Company disappoints once again on margin performance
HCLT disappointed with 110 basis points quarter-on-quarter and 400 bps year-on-year decline in Ebit margin. We view the decline as a catch-up of underinvestment in the business. This will show up either in margins or in revenue growth (in case underinvestment continues). Either way, there are downside to consensus EPS estimates. We maintain below-consensus EPS estimates and target price. Maintain Reduce rating with unchanged target price of Rs 850.
Margin deteriorates: HCL Technologies disappointed overall with a 9% miss in Ebit and 3% miss in net profit. More importantly, Ebitda (earnings before interest, taxes, depreciation and amortisation) and Ebit declined 480 bps and 400 bps on a y-o-y comparison. The management attributed the decline to (i) additional visa costs and (ii) upfront investment in large deals. The company re-badged close to 3,000 people in FY15. While this helped revenues, Ebit margins suffered. This also offset close to 40 bps of tailwind from rupee depreciation. Revenue growth was 2.9% in c/c (constant currency), robust and in line with our estimate. Revenue growth was led by IMS (infrastructure management services) practice that grew 5.4% q-o-q. On expected lines, growth in applications portfolio was muted at 1.7%. Net profit grew 5.8% q-o-q but declined 2.5% y-o-y to R17.8 bn. Free cash generation was excellent for the quarter at 147% of net profit.
Ebitda margin decline is not a one-off: HCLT faces a few headwinds-(i) catch-up on underinvestment in the past.
This shows up in decline in SG&A, continued weakness in the applications portfolio and unsustainably high utilisation against the backdrop of relatively higher attrition. Thankfully, SG&A (selling, general and administrative expenses) has started trending up recently, (ii) pressure on profitability of old deals coming up for renewal, and (iii) high competitive pressures in the core IMS business. In addition, investments are required in digital and new growth engines to sustain revenue growth. We believe HCLT is taking the right measures to ensure it sustains revenue growth. However, the Street is yet to adjust to the reality of lower margin trajectory to sustain this revenue growth.
Put differently, HCLT can either deliver revenue growth or margins but not both. Either way, there are downside risks to consensus EPS. We forecast Ebitda margin of 20.7% for FY16e and 20.2% for FY17e.
Expect muted EPS growth for FY16e: In addition to Ebitda margin decline, HCLT faces additional pressure from higher depreciation charge and tax rates in the medium term. We forecast modest EPS growth of 6.8% in FY16e and 8.9% in FY17e. The HCLT stock trades at 15.7x FY17e earnings. We value the stock at 14x FY17e earnings, fair considering the relatively higher risks to earnings. Depreciation of INR against the USD is the key risk to our call.
FY15-re-badging helps revenues and drags Ebit margins: HCLT highlighted it has re-badged close to 3,000 people, most of them onsite. The re-badging constitutes close to 15% of HCLT’s onsite headcount, and 4X of the normal levels of the past years and it (i) helped revenues but also (ii) impacted Ebit margin. The management believes profitability of these deals can be improved via better use of resources, offshoring and use of near-shore delivery centres. But the downside of offshorisation is a deflationary impact on revenues (which helped revenues in FY15) once the business moves offshore (except in contracts, which has single price whether the project is delivered onsite or offshore).
Robust free cash generation in FY15: FY15 OCF(operating cash flow)/net income was robust 84% despite increase in receivables days by four. The increase was helped by a sharp decline in finance lease receivables (down 51% to $72m) and a 40% increase in trade payables and 19% increase in accrued employee expenses.
Q4FY15 OCF was $450m, 162% of net income and helped by: (i) four days sequential decline in receivables collection cycle, (ii) $54m (43%) decline in finance lease receivables and (iii) rise in current liabilities, viz. accounts payables and accrued salary expenses.
Modest wage increase: HCLT announced 6% wage hike in offshore and 2% onsite. The offshore wage hike is slighly lower than peers. We expected a higher number noting its high attrition rate, which on a quarterly annualised basis stands at 28.6% and 16.5% for IT services business on TTM (trailing twelve months) basis.
Highlights from Q4 results and earnings call
* HCLT reported 2.9% sequential constant-currency revenue growth and 3.2% growth in dollar terms. Growth was driven by Americas (+5.1% c/c); Europe and rest of the world geographies were flat sequentially. On services front, IMS led with 5.2% c/c growth followed by enterprise system integration (+4.6%) and BPS (+4%). Among verticals, life sciences and healthcare grew +10.2%, telecom, media & entertainment grew 9.6% and retail & CPG (consumer packaged goods) grew 7.1% .
* Ebit margin declined 110 bps q-o-q (after a 250 bps q-o-q decline in the March quarter). HCLT has maintained its 21-22% target Ebit margin band for FY16. The management indicated that the impact of wage hike will be spread across next four quarters (85 bps, 75 bps, 10 bps and 10 bps).
* HCLT has signed deals worth $5 bn of total contract value (TCVs) in FY15. The management indicated that the number was marginally higher than aggregate TCV of deals signed in the previous year. We note HCLT reported ‘more than $1 bn’ of deal wins in each of the previous three quarters. Hence, precise TCV of deal wins in Q4 cannot be calculated.