Stock corner: ‘Neutral’ on HCL Technologies, a miss on margins even as revenue was strong

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Published: May 21, 2019 6:47:11 AM

FY20e EPS down 4.4% due to lower margin guidance and extra costs; ‘Neutral’ retained with TP of Rs 1,200

Stock corner: 'Neutral' on HCL Technologies, a miss on margins even as revenue was strongStock corner: ‘Neutral’ on HCL Technologies, a miss on margins even as revenue was strong

For FY19, HCLT’s CC revenue/Ebit/PAT grew by 11.8%/22.0%/15.2% y-o-y. The company returned 53% of net income to investors in the form of dividend and buyback. Q4FY19 CC revenue grew 15.3% y-o-y (our estimate: +15.1%), operating profit increased 18% y-o-y (our estimate: +21%) and PAT was up 15% y-o-y (our estimate: +16.3%). Ebit margin for the quarter shrank 60bp q-o-q to 18.9%, below our estimate of 19.5%. Currency movement (40bp impact) and lower IP revenue (20bp impact) dragged profitability. PAT increased 15.3% y-o-y to `25.7 bn, marginally below our estimate of `25.9 bn.

Low-margin Digital drove the revenue momentum
Mode-1 revenue (70.5% of revenue) grew 2.5% q-o-q CC, Mode-2 (19%) revenue increased by a sharp 14% q-o-q, while Mode-3 revenue (10.6%) declined by 7.6% q-o-q CC. Among services, growth was led by IMS again (39% of revenue) (+7.3% q-o-q CC). Engineering Services (24%) revenue declined 3% q-o-q. Application Services (33%) turned a corner, with growth of 5% q-o-q and 8.4% y-o-y CC. Financial Services (21%) saw growth of 0.9% q-o-q CC. Europe (30% of revenue) drove growth among geographies.

Margin guidance band lower than previous year
HCLT guided for revenue growth of 14-16% y-o-y CC for FY20, of which 7-9% is organic. Organic growth is expected to be back-ended like FY19. HCL expects an Ebit margin of 18.5-19.5% – the range is 100bp lower than the previous year due to (i) investments in Mode-2, (ii) faster growth in lower-margin Mode-2, (iii) cost inflation for talent, (iv) ramp-up of multiple large deals and (v) Q1 impact from IBM IP’s integration.

Valuation view
Due to the (i) lower margin guidance than our expectation and (ii) additional $25 mn cost towards forex cover on debt, our earnings estimate for FY20 is lower by 4.4%. Over FY19-21, we expect USD revenue CAGR of 12% and earnings CAGR of 11%. The stock trades at 14.6x/12.5x FY20/21e earnings. We continue to separately value IPs (~$3 bn in total), at 8x – a multiple that assumes no growth in the portfolio of IPs. This contributes `80/share to HCLT’s value. For the remaining IT Services business, our TP of `1,120 discounts forward earnings by 14x (v/s 13x earlier), as the organic growth trajectory inches up. Consequently, our TP of `1,200 implies an upside of 6%. Maintain Neutral.

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