HCLT Q3 was ahead of expectation on revenue growth and reduces investor concerns on achievement of full-year growth guidance. Overall, our positive stance stays on: (i) better-than-peer-group growth in developed markets (US/Europe) at 92% of revenue; (ii) strength in applications and engineering services; and; (iii) attractive valuation of 13x FY20F EPS, a 15-30% discount vs. peers despite leading revenue/EPS growth over FY17-20F (10%/8% vs 7%/5% for INFO, 7%/4% for TCS). We reiterate our Buy rating with a target price of Rs 1,100.
Catalyst: IMS recovery and traction in IP deals
While IMS slowdown is a concern, given HCLT’s strong positioning and 12-quarter-high deal wins in Q3, we remain hopeful of a recovery in FY19F and build in USD revenue CAGR of 10% over FY18-20F. HCLT’s significant investments of
~$1.15 bn ($300 mn in Q3) and likely ROI is another investor concern. While success has yet to be demonstrated, we find the strategy of acquiring well established IPs, extending their functionality and selling through partner sales channel to an already existing large customer base to be a lower-risk strategy than building/selling its own products and finding areas where these acquired IPs could be extendable.
Q3: Ahead of expectations on growth; guidance retained
HCL Technologies posted CC revenue growth of 3.3% q-o-q (vs. our estimate of 2.5% q-o-q) and retained its guidance of 10.5%+ y-o-y growth in CC. Key positives: (i) 12-quarter-high deal wins; (ii) strength in apps and engineering services (even ex IPs) driven by core business and synergies from Geometric acquisition. A key negative was the slowdown in IMS (37% of revenues), where HCL Technologies expects a recovery in 1HFY19 driven by deal wins.
Estimates largely unchanged; raise TP to Rs 1,100 on roll forward
We estimate USD revenue growth of 10.3/8.9%, Ebit margins of 19.7% and EPS of Rs 67.6/73.1 for FY19/20F. Our TP of Rs 1,100 is based on 15x FY20F EPS of Rs 73.1 (methodology unchanged). 15x is at a 10% discount to our valuation multiple for TCS (TCS IN, Reduce).
Success in IP deals is important
Over the past seven quarters HCLT has announced six IP deals with IBM, conversion of a JV to an IP deal with DXC in Q2FY18 and an IP deal with a new partner starting this quarter. The total investment in these IP deals includes a total payout of $1.15 bn and is likely to add revenues of $360 mn annually for HCLT, we estimate. Of the $1.15 bn, HCLT has paid out $970 mn in the past seven quarters and is expected to pay $180 mn over the coming quarters.
There are three sources of revenues from these IP deals for HCLT: (i) revenue share of the current IPs; (ii) revenue from sale of extended functionality to both existing and new clients in these IPs; and (iii) HCLT using these IPs in its pursuit of deals by combining software and services. The key risks in these deals, according to the company are: (i) product obsolescence; and (ii) betting on the wrong product and wrong technology. To mitigate these risks the company indicates it is doing extensive due diligence. We believe the areas in which these investments are being made are attractive, and there is extension possibility in terms of additional functionality to cater to newer areas. The success of these initiatives is key for the stock to re-rate.