Published on 26/11/2020 11:07:00 AM | Source: Motilal Oswal Financial Services Ltd

Buy HCL Technologies Ltd For Target Rs.1,050 - Motilal Oswal

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Cloud demand to boost FY22 growth

Broad-based recovery; margin guidance raised for FY21

* HCL Technologies (HCLT) delivered strong revenue growth (4.5% QoQ CC) on the back of broad-based recovery across geographies, verticals, and services.

* EBIT margin expansion (+110bp QoQ), driven by operating leverage, was better than expected. HCLT also revised its FY21 margin guidance upward (by 50bp to 20–21%) despite a potential wage hike in 3Q/4Q. This indicates its ability to sustain some amount of margin improvement, which is a positive.

* Strong new deal wins (+35% QoQ), good renewals, and a robust deal pipeline (+20% QoQ, all-time high) give us comfort. This, coupled with broad-based sequential growth across segments in 2Q, indicated an improved outlook.

* HCLT reported 15 transformational wins, all from new clients, exhibiting its ability to capture a larger share of client wallets. In our view, the company would continue to benefit from demand for digital services – especially in cloud migration (digital foundation) work – which should help it deliver 11% revenue growth in FY22.

* We marginally upgrade our EPS estimate for FY22 by 2%, while keeping it unchanged for FY21. Maintain Buy, as we expect HCLT to emerge stronger on the back of an expected increase in enterprise demand for digital and cloud services. Our TP implies 19.5x FY22 EPS (~30% discount to TCS).


Performance marginally ahead of estimates

* HCL reported revenue (USD) / EBIT / PAT growth of 1%/15%/18% YoY v/s our estimate of 0%/11%/17% YoY. For 1H, the company reported revenue (USD) / EBIT / PAT growth of 0%/22%/24% YoY.

* Revenue increased 4.5% QoQ CC (v/s est. 3.7% QoQ CC). 2Q saw a broadbased performance with all growth engines firing.

* Across geographies, excl. Europe (2.2% QoQ CC), the Americas (4.9% QoQ CC) and RoW (9% QoQ CC) reported above company average growth.

* Except for Public Services (0.2% QoQ CC), which came in flat, other verticals reported modest/strong growth during the quarter. Strong growth in Retail & CPG (8.4% QoQ CC) indicates faster-than-expected recovery.

* Broad-based growth across service lines is also a key positive.

* The EBIT margin expanded 110bp QoQ to 21.6%, moderately ahead of our est. of 21.0%. Key factors included (a) operational efficiency (increased utilization/ offshoring /automation): +157bp, (b) headwind from INR appreciation: -24bp (c) investment in P&P SGA: -32bp, and (d) lower depreciation/amortization: +7bp.

* Attrition in IT Services (LTM basis) at 12.2% contracted by 470 bps YoY.

* The company maintains its guidance for revenue growth of 1.5–2.5% QoQ CC for the remaining quarters of FY21. On the other hand, EBIT margin guidance was raised to 20–21% for FY21 from 19.5–20.5% earlier.

* FCF/PAT continued to be healthy at 136% in the quarter.

* The board declared dividend of INR4/share, marking the 71st consecutive quarter of dividend payout.


Key highlights from management commentary

* The company saw sharper and broad-based recovery across segments during the quarter. Hence, the management had increased its revenue and margin guidance for the quarter a month ago.

* (a) Increasing intensity of technology spend, (b) client stickiness (existing clients giving new deals), (c) an early lead in the Digital Foundation Business (Cloud, Security, Digital Workplace, Networks), (d) operational efficiency measures (offshoring, automation), and (e) employees have helped the company achieve growth/improvement.

* Margin expansion in the quarter was driven by increased utilization, offshoring, and automation. Revenue growth and margin expansion in Mode 2 is aiding overall performance.

* The company would offer wage hikes (similar to last year, but with a lag of a quarter – the best in the industry) and variable payouts similar to last year.

* 2QFY21 is seasonally weak for Products, but it saw decent growth on a sequential basis as some bookings were pulled forward from 3Q.

* HCLT signed 15 transformational deals in 2QFY21 (v/s 11 in the last quarter) and gained wallet share in some consolidation opportunities.

* While renewals have been good in 2QFY21, net new deal wins have also grown (+35% QoQ). The deal pipeline is robust (+20% QoQ) and at an all-time high. A good mix of deals is in the pipeline from across geographies (the US and Europe).

* Digital Foundation Services is witnessing significant traction in transformation, cloud adoption, security, etc.

* Strong momentum is seen in Life Sciences and Healthcare, Technology, BFSI, and Telecom. Manufacturing demand has improved, but some impact has been seen from increased offshoring in a large deal. Hence, this vertical would grow slower than others.

* Recovery in ER&D was largely driven by improved demand (new product engineering and product sustenance), which is expected to grow in the near term.

* FCF/PAT conversion continues to be strong due to (a) improved DSO and (b) higher non-cash expenses (depreciation & amortization; some part of tax).

* High localization in the US (two-thirds) helps. H1B visa regulatory changes would still have some impact as HCL needs to provide wage hikes in some cases.


Valuation and view – subdued multiples offer safety margin

* HCLT’s exposure to deeply troubled verticals (e.g., Energy, Travel, Transportation, Hospitality, and Retail) is lower v/s peers. Moreover, the company has higher exposure in Financial Services, Technology Services, and Life Sciences, wherein we anticipate a better outlook.

* Additionally, higher exposure in IMS (~37% of revenue), comprising a larger share of non-discretionary spend, offers better resilience to its portfolio in the current context – with increased demand for cloud, network, security, and digital workplace services.

* Broad-based sequential growth, coupled with healthy deal wins and a robust pipeline, indicates an improved outlook. The upgrade in margin guidance is another positive and indicates its ability to sustain some amount of margin improvement.

* However, the company’s high exposure to ER&D (~16% of revenue) is a key monitorable. While decent sequential growth was seen in this segment in 2Q, the growth outlook in the near term is comforting.

* Given its deep capabilities in the IMS space and strategic partnerships, investments in cloud, and digital capabilities, we expect HCLT to emerge stronger on the back of an expected increase in enterprise demand for these services. The stock is currently trading at a modest ~15x on FY22E earnings and offers a safety margin. Our TP is based on ~19.5x FY22E EPS (a 30% discount to TCS). Maintain Buy.


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