THE COMPASS: STRONG Q4, BUT WILL HCL TECH’S STOCK RE-RATE?

Margin improvement key to bridge valuation gap with peers

Investors have very little to complain about HCL Technologies’ (HCL Tech’s) results for the March quarter (Q4). The company delivered yet another quarter of industry-leading revenue growth on the back of all-round performance by most of its segments and healthy contribution from recent acquisitions. In fact, its sequential constant currency revenue growth of 3.8 per cent is higher than other comparable peers such as Tata Consultancy Services (TCS), Infosys and Wipro. This metric grew between 0 and 1.7 per cent sequentially for these peers in Q4. Importantly, HCL Tech expects its constant currency revenues to grow 10.5-12.5 per cent in the current financial year — much ahead of the 6.5-8.5 per cent growth expected by Infosys (TCS does not given any guidance). HCL Tech’s aggressive approach on chasing inorganic growth differentiates it from peers TCS and Infosys, which continue to be rather conservative on this front. Though Wipro, too, has not shied away from making strategic acquisitions, it has not reflected in its revenue growth, indicating some execution challenges faced by the company.

In this backdrop, it is not surprising that HCL Tech is the top pick in the sector for most analysts. Even as the sector grapples with multiple growth headwinds, the company’s aggressive focus on delivering healthy growth is commendable and is rewarded well by the Street. The stock is currently trading not far from its 52-week high of ~889.65 against peers which are trading 13-26 per cent lower than their respective year highs. HCL Tech’s current valuations of 13x FY18 estimated earnings are also lower than that of TCS (17x), Infosys (15x) and Wipro (14x). But, despite the strong growth momentum, this valuation discount is unlikely to correct much from here on, believe analysts. This is because the high growth for HCL Tech has come at lower Ebit (earnings before interest and taxes) margins. The company’s Ebit margins of 20 per cent are much lower than the 25-26 per cent margins enjoyed by Infosys and TCS. Acquisitions are one reason behind HCL Tech’s lower margins. Importantly, given the macro headwinds facing the sector, most IT companies are running out of margin levers. While automation could drive profitability, it will take some more time to scale up and have a meaningful impact on Indian IT companies. This partly explains the softness in HCL Tech’s scrip in Thursday’s trading session. The fact that forex gains coupled with tax reversal led to a sharp rise in its net profit in Q4 could be another pressure point on the scrip, believe analysts. Continued weakness in the infrastructure business is a concern even though the management remains positive on improving this trend.

If HCL Tech can sustain the better growth rates and narrow the gap with its larger peers on margins, rewards for its shareholders could also increase.