HCL Technologies: Buy

HCL Technologies is among the Tier-I software players which has delivered good numbers for this fiscal, supported by strong March quarter numbers.

The company’s differentiated service offerings and the good growth prospects suggest that investments with a one-year perspective can be considered in the stock. At Rs 262, the stock trades at a modest valuation of 13 times its estimated 2007-08 earnings.

In an uncertain macro environment where Tier-1 and only select Tier-2 players are, perhaps, well-placed to weather the slowdown-related difficulties, HCL Technologies appears a better investment bet.
IMS holds the key

Infrastructure management services (IMS) contribute as much as 15 per cent of HCL’s total revenues and have grown 40 per cent over the past year.

This places HCL Tech above all other Tier-1 players in the proportion of revenues derived from this service offering. Infrastructure services is a key component of many large outsourcing deals (multi-million, multi-year, multi-service) that have flowed to IT majors in the past year. IMS is billed at higher rates compared to other volume-driven services and a higher contribution from this service means better realisations.

HCL Tech takes an ‘asset-light’ approach to IMS by focussing on the services component of the deals alone. Its becoming both hardware and vendor ‘agnostic’ would help in this endeavour.
Changing service and geographic mix

In terms of service mix, engineering and R&D services which command higher billing rates, have grown over the year and now contribute 25 per cent of its total revenues.

This may stem from the fact that HCL Tech was a late entrant to the BFSI client segment. The advantage here is that verticals such as Hitech (including aerospace, automotive verticals), at 29.5 per cent of revenues, have overtaken BFSI (28.4 per cent) as the key contributor to revenues.

The automotive and aerospace sectors are becoming increasingly software-driven and are expected to drive the proportion of IT outsourcing upwards. HCL Tech, given its relationships with top automotive and aircraft manufacturing and design companies, is well-placed to tap this pie.

Similar is the case with the telecom vertical (16.5 per cent). In terms of geographic spread, higher contributions from Asia-Pacific (14.5 per cent) and Europe (29.6 per cent) are healthy trends.

The company has been able to win multi-million, multi-year, multi-service deals from relatively newer outsourcing geographies such as New Zealand and Australia, reducing the company’s exposure to any US-centric problems.
Recent acquisition strengthens BFSI

HCL Technologies’ $40-million all-cash acquisition of Capital Stream in the US may help expand its offering to its financial services clientele.

Capital Stream provides processing solutions to banks in the areas of credit analysis, prospecting and sales, due diligence, documentation and portfolio monitoring.

HCL Tech had been using these products since 2002, which suggests that it would already have fair understanding and comfort in Capital Streams’ offerings. There appear to be two advantages from this acquisition.

One of the products of Capital Stream is a Web-based application. This will mean easier and quicker delivery of certain services at lower cost, as manpower required for this mode of delivery would be low. Capital Stream’s solutions could also be used to tap into clients in geographies outside North America.
Improvements in operational-metrics

Fixed-price contracts now contribute 35 per cent of HCL Tech’s revenues. Fixed-price contracts require greater planning in terms of resource allocation and utilisation and definitive timelines of implementation.

It enables the company to predict cash-flows better, formulate a suitable hedging strategy and generate realisations.

This may become even more relevant in the current turbulent times where clients of HCL and, indeed, all Tier-1 IT service companies’ clients are demanding output/outcome-based pricing with service-level agreements.

Utilisation at 71.3 per cent has improved over the past year and still leaves some room to drive volume growth.

The increase in offshore revenues, which now contributes in equal measure as onsite revenues, creates a lower cost structure for HCL Tech. Attrition has come down from 17.5 per cent to 15.2 per cent, lowering execution risks.
Concerns

Two of HCL Tech’s top 10 clients have kept IT budgets at the same level. The company has indicated that clarity from other clients on IT spend will emerge over the next few months.

The visibility on IT spend and pricing continues to be an area of concern for all Tier-1 IT companies. Infosys has indicated that 76 of its top 100 clients have suggested flat to lower IT budgets. Infosys and Satyam expect clarity on the BFSI-related problems and its effects on IT spends only over the next few months.

The pricing or billing rates are not expected to grow and may remain flat.

This may hinder any increase in realisations and may lead to a more volume-driven growth. Most of these concerns also apply to HCL Tech.