Margin beat; Encouraging guidance
Valuations are the icing on the cake
* HCL Technologies (HCLT) reported EBITDA margin expansion (+20bp QoQ) despite the COVID-19 disruption, which is impressive. Notably, it had reported margin expansion even in 4QFY20, when most other large companies had witnessed contraction. A decent increase in net new deal wins and a robust deal pipeline (+40% QoQ) comfort us. HCLT surprised us by reinstating revenue growth (+1.5–2.5% CQGR, CC) and EBIT margin guidance (19.5–20.5%). Besides bringing back performance visibility, it further hinted that the worst was behind.
* We upgrade our FY21/FY22E EPS by 12–14%. Maintain Buy, as we expect HCLT to better navigate the current crisis and emerge stronger on the back of an expected increase in enterprise demand for Digital Services.
In-line revenue; Strong beat on margins
* HCLT reported revenue (CC) / EBIT / PAT growth of 1%/30%/32% YoY v/s our estimate of 1%/17%/19% YoY.
* Revenue decline was in-line with estimates. As expected, Engineering Services (-9% QoQ, CC) was the biggest overhang on revenue this quarter. While the IT & Business Services segment declined ~8% QoQ (CC), the Products & Platforms business remained resilient (-2% QoQ, CC).
* Across geographies, revenue decline was more or less broad-based.
* Across verticals, BFSI (-1.7% QoQ, CC) remained resilient. Manufacturing (- 19% QoQ, CC), Telecom (-16% QoQ, CC), and Retail (-9% QoQ, CC) were the most impacted.
* The EBIT margin was ~200bp ahead of our estimate. Margins across segments (Mode-1, Mode-2, & Mode-3) remained resilient.
* Operationally, while margins expanded ~20bp QoQ to 25.6%, an increase in the D&A run-rate translated to EBIT margin contraction.
Key highlights from management commentary
* The business impact in 1QFY21 was lower than management initially feared. Revenue decline was led by a) COVID-19 and b) offshoring in large deals, which were ramped-up in FY20.
* A third of the COVID-19 impact was witnessed due to supply-side issues.
* 1QFY21 witnessed cases of deal ramp-downs, volume reductions, and requests for price cuts by clients. However, demand-side challenges have now stabilized, with management indicating the worst is behind.
* HCLT signed 11 transformational deals in 1QFY21 and gained wallet share in some of the consolidation opportunities.
* While renewals have been robust in 1QFY21, net new deal wins have also grown (YoY).
* The deal pipeline is robust (+40% QoQ). Digital and IMS are witnessing significant traction in transformation, cloud adoption, security, etc.
* While the Auto, Aero, and Energy verticals would take longer to recover, BFSI, Retail & CPG, Telecom, and Healthcare should do well going forward.
* The company has guided for a CQGR of 1.5–2.5% (CC) for the next three quarters, which translates to -2.3% to -0.8% YoY revenue growth (CC) for FY21.
* The EBIT margin was guided to be in the range of 19.5–20.5%, 100bp higher than its FY20 guidance.
Valuation and view – Subdued multiples offer margin of safety
* HCLT’s exposure to deeply troubled verticals (e.g., Energy, Travel, Transportation, Hospitality, and Retail) is lower v/s peers. Additionally, higher exposure to IMS (~37% of revenue), comprising a larger share of nondiscretionary spend, offers better resilience to its portfolio in the current context. Besides this, the company has higher exposure to Financial Services, Technology Services, and Manufacturing, wherein we anticipate an uptick in IT spends in the post-COVID-19 era.
* However, the company’s high exposure to ER&D (~16% of revenue) is a key monitorable. The discretionary nature of projects and supply-side challenges make us cautious on this segment.
* We expect HCLT to better navigate the current crisis and emerge stronger on the back of an expected increase in enterprise demand for Digital Services. Our confidence partly stems from the company’s historical track record of adapting to multiple business challenges and technology change cycles. The stock is currently trading at a modest ~12x on FY22E earnings and offers superior margin of safety. Our TP is based on ~15x FY22E EPS.
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