HCL Tech beats growth estimates, but profitability is a niggling worry

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Shares of HCL Technologies Ltd lost about 10% since its March quarter results, underperforming the Nifty IT index, due to concerns over growth and profitability. The June quarter results will reassure investors to some extent.

Constant currency revenues grew 4.2% from the March quarter, better than the most optimistic estimate on the Street. From a year ago, they are up 17%, the highest in recent years. Excluding the benefit of a recent acquisition, sequential revenue growth stood at 3.8%, which is healthy.

However, the benefit of revenue acceleration was negated by a steep fall in profitability to 17.1%. It is down a good 1.8 percentage points from the March quarter. As a consequence, operating earnings (earnings before interest and tax ) in dollar terms fell 6.3% sequentially. “Management already guided that Q1 margins will be weak owing to IBM products acquisition led transition costs while revenues would be absent and flow only from Q2. However, quantum of margin drop is steep,” said an analyst on condition of anonymity.

Apart from IBM product acquisition-related costs, a significant part of the incremental growth last quarter is on-site dependent, which has low margin.

Even so, the company retained the 18.5-19.5% margin guidance for the full year. “I know that there is a bit of a climb from 17.1%, but we have an action plan,” said C. Vijayakumar, president and chief executive officer of HCL Technologies.

The plan involves cost rationalization and revenue generation from recent investments. The IBM products acquisition will begin generating revenues from the current quarter, covering the costs of this investment. Investments and spends in the engineering division are projected to moderate. Further, the management plans to optimize the on-site-offshore mix and rationalize several other costs.

The steps will aid HCL Technologies’ profitability. But how well the management will succeed in eking out the gains will be known only when it delivers the September quarter results. Otherwise, it is confident of delivering 14-16% constant currency revenue growth it had guided for FY20.

Deal bookings moderated a bit last quarter, but the pipeline is strong. This should help the HCL Technologies stock, especially given its undemanding valuations and recent underperformance. “Potential acceleration in revenue growth, encouraging investments in applications business and momentum of large deals have been completely ignored,” Kotak Institutional Equities said in a note. “To be clear, we do not like the products strategy of HCL, but find valuations at 12 times FY2021 estimated earnings difficult to ignore.”

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