continued decline in EBITDA margin as SGA costs increase and utilization drops (%) EBITDA Margin - LHS SGA - LHS Utilization (Incl. Trainees) - RHS Promoter 64.8 Others, Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec Stock performance (1 year) Mar-10 HCL Technologies Sensex - Rebased Jun-10 Sep-10 Dec-10 Mar-11 Given the "investment centric" reasons for margin deterioration and our belief that the heavy lifting on investments is behind the company, we expect HCL Tech to begin harvesting the benefits of its investments in the next few quarters, leading to margin expansion. We see margins expanding on account of the following levers: [1] SGA investments (as a proportion of revenue) are likely to decline, providing scope for bp margin expansion, [2] increase in utilization to the historical average (since 4QFY07) if not the recent highs (back to 73-74%; recent high has been 76%+) can contribute ~100bp of margin expansion, [3] improvement in bulge mix according to our calculations (detailed explanation on page 6-7) can aid another 50bp margin expansion, Kuldeep Koul (Kuldeep.Koul@MotilalOswal.com); Tel: /Ashish Chopra (Ashish.Chopra@MotilalOswal.com); Tel:

2 and [4] BPO turnaround from the current quarterly loss run rate of US$5m-6m can add another ~60bp (just by breaking even). We would expect the first two to be more of nearterm drivers and last two to be long-term drivers (BPO breakeven expected only in 3QFY12). We are reasonably confident about HCL achieving EBITDA margin expansion of ~200bp over the next two quarters. Though wage inflation should impact margins in the September and December quarters, it is very likely that HCL will be able to average % EBITDA margin for FY12 as well. Higher pricing realization driven by productivity improvement, increase in fixed bid mix and continued improvement in offshore mix is likely to offset the negative impact from wage inflation. Issue #2: Cash conversion trails behind peers The meager 14% operating cash conversion in 1QFY11 has fuelled concerns over HCL Tech's working capital management. We have looked at the company's cash flow/working capital metrics over the last 3-4 years. We find that though HCL Tech's numbers exhibit more volatility from quarter to quarter, its cash conversion is actually better than peers, ex-infosys, when aggregating the numbers on annual or multi-quarter basis. Looking at the performance over the last three years, HCL Tech's cash conversion is second only to Infosys. Over CY08-10, HCL Tech's OCF to Net Income conversion has been 117.5% as against 93% for Wipro and 107% for TCS. Only Infosys scores higher, with 131% conversion. Likewise, even some of the key working capital metrics like receivable days compare favorably with respect to competition. Excluding unbilled revenue, HCL Tech's receivables have averaged at 63 days over the last three quarters, lower than 79 days for TCS. Even including unbilled revenue, HCL Tech scores better than TCS, with the last three quarter average at 88 days as against 99 days for TCS. On an annual basis, cash conversion at HCL Tech is the best after Infosys (OCF as a % of NI) HCL Tech TCS Infosys Wipro CY08 CY09 CY10 Limited risk to our numbers; valuations reasonable; reiterate Buy The stock trades at 14.6x FY12E and 12.4x FY13E earnings v/s a median P/E of 16.5x. We expect revenue to grow at a CAGR of 22.9% and EPS to grow at a CAGR of 27.5% over FY11-13 (highest expected EPS growth amongst the top-4). We reiterate Buy, with a target price of Rs550 (15x FY13E earnings), ~22% upside, with further upside likely on account of multiple expansion driven by better execution on the above two concerns. 22 March

3 Despite faster than peer quarterly revenue growth over the period March 2009 to December 2010 (CQGR of 6.3% v/s 5.1% for Infosys and 5.9% for TCS), HCL trades at a one-year forward P/E of just 14.6x, lower than its five-year median P/E of 16.5x. We believe that HCL's subdued multiple reflects investor concerns around the following two issues, which we attempt to address in this report: Issue#1: Revenue growth/margin conundrum - can the twain meet? While emerging from the downturn, HCL Tech has been unable to manage revenue growth and margin expansion concurrently. Though its revenue has grown at a CQGR of 6.3% post the acquisition of Axon, EBITDA has grown at a CQGR of just 0.3%. In fact, over the last five quarters (since September 2009, when EBITDA margin peaked at 22.1%), while revenue CQGR has been 6.5%, EBITDA CQGR has been -2%. Robust revenue growth, but EBITDA has declined over the last five quarters Revenue and EBITDA (Indexed at 100) Revenue EBITDA Sep 09 Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 Continued decline in EBITDA margin as SGA costs increase EBITDA Margin SGA EBITDA Margin and SGA (%) Investment centric factors lead to decline in EBITDA margins key among them being increased SGA investments and drop in utilization on hiring ahead of demand Sep 09 Dec 09 Mar 10 Jun 10 Sep 10 Dec 10.and utilization drops on increased hiring (%) Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec March

4 Part of margin decline from recent peak (22.1% in 1QFY10) driven by factors transient in nature and not structural While we would ideally like to see a fine balance between revenue growth and margins from quarter to quarter, we understand that real world dynamics may drive a short-term disparity for opportunistic growth oriented companies like HCL Tech. HCL Tech's gross margins are structurally disadvantaged relative to peers like Infosys and TCS due to higher use of experienced manpower (more laterals). However, we believe that a part of the recent margin decline of 640bp from the recent peak of 22.1% in 1QFY10 is because of factors transient in nature and not structural. The reasons because of which HCL Tech's margins have taken a hit are mostly investment driven (barring wage inflation and currency), as exemplified by the following: 1. Significant employee addition ahead of demand, as reflected in utilization declining from 76% in 1QFY10 to 70% in 2QFY11. For its peers, utilization has increased during this period - from 67.3% to 72.6% for Infosys, and from 73.6% to 77.1% for TCS. Strong hiring ahead of demand 80,000 Total Headcount (LHS) QoQ Grow th - % (RHS) 12 70, , , , QFY08 2QFY08 3QFY08 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 1QFY11 2QFY11 Highest proportion of laterals addition compared to peers 80% over the last five quarters v/s 30% at Infosys and 36% at TCS 2. A large part of the gross additions over the last five quarters has been laterals, which puts an upward pressure on costs. In the last five quarters, with the exception of 1QFY11 when laterals constituted 67% of the gross additions, lateral additions have been at least 80% v/s the historical average of ~70%. Lateral additions during this period have averaged at 30% for Infosys and 36% for TCS. 3. HCL Tech has made significant investments in ramping up sales engine to drive sustained growth. SGA increased by 110bp to 15.2% within five quarters. In absolute terms, the expenditure on SGA increased from Rs4.3b in 1QFY10 to Rs5.9b in 2QFY11, growing at a CQGR of 6.6%. Surge in SGA costs amidst demand recovery (Rs m) 5,553 5,884 4,950 4,279 4,432 4,304 1QFY10 2QFY10 3QFY10 4QFY10 1QFY11 2QFY11 22 March

5 Heavy lifting on investments behind; operating leverage ahead We believe that the heavy lifting on investments is largely behind the company. In the next few quarters, we expect HCL Tech to harvest the benefits of these investments. We believe that the next leg of earnings growth for HCL Tech will be driven by margin expansion in consonance with industry-matching revenue growth. We present below the key drivers available to HCL Tech to improve on its margin profile, along with the approximate quantification for each factor. 1. SGA leverage:hcl Tech's SGA has increased by 110bp over the past five quarters. However, we believe that further absolute upsides in SGA over the next few quarters should be marginal, providing significant leverage (75-100bp). Higher SGA investments manifest in the company's client metrics, as well. The number of active clients at HCL Tech increased by 16.4% to 434 in December 2010 from 373 in September To put this in context, the absolute number of client additions was same in the case of both HCL and TCS at ~60 clients, despite a much higher base at TCS (from 896 to 959). SGA costs have grown the fastest at HCL Tech (SGA costs - indexed at 100) SGA leverage can potentially add bp to the margins. Gradual ramp up in the new client engagements to manifest in better SGA leverage going forward HCL Tech Infosys TCS Wipro Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Looking at it differently, HCL's annualized revenue per client five quarters ago (in September 2009) was the same as that for TCS at US$6.8m. However, this metric currently stands at US$8m per client for HCL, well below TCS' US$8.9m in December We believe that, gradual ramp-up in engagements with new clients should help raise HCL Tech's revenue per client, consequently manifesting in better SGA leverage, as well. What exemplifies this is that in 2QFY11, when HCL Tech's annualized revenue per client increased by 5.5% sequentially, SGA (as a percentage of revenue) declined by 20bp QoQ. 22 March

6 Client additions at HCL Tech much faster than at TCS, leading to a temporary underperformance in revenue per client TCS HCL Tech TCS HCL Tech indexed at Sep 09 Dec 09 Mar 10 Jun 10 Sep 09 Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 Annualized (US$m) Sep 10 Dec Improvement in utilization: The reversion of utilization to the historical average (since 4QFY07) if not the recent highs (back to 73-74%; recent high has been 76%+) can contribute ~100bp of margin expansion for HCL Tech over the next few quarters. One percentage point improvement in utilization contributes 25-30bp to the margins. Least utilization among peers implies maximum scope from the potential lever 1% point improvement in utilization contributes 25-30bp to margins; utilization is least among peers, with a potential to go up by at least another 3-4% points Utilization (including Trainees, %) HCL Tech TCS Infosys Wipro Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec Improvement in bulge mix: According to our calculations, lateral hiring returning to the historical average, i.e. 70% laterals v/s ~80% in the recent quarters, can raise margins by another 50bp. The details of the same are appended in the table below, which is modeled on the following assumptions: Laterals' average salary per annum: Rs700,000 Fresher's salary per annum: Rs300,000 Percentage of employees offshore: 75 (derived from efforts and utilization data) 22 March

7 Lateral addition as a proportion of gross additions reverting to the historical average of 70% can add another 50bp to margins Lateral hiring returning to the historical average can raise margins by another 50bp HCL Tech Employees (%) Total Onsite Offshore Employees as on Sep Laterals Freshers Total employees increased 40% in the past 5 quarters (ex BPO) Incremental additions Laterals have constituted 80% of these additions Total Employees as on Dec Total Laterals Total Freshers Taking Dec 10 as the new base Employees Laterals = 102 / 140 * Freshers = 38 / 140 * Salary Details 70% Laterals 73% Laterals (Historically) (last 5 quarters impact) Offshore employees as % of total - (I) Of them, Laterals - (II) Freshers Offshore Employee break-up Offshore Laterals as % of total offshore employees (I II) Freshers as a % of total offshore employees Lateral Salary per annum (Rs) 700, ,000 Fresher Salary per annum (Rs) 300, ,000 Blended (assuming 70% Laterals) 580, ,000 Change in Blended Salary due to more laterals (%) 2.1 Offshore salaries as % of revenues 25 Impact on margins due to higher lateral addition 2.1% * 25% = 50bp Proportion of lateral hiring has remained significantly higher than peers HCL Tech (IT Services) TCS Infosys Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec March

8 Absolute lateral hires more than Infosys in all but one of the last 11 quarters on much lower employee base - gross Higher absolute lateral hires than Infosys (which has a much larger employee base) highlights HCL s structurally disadvantaged gross margins 2,391 2,013 2,802 1,763 1,704 1,338 HCL Tech 1, Infosys Jun-08 1,671 1,064 2,980 1,420 4,973 2,041 6,854 2,942 5,598 4,138 3,971 5,212 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 BPO turnaround is a margin lever over the intermediate term, with mere break-even yielding another 60bp upside 4. Eventual turnaround of BPO: Though not imminent, BPO business just reverting to breakeven (expected from 3QFY12) from the current quarterly loss run rate of US$5m- 6m can add another ~60bp to margins. The BPO business constitutes 5.7% of revenue currently, with the current EBIT margin being -11%. In aggregate, the above four factors by themselves imply potential for margins to expand by ~300bp. As against that, our EBITDA margin assumption for HCL Tech stands at 17.9% for FY12, an expansion of 220bp from current levels. We are reasonably confident about HCL achieving EBITDA margin expansion of ~200bp over the next two quarters. Though wage inflation should impact margins in the September and December quarters, it is very likely that HCL will be able to average % EBITDA margin for FY12 as well. Higher pricing realization driven by productivity improvement, increase in fixed bid mix and continued improvement in offshore mix is likely to offset the negative impact from wage inflation. The focus point for us will be to see whether HCL is able to keep pace with its peers on revenue growth while it is improving on its margin profile. Any slackening on the growth front relative to peers would again raise the issue of HCL Tech not being able to manage both margin expansion and revenue growth at the same time. We do not expect industryleading growth, but growth needs to be around peer averages for HCL Tech to command higher valuation multiples. 22 March

9 14% OCF conversion (OCF as a % of NI) in 1QFY11 was an aberration resulting from investments in a turnkey smart grid project Issue#2: Cash conversion trails behind peers The meager 14% operating cash conversion in 1QFY11 has fuelled concerns over HCL Tech's working capital management and of cash conversion trailing peers. This was, however, a one-time aberration resulting from increased investments in the execution of a turnkey smart grid project for the power industry. The project requires smart meters to be integrated with the company's software and solutions. HCL Tech had to get smart meters in its labs to develop the management software around them. The billing of this project is expected to start from 3QFY11 (March 2011 quarter) and the assets will be off the company's books post the implementation. Long-term analysis of working capital/cash management reveals consistent execution Looking at the performance over the last three years, HCL Tech's cash conversion is second only to Infosys, with TCS and Wipro lagging behind (Wipro's numbers get distorted by its consumer business, where the working capital dynamics are different). Over CY08-10, HCL Tech's OCF to Net Income conversion has been 117.5% as against 93% for Wipro and 107% for TCS. Only Infosys scores higher, with 131% conversion. When viewed on an annual basis, cash conversion at OCF to Net Income conversion only behind Infosys, HCL Tech is the best after Infosys (OCF as a % of NI) but more volatile than peers (%) HCL Tech TCS Infosys Wipro 320 HCL Tech TCS Infosys Wipro CY08 CY09 CY10 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Long term analysis shows that HCL s working capital management is second only to Infosys; just more volatile than peers The only issue with HCL Tech is that its cash collection efforts and consequently cash flow conversion seem to be lumpier than peers (more variability from quarter to quarter, as evident in the exhibit above). We would like to point out here that even on a disaggregated basis, key metrics for HCL Tech are better than peers. Excluding unbilled revenue, HCL Tech's receivables have averaged at 63 days over the last three quarters, lower than 79 days for TCS. Even including unbilled revenue, HCL Tech scores better than TCS, with the last three quarter average at 88 days as against 99 days for TCS. 22 March

10 Improved DSO days; comparable to Infosys 90 HCL Tech Infosys TCS HCL Tech's debtor days consistently lower than TCS' Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Infosys, on the other hand, outscores both, having receivables of 62 days excluding unbilled revenue and just 76 days including unbilled revenue. We see impeccable working capital and cash management as one more reason as to why Infosys should trade at a sustained premium to peers, even including TCS. However, capital intensity has been higher at HCL Tech. Capex/Sales at HCL Tech averaged 4.8% during the last two years, v/s 3.8% for TCS and 3.9% for Infosys. HCL Tech has been a relatively late entrant into the IT Services business, and much of this higher intensity is explained by its investments in setting up global delivery centers across various destinations, as the company ramps up its business. Capex intensity highest at HCL Tech in six of the last eight quarters (% of sales) HCL Tech Infosys TCS Higher capital intensity at HCL Tech v/s peers given its ongoing investments in Global Delivery Centers Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Limited risk to our numbers; valuations reasonable; reiterate Buy The stock trades at 14.6x FY12E and 12.4x FY13E earnings v/s a median P/E of 16.5x. We expect revenue to grow at a CAGR of 22.9% and EPS to grow at a CAGR of 27.5% over FY11-13 (highest expected EPS growth amongst the top-4). Expectation of better EPS CAGR is mainly due to: [1] margin expansion driven by the levers mentioned above, and [2] reduced forex losses on hedges (in FY10, losses on hedges amounted to Rs4.8b on an EBIT of Rs19.8b). We reiterate Buy, with a target price of Rs550 (15x FY13E earnings), ~22% upside, with further upside likely on account of multiple expansion driven by better execution on the above two concerns. 22 March

11 Financials and Valuation Income Statement (Rs Million) Y/E June E 2012E 2013E Sales 106, , , , ,779 Change (%) Cost of Goods Sold 66,280 82, , , ,485 Gross Profit 39,734 42,767 49,657 65,116 75,294 % of Net Sales Selling Expenses 17,362 17,965 24,009 29,512 34,078 % of Net Sales EBITDA 22,372 24,802 25,648 35,604 41,216 % of Net Sales % Growth Depreciation 4,493 5,009 5,031 6,686 7,834 EBIT 17,879 19,793 20,617 28,917 33,383 % of Net Sales Interest , PBT 14,492 14,491 20,047 28,897 33,777 Tax 2,514 2,724 4,400 7,224 7,938 Rate (%) Net Profit 11,978 11,767 15,646 21,673 25,840 Minority Interest Net Income 12,008 11,766 15,646 21,673 25,840 % of Net Sales Change (%) Balance Sheet (Rs Million) Y/E June E 2012E 2013E Share Capital 1,337 1,345 1,363 1,373 1,381 Other Reserves 55,506 69,023 82, , ,487 Net Worth 56,843 70,368 83, , ,868 Loans 29,771 26,632 19,352 14,131 8,534 Minority Interest Capital Employed 86,633 97, , , ,402 Gross Block 32,423 40,056 48,269 50,533 52,324 Less : Depreciation 16,561 21,570 26,601 26,601 26,601 Net Block 15,862 18,486 21,668 23,932 25,723 Intangibles 53,933 52,762 53,488 55,964 58,197 Investments 15,162 20,440 18,998 18,998 18,998 Curr. Assets 41,985 44,027 52,140 70,248 92,319 Debtors 27,083 30,496 37,377 46,922 54,909 Days Cash & Bank Balance 4,203 4,686 3,373 7,515 19,086 Loans & Advances 10,699 8,845 11,390 15,811 18,324 Current Liab.&Prov 40,309 38,715 43,148 52,753 61,834 Current Liabilities 32,675 31,329 36,036 44,120 51,827 Provisions 7,634 7,386 7,112 8,634 10,007 Net Current Assets 1,676 5,312 8,992 17,494 30,485 Application of Funds 86,633 97, , , ,402 E: MOSL Estimates Ratios Y/E June E 2012E 2013E Diluted (Rs) EPS after ESOP chg Cash EPS Book Value DPS Payout % Valuation (x) P/E after ESOP chg Cash P/E EV/EBITDA EV/Sales Price/Book Value Dividend Yield (%) Profitability Ratios (%) RoE RoCE Turnover Ratios Debtors (Days) Asset Turnover (x) Leverage Ratio Debt/Equity (x) Cash Flow Statement (Rs Million) Y/E June E 2012E 2013E CF from Operations 16,501 17,147 20,677 28,359 33,673 Chg. in Working Capital 2,076-3,153-4,993-4,360-1,420 Net Operating CF 18,577 13,994 15,684 23,999 32,254 Net Purchase of FA -46,323-6,462-8,939-11,426-11,858 Net Purchase of Invest. 5,718-5,294 1, Net Cash from Inv. -40,605-11,756-7,497-11,426-11,858 Issue of shares -1,908 4,540 2, Proceeds from LTB/STB29,771-3,139-7,280-5,221-5,597 Dividend Payments -5,475-3,153-4,390-3,215-3,232 Net CF from Finan. 22,388-1,752-9,500-8,431-8,825 Free Cash Flow -27,746 7,532 6,744 12,573 20,396 Net Cash Flow ,313 4,142 11,570 Opening Cash Bal. 3,840 4,200 4,686 3,373 7,516 Closing Cash Balance 4,200 4,686 3,373 7,516 19, March

12 For more copies or other information, contact Institutional: Navin Agarwal. Retail: Manish Shah Phone: (91-22) Fax: (91-22) Motilal Oswal Securities Ltd, 3rd Floor, Hoechst House, Nariman Point, Mumbai This report is for the personal information of the authorized recipient and does not construe to be any investment, legal or taxation advice to you. Motilal Oswal Securities Limited (hereinafter referred as MOSt) is not soliciting any action based upon it. This report is not for public distribution and has been furnished to you solely for your information and should not be reproduced or redistributed to any other person in any form. The report is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon such. MOSt or any of its affiliates or employees shall not be in any way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained in this report. MOSt or any of its affiliates or employees do not provide, at any time, any express or implied warranty of any kind, regarding any matter pertaining to this report, including without limitation the implied warranties of merchantability, fitness for a particular purpose, and non-infringement. The recipients of this report should rely on their own investigations. MOSt and/or its affiliates and/or employees may have interests/ positions, financial or otherwise in the securities mentioned in this report. To enhance transparency, MOSt has incorporated a Disclosure of Interest Statement in this document. This should, however, not be treated as endorsement of the views expressed in the report. Disclosure of Interest Statement HCL Technologies 1. Analyst ownership of the stock No 2. Group/Directors ownership of the stock No 3. Broking relationship with company covered No 4. Investment Banking relationship with company covered No This information is subject to change without any prior notice. MOSt reserves the right to make modifications and alternations to this statement as may be required from time to time. Nevertheless, MOSt is committed to providing independent and transparent recommendations to its clients, and would be happy to provide information in response to specific client queries. 22 March