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Defensive portfolio to help navigate macro headwinds

ER&D slowdown leads to 4QFY23 miss

* HCL Technologies (HCLT)’s 4QFY23 revenue declined 1.2% QoQ in constant currency (CC), dragged by seasonal weakness in Software business (-14.6% QoQ in CC) along with a sudden ramp down in ER&D vertical (-3.8% QoQ in CC). IT Services, however, grew by a reasonable 1.6% QoQ in CC despite slowing demand environment. Net new deal TCV was also soft at USD2.1b (down 12% QoQ and 8% YoY) in 4Q, while FY23 TCV (USD8.86b) was up 6.7% YoY. Management guided for FY24 USD revenue growth of 6-8% YoY in CC (6.5%-8.5% YoY in CC for Services).

* EBIT margin for 4QFY23 (at 18.2%, down 140bp QoQ) was in line and dipped due to seasonal weakness in Software business coupled with the adverse impact from revenue decline in ER&D business. Management guided for FY24 EBIT margin to be in the 18-19% range and it maintained its mediumterm margin aspiration of 19-20%.

* While HCLT’s IT Services vertical (+1.6% QoQ in CC) fared better than its larger peers (TCS and INFO), cutbacks in discretionary spends in tech and telecom verticals hit ER&D and overall Services business (up 0.6% YoY in CC). With continued traction in renewals and vendor consolidation, we expect the IT services vertical to deliver decent growth of 8.5% YoY in CC despite muted TCV (book-to-bill of 0.6x). The ER&D business should remain soft in 1QFY24E, which would pull down the performance of Services segment to 7.3% YoY in CC in FY24E, a little below the mid-point of its guidance.

* There is a visible weakness in macro with delays in decision making and cuts in discretionary spending. Management suggested that ‘Run the Business’ spends are not impacted though. There is increased traction in cost takeout and vendor consolidation deals. Though there will be a few mega deals starting in 1QFY24, we expect growth to be back-ended for FY24.

* HCLT has delivered good margin improvement over the last few quarters. Its guidance of 18-19% EBIT margin in FY24, despite the prevailing uncertainties and larger share of cost take out deals in pipeline, suggests good cost control measures. We expect HCLT to deliver an FY24 EBIT margin of 18.4% and further improve this to 18.8% in FY25.

* We continue to view HCLT’s defensive business as positive in a demandconstrained environment. On a combined basis, HCLT is expected to deliver USD revenue growth of 10.2% and a corresponding PAT CAGR of 12.5% over FY23-25. The stock is currently trading at an inexpensive 15x FY25E EPS.

* We have cut our EPS estimates by 3-4% to account for 4QFY23 miss and weak macro. Reiterate BUY with a TP of INR1,250 (based on 18x FY25E EPS).

Revenue misses estimates; margins in line

* Revenue declined 1.2% QoQ in CC and 0.3% in USD terms v/s our estimate of 0.6%. New deal TCV stood at USD2.1b (down 12% QoQ and 8% YoY) in 4Q.

* For FY23, HCLT delivered USD Revenue/INR EBIT/INR PAT growth of 9.6%/14.3%/9.9%.

* FY23 OCF to Net Income stood at 121%. Cash and Cash equivalents were at USD2.5b.

* For FY24, revenue growth guidance was at 6-8% YoY in CC (6.5-8.5% CC for Services). Management guided EBIT margin at 18.0-19.0% in FY24.

* HCLT’s EBIT margin was in line at 18.2%, down 140bp QoQ in 4QFY23.

* LTM attrition was down 220bp QoQ to 19.5%. HCLT added 3.7k employees in 4QFY23.

* Management declared a dividend of INR18/share bringing the full-year (FY23) dividend at INR48. This translates into 87.5% payout.

* FCF/Net Income conversion remains strong at 110%

Key highlights from the management commentary

* For ER&D, management saw the impact in technology and telecom due to cuts in discretionary spends. The weakness is expected to continue in 1QFY24 too.

* The macro environment remains a concern. HCLT is seeing delays and ramp downs on discretionary spends. However, it does not see much stress on ‘Run the Business’ services.

* Client budgets are contracting for industries that are witnessing high inflation. Clients are adjusting to the new budgets.

* There is a huge uptick in cost optimization and vendor consolidation deals in pipeline.

* HCLT hired 25k+ freshers in FY23 and sees good opportunity for improvement there. It will continue to hire high number of freshers over the next 2-3 years.

Valuations offer a margin of safety; reiterate BUY

* Higher exposure to Cloud, which comprises a larger share of non-discretionary spends, offers a better resilience to its portfolio in the current context, with higher demand for Cloud, Network, Security, and Digital workplace services.

* An easing supply scenario and a strong margin trajectory provide comfort on margins for the company.

* Given its capabilities in the IMS and Digital space along with strategic partnerships and investments in Cloud, we expect HCLT to emerge stronger on the back of healthy demand for these services in the medium term. The stock is trading at ~15x FY25E EPS, which offers a margin of safety. Our TP of INR1,250 is based on 18x FY25E EPS. We reiterate our BUY rating.

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