HCL Technologies - Coming of age - Ambit

HCL Tech's revenues increased 3.6% QoQ and 13% YoY in 2QFY13, in line with our estimates and ahead of TCS's revenues but behind that of Infosys. However, the sources of growth were more understandable; continued traction in Remote Infrastructure Management (RIM), which increased 10% QoQ on the back of tough comps, was offset to some extent by weakness in discretionary spending (EAS revenues were down 1% QoQ) and moderate performance in ADM (up only 2.3% QoQ). The phenomenal margin outperformance of 323bps and 213bps compared to our and consensus expectations despite the mix (RIM rather than ADM/EAS) was the biggest positive surprise. HCL Tech managed to overcome wage increases and a ramp up in SG&A costs (up 5% QoQ) in a seasonally weak period by increasing utilisation (up 140bps offshore and 200bps onsite) and employee rationalisation (net decline in the number of employees). These factors trickled into a massive 27% earnings beat. Furthermore, deal wins of US$1bn (12 deals with Fortune 500/G2000) remained robust despite weak contracting activity (as indicated by ISG in its 4QCY12 TPI Index call). Cash conversion improved significantly with a decline in debtor days by 7 days (including unbilled). Finally, the sole negative was the announcement of the departure of the long-time CEO Vineet Nayar from an executive role as his protégé Anant Gupta formally took over as CEO.

Where do we go from here? The only sore point with HCL Tech's numbers were its USD revenue growth QoQ/YoY, which are not sector-leading numbers anymore: TCS' YoY revenues have increased faster at 13.8% whilst Infosys' QoQ revenues have increased faster at 4% QoQ. However, the quality of HCL Tech's growth is the most appealing, with a combination of improving margin and cash conversion profile driven by new customer additions (growth in top-20 accounts was at only 2.2%) over the past 3-4 quarters. HCL Tech's growth also appears to be the most sustainable and from traditional areas of strength - RIM (the leading scale service line). The weakness in discretionary spending was in line with the commentary heard from Accenture, SAP and industry analysts, ISG/Nelson Hall. With a strong SAP practice, HCL Tech remains positioned to gain as and when discretionary spending truly picks up. As long-term believers of the HCL Tech story, we have consistently highlighted HCL Tech's largest potential was the improvement of its quality of business, with improving margins and return ratios (32% RoE in the December quarter). This has begun to manifest itself. Whilst earnings upgrades are likely to be strong, the biggest stock price driver is likely to remain a re-rating. We see the transition from Vineet Nayar to Anant Gupta as smooth and well planned internally. We are likely to upgrade our earnings estimates for FY13/14 by ~10% and remain BUYers.

Our view of the sector: HCL Tech's results closely mirror actual sector performance. The market continues to be driven by scale restructuring deals, with RIM and BPO continuing to see the greatest amount of activity and with continued weakness in demand for discretionary services. HCL Tech's deal wins of ~US$1bn in December 2012 were perhaps softer than expected (deal wins were at ~US$1.5bn in December 2011) given the slower contracting and deal push outs into March. HCL Tech's net decline in employees also suggests persistent weakness in demand conditions. Growth in the Europe business was stronger, indicating the opening up of the market, as suggested by Infosys' numbers last week. However, we remain circumspect of sustainability here, given the weakness in SAP's EMEA numbers yesterday. Finally, sustained traction in the US market bodes well for the industry. We continue to view this as a weak market with uncertain demand for discretionary services. HCL Tech remains our preferred pick in the sector along with TCS. We remain Sellers in Infosys and Wipro.

Source : Equity Bulls

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