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  • Stock Recommendation | HCL Technologies - ADD - Target price : 1,100

    Publish date: OCTOBER 24, 2018

    Upgrade on attractive valuations. We upgrade HCLT to ADD from REDUCE on attractive valuations with the stock trading at 12X FY2020E earnings. Our structural concerns on the business model persist—continued deflationary pressure in IMS, underinvestment in digital and questionable capital allocation. However, these concerns are captured in the steep stock price underperformance. Reasonable deal wins and likely step-up in organic revenue growth in the near term are comforting. We value HCLT at 14X September 2020E earnings. Target price and EPS remain unchanged.

    We have been negative on HCLT’s business model for a fairly long time. These concerns emanate from single-service line dependence (IMS) for growth, underinvested applications portfolio and of late capital allocation. The concerns have not abated. In fact, slowing organic growth and high acquisition appetite make the current EBIT margin guidance band of 19.5-20.5% unsustainable (our FY2020-21E EBIT margin forecast stands at 18.5-19%). However, our concerns are adequately captured in the stock price underperformance; in fact, the stock has barely moved in the past 12 months despite sector-wide benefits from rupee depreciation and acceleration in growth. The stock now trades at attractive12X FY2020E earnings. This combined with good deal wins and likely pickup in growth rates in IMS in the near term creates an opportunity to generate reasonable returns. Our EPS estimates and target price of ₹ 1,100 remain unchanged. Upgrade to ADD valuing the stock at 14X September 2020E earnings.

    HCLT reported constant-currency revenue growth of 3%, in line with our estimate. Revenues include ~US$21 mn contribution from Actian Corporation and some contribution from IP acquired in the previous quarter. Organic constant-currency revenue growth rate stood below 2%. Revenue growth in IMS picked up and grew 2.5% sequentially and 4.4% yoy. Application services was weak and grew at modest 0.4% qoq and 1.8% yoy. EBIT margin of 19.9% increased 20 bps qoq on the back of rupee depreciation (+90 bps) and productivity improvements (+80 bps), offset to some extent by wage revision (-70 bps), higher SG&A (-50 bps) and other operational factors (-30 bps). Net profit of ₹ 25.4 bn grew 5.7% qoq and 16.1% yoy and was ahead of our estimate due to higher-than-expected other income and lower-than-expected tax rate.

    Management is confident of a strong 2H as some of the large IMS deals (such as Nokia) flow through revenues. Guidance implies 3% revenue CQGR over the next two quarters. Management indicated that organic revenue growth contribution in FY2019 will be higher in the overall growth composition compared to the assumption at the beginning of the year. The company has retained EBIT margin guidance band of 19.5-20.5% and expects better EBIT margin in 2HFY19.

    IMS revenues grew 2.5% sequentially and 4.4% yoy. Growth rates have recovered from a low of 2.0% yoy in 1QFY19 to 4.4% in the current quarter and can improve further. We note that IMS growth slowed down over the past 18 months due to a mix of things—impact from shift of workloads to public cloud, renewals of its own deals, a more aggressive competition and increasing trend of bundling of deals.

    Management indicated that impact on revenues from renewals of old IMS deals will continue in FY2020E albeit at marginally lower than FY2019. The company expects most of the deals to be reconfigured to cloud and next-gen services by FY2021E.

    Application services grew at insipid 0.4% qoq and 1.8% yoy. The company attributed weak numbers to continued pressure in traditional areas such as SAP and a couple of clientspecific issues.

    Weak application is not a new concern. In fact, this service offering has not grown in double digits in the past 6 years (Exhibit 7) and has seen growth rates slide down progressively. Reason? The company has been underinvested in the offerings for many years and has done little to address this issue. It is interesting to note that out of the 21 inorganic initiatives, the company has barely acquired anything in application services. It is not as if this segment is short of acquisition candidates. HCLT’s competitors have snapped up many small digital companies in the cloud apps, digital studios and customer experience management space. It is surprising to see that an acquisitive company like HCLT Is missing from that list of acquirers.

    HCLT’s revenues from Mode 3 offerings have hit the US$1 bn run-rate. The company is investing heavily in own platforms and products. The company has started investing in products and platforms sales program. The company will also aggressively pursue licensing of IPs from product vendors where the core product needs transformation to be relevant in future, is in the focus areas and is available at the right price.

    At the risk of repetition, our discomfort with HCLT’s acquisition strategy continues. We favor acquisitions to augment digital capabilities or the ones that can provide meaningful revenue synergies. HCLT has demonstrated risk-taking appetite through 10 IP deals and 12 acquisitions in the past three years. A few ERD acquisitions are encouraging, though the broader emphasis on IP deals and certain non-strategic acquisitions are disappointing. We are especially disappointed with three recent acquisitions, viz. C3i, Actian and H&D. These acquisitions will provide revenue kicker but does not help bring in anything differentiated or new.

    We do hope that aggressive acquisitions do not lead to slowdown of organic growth endeavors and will be an important element to focus on. And so does the implications for profitability of the strategy.

    ▶ Margin walk-through. HCLT’s EBIT margin increased 20 bps sequentially to 19.9% due to (1) 70 bps headwind from wage increments, (2) 50 bps headwind from SG&A costs and (3) 30 bps negative impact from seasonality and other headwinds offset by (4) 90 bps tailwind from rupee depreciation net of cross-currency movements and (5) 80 bps tailwind from productivity benefits.

    ▶ Guidance. HCLT retained constant-currency revenue growth guidance of 9.5%-11.5%. The company expects to deliver in the midpoint of the guided range, i.e. 10.5%. EBIT margin guidance was also unchanged at 19.5%-20.5%. The company plans to reinvest gains from rupee depreciation.

    ▶ Mode 2 & Mode 3 margins. HCLT reported 400 bps sequential decline in Mode 2 EBIT margin to 10.8%. Volatility in Mode 2 margins will continue in the short term due to investments. The company expects margin expansion as Mode 2 revenues scale up. HCLT expects Mode 3 margins to stay in the 24-25% range on an annualized basis.

    ▶ Application services outlook. Management reported that while traditional services such as SAP faced pressure, the company has been able to defend share during renewals by helping clients migrate to digital.

    ▶ IMS. HCLT expects vendor consolidation trend to continue in IMS. Management is of the view that the company is well-positioned to benefit from the trend, especially among US clients. HCLT is able to offset revenue loss from pricing pressure during renewals by offering additional services.

    ▶ Europe outlook. Europe geography revenues declined 0.9% sequentially in c/c terms. Management reported that the weak growth was due to softness in a couple of financial services clients in the geography (HCLT reported weak financial services revenue growth of 0.1% in c/c terms). Though HCLT expects the weakness in the client accounts to continue in the near term, it is optimistic on better revenue growth in Europe in the next couple of quarters based on order flows.

    ▶ Client metrics. US$100 mn client bucket was flat at 9 while number of US$50 mn clients decreased by 1 to 31 sequentially. Number of US$20 mn clients was up by 3 sequentially to 90.

    ▶ Tax rate. HCLT reported a tax rate of 21.1%, which was lower than our estimate of 23.0%. The company has guided for a tax rate of 22-23% for the rest of the fiscal.

    ▶ Capital allocation. HCLT completed share buyback of `40 bn announced in the previous quarter on October 11, 2018. The company has declared an interim dividend of `2/share for the quarter.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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