HCL Technologies shares: Effortless growth, as usual

Written by Kotak Institutional Equities | Updated: Apr 29 2013, 22:21pm hrs
HCL Technologies shares: Profitability supported by unsustainable rise in utilisation rates

Growth without/or marginal people addition has been the hallmark of HCL Technologies' performance for past the few quarters. Q3FY13 was no different, with solid revenue growth of 3.2% despite people decline. HCLTs per person revenue productivity is now 13-25% higher than other Tier-I IT firms, even as the reported offshore pricing is lower than peers. Profitability for the quarter was supported by an unsustainable increase in utilisation rates. We maintain our Cautious stancehigh-risk business and unsustainable margins worry us. Maintain Reduce with unchanged target price.

Good headline numbers but the devil lies in the details: HCLT reported 3.2% quarter-on-quarter revenue growth to $1,191 million, in line with our estimate. Net income of R10.2 billion was 8.2% ahead of our estimate and largely contributed by other income. Revenue growth for the quarter was once again infra-led, which grew 8.6% q-o-q and 41.6% year-on-year. Growth in software services was muted at 1% q-o-q and 4.8% y-o-y. Ebitda (earnings before interest, taxes, depreciation and amortisation) margin was stable at 22% and 30 bps ahead of our estimate. Margin performance of the company continues to surprise us. The company announced $1 bn worth of new deals singing for the quarter.

Effort-less growthheadcount declines again: Employee metrics of HCLT are puzzling. Overall and IT services headcount declined for the second consecutive quarter. Net employee addition was a marginal 1,752 on a y-o-y basis (2.4% growth). Quarterly annualised attrition rate increased to 28% from 24.8% in Q2FY13. High and sticky attrition is a surprise for a company that is performing well. What is even more surprising is that the company increased utilisation rates by 190 bps to 83.8%, despite such high attrition. Peers have struggled to maintain utilisation at reasonable levels during periods of high attrition.

Profitability is unsustainable with stretched core metrics: At the risk of repetition, we are surprised with HCLTs high profitability and the near convergence with Wipro. That HCLT has lower offshore pricing (16-18% lower than Infosys and Wipro), inefficient employee pyramid captured by delay in absorption of freshers, higher subcontracting costs (at least 2x of peers) and growth that is driven by relatively lower-margin infra management business raises concerns on sustainability. We find management guidance of margins aggressive.

Revenue growth that is single-service driven, stretched operating metrics with unsustainable profitability and sticky attrition numbers raise the risk profile of the business. Valuations at 14x FY2014e earnings are not inexpensive either. We maintain our 12-month forward target price of R650/share.

Solid signings of TCVs but require more data: HCLT announced aggregate TCVs (total contract value) of deals worth $1 bn, 90% of which is in the rebid market. While this is down from $1.5 bn for the same quarter in the previous year, yet this is creditable, especially after similar signings in Q2FY13. While deals signed in the quarter are impressive on face value, more disclosures are required on the quality of the dealsnature of work and timeframe of executionto help us put the numbers into context. For example, an existing relationship converted into a longer tenure contract would lead to incremental TCV; however, utility of such TCVs would be limited if there is no increase in annualised billing.