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Is HCL Technologies Poised For A Rerating?

HCL Technologies is the cheapest Indian information technology stock though it has guided for the best growth among peers.

HCL Technologies at Inforum 2016 (Source: Twitter)
HCL Technologies at Inforum 2016 (Source: Twitter)

HCL Technologies Ltd. is the cheapest Indian information technology stock though it has guided for the best growth among large-sized peers and some of the concerns stemming from its acquisition of software assets of International Business Machines Corp. have waned.

The software services provider trades at 14 times its estimated 12-month forward earnings. Along with Tech Mahindra Ltd., that’s the lowest PE multiple among software services providers with a market capitalisation of at least Rs 5,000 crore.

The company, whose revenue grew 17 percent in the quarter ended June, has guided for 14-16 percent growth in constant currency for the ongoing financial year. That compares with the double-digit growth estimates by peers Infosys Ltd. and Tata Consultancy Services Ltd. Bengaluru-headquartered Wipro Ltd. and Tech Mahindra are expected to grow between 3 percent and 7 percent, according to analysts.

Why HCL Tech’s Valuation Fell

The company was trading at 16 times its earnings in December last year. The valuation, however, declined after it bought some of IBM’s software assets for $1.8 billion.

Jefferies and Nomura were among the brokerages that questioned the move citing the lifecycle of certain products, the financial commitment involved and HCL Technologies’ lack of experience in the acquired business. The company allayed concerns saying that the unit would result in addition of $650 million in annual revenue.

While its valuation rose above 16 times in April, it fell again as its margin contracted sequentially in the quarters ended March and June.

Revenue growth in the first quarter surprised investors, its operating margin narrowed 190 basis points sequentially to 17.1 percent on costs incurred to integrate product lines acquired from IBM, higher visa costs and a stronger rupee. Moreover, the company offers salary hikes after June, which may be reported in the second quarter ending September.

Yet, it has guided for operating margin between 18.9 percent and 19.5 percent despite a sharp sequential contraction.

HCL Technologies is optimistic. “While our margins in this quarter were muted, they were in line with our investment strategy to leverage future growth opportunities. I am confident that our time-tested operating model will deliver margins within our guided range this year,” C Vijayakumar, president and chief executive officer at HCL Technologies, said while announcing the earnings for the quarter ended June. “With our current momentum, we aspire to register an industry-leading organic growth in FY20.”

CLSA expects the margins to improve as the impact of one-offs from the IBM deal is absorbed. The company’s organic revenue growth of 13 percent for the quarter ended June was higher than TCS, Infosys and Accenture, the brokerage said in a note. “HCL Technologies is ripe for a rerating after exceeding estimates for organic revenue growth for three straight quarters.”

Edelweiss Securities, too, is optimistic. “We believe HCL’s acquisitions in IP (intellectual property) as well as capabilities in digital will enable it to deliver industry-leading organic growth,” it said in a note.

As many as 35 of the 48 analysts tracked by Bloomberg have a ‘Buy’ rating on the company with nine recommending ‘Hold’ and four suggest ‘Sell’. The average 12-month price target of Rs 1,197 per share indicates an upside of 13 percent.

Not everyone is that upbeat. The “absence of any major organic growth driver” may lead the company to chase acquisitions for growth, leading to repercussions on its balance sheet, Phillip Capital said.

HSBC, too, is cautious. Growth for the quarter ended June cannot be extrapolated to the rest of the financial year as many of the revenue from large deals have “front-end recognition”, it said. Still, the momentum in core business is “decent” with deal pipeline in managed services deals remaining steady, according to HSBC.

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