We recently hosted HCL Tech’s (HCLT) CFO for investor meetings. The discussions covered organic business and Mode-3 strategy (esp. the recent product acquisition).
We recently hosted HCL Tech’s (HCLT) CFO for investor meetings. The discussions covered organic business and Mode-3 strategy (esp. the recent product acquisition). HCLT has under-performed peers 30% over the last two years on (1) Organic growth slowdown, with IMS slowing from 9% to 4% YoY, and (2) Balance sheet-heavy capital allocation strategy.
HCLT’s rev/PAT/OCF share in tier-1 IT has been steady at 15%. However, the high investment intensity (USD 1.7bn ex-IBM products in acquisitions and IPP) relative to peers (35% capex share of tier-1 IT) has led to a disproportionate increase in balance sheet size. HCLT’s transition from a low capital-intensity services business to an asset-heavy, IP-led model has hit FCF generation (8% share of tier-1 IT).
It has also slowed down core RoCE from 35% to 28% over FY17-19. HCLT’s latest product acquisition is a bold move into uncharted territory (both scale and nature). While integration and cross-sell hold challenge and opportunity here, the organic business is also set to benefit from ramp up of large deal wins. If both engines fire, a re-rating is likely, though investors will wait for sustained evidence.
We maintain faith in HCLT based on (1) Organic business recovery, supported by ramp-up of large deal wins, (2) ER&D/IMS pedigree (strong growth in >USD 50mn client bucket), (3) Strong ‘option value’ in synergies from product acquisition – cross-sell, market opportunity. Maintain BUY. Our TP is Rs1,255 at 14x Dec-20E EPS (in-line with 5-yr avg multiple). FY19E revenue growth guidance at mid-point of ‘9.5 to 11.5%’ maintained (50% organic), with better traction seen in the organic business. The payout policy of 50% of net income is unchanged. BFSI outlook is healthy ex-two large accounts. No incremental negative. Large deal wins have started contributing, such as P&G (USD 250mn TCV over 5 years) in 2QFY19.
The Nokia deal (USD 500mn TCV) will contribute from 3QFY19. IMS is coming off a sluggish phase and expected to be the largest driver of organic business. HCLT’s competition in IMS is with leading services majors in NorthAm and Europe. HCLT’s ER&D scale is improving.