HCL’s margins set to receive a boost from the IBM deal
A decade after it purchased UK-based Axon, HCL Technologies (HCL) has bought seven products from global technology major IBM. However, perception in some quarters that the deal is overvalued and concerns over the fact that the company has to take on debt knocked the stock down by around 5 per cent in Friday’s trade.
The company will pay about $1.8 billion for the seven products, with HCL having an ongoing IP partnership on five. About 48 per cent of the total cash consideration is payable by mid-2019 and the balance about a year later.
According to reports, HCL expects an annual revenue run-rate of $650 million from the deal, though the amount is likely to be slightly lower in the first year due to transition issues. Thus, the company is paying more than 2.7 times the expected annual revenue from these products as consideration, which some might think is expensive. But margins are likely to increase after this deal.
HCL has indicated that it would fund the deal by taking $300 million in debt, mainly because some of its funds are locked up in FDs and longterm bonds that it has chosen not to liquidate.
The fresh debt should not be a major financial burden for the company, as it has almost $1.6 billion in funds (as cash, FDs, available-for-sale securities etc.) as of September 2018 and borrowings of $424 million. On the whole, even after the full payment is made over the next 12-18 months, HCL would have a comfortable net cash position.
The deal is expected to augment HCL’s Mode-3 (products and platforms) offerings, which accounted for 11.9 per cent of revenues (September 2018) and enjoy an EBIT margin of 24.4 per cent, much higher than the firm’s overall margin of 19.5-20 per cent. The IBM products reportedly enjoy better margins than HCL’s other service lines. Over the next couple of years, HCL’s EBIT margins are likely to get a a boost from these products.
Given that the company managed to integrate Axon well and drive growth, these new products too are most likely to provide synergies and scale for HCL.
The markets may have overreacted because of the perception that HCL is overpaying for IBM’s products.
But given the growth trajectory of the company – it is likely to record double-digit dollar revenue growth for FY19 – and the stock’s high valuation comfort, the negativity is likely to fade out quickly.