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Good growth in Services and outlook to aid valuations

Uncertainty continues in P&P commentary

HCLT delivered a revenue growth of 1.1% QoQ CC in 4QFY22 (inline), with a strong growth in Services (+5% QoQ CC). However, the same was dragged down by its troubled Products and Platforms (P&P, -24% QoQ) vertical due to seasonality. It reported a good new deal TCV of USD2.26b (+6% QoQ).

EBIT margin at 17.9% (-110bp QoQ) was in line, with a 180bp hit in the P&P business partially offset by an 80bp improvement in Services’ margin. The management had initially guided at a FY23 revenue growth of 12-14%. It lowered its margin guidance to 18-20% (as against 19-21% guided in FY22).

We are encouraged by its strong performance in Services (IT + ER&D) as this is the third straight quarter of strong revenue growth in this segment. With an organic growth of over 5% QoQ in IT Services, we believe HCLT will outgrow its largecap peers in 1QFY23. Within the Services business, IT Services has delivered 5% CQGR in the last three quarters. ER&D has delivered 5.9% CQGR over the same period – one of the best among its peers. We continue to expect Services to gain from the strong momentum in Cloud migration and R&D outsourcing. Strong hiring of ~11.1K (+5% QoQ) indicates better demand visibility.

While the performance of its P&P vertical in 4QFY22 was on expected lines, the segment remains an area where growth visibility continues to elude HCLT. We continue to see good potential for the business in the long run. But as the company shifts to a subscription-based SaaS model from an on premise one, we see growth challenges persisting in FY23. We now expect this vertical to stagnate for the second successive year.

On the margin side, we expect HCLT to continue to struggle due to elevated supply-side issues and a higher investment requirement, which will result in its EBIT margin staying at the lower end of its guidance, before recovering in FY24.

On a combined basis, HCLT should deliver an FY22-24 USD revenue growth of 14.4%. With profitability improving by FY24E, corresponding PAT CAGR will be 11.7%.

We lower our FY23 and FY24 EPS estimate by ~7% each due to the margin hit and lower growth guidance. We maintain our Buy rating with a TP of INR1,310/share (21x FY24E EPS).

Strong performance in Services in 4QFY22

In CC terms, revenue grew 13.3% YoY, INR EBIT rose 25% YoY, and INR PAT increased by 51% YoY in 4QFY22.

In USD terms, revenue grew in line at 1.1% QoQ CC (+0.5% QoQ reported).  USD revenue/INR EBIT/INR PAT grew 12.8%/5.4%/13.7% in FY22.

The strong growth (+5% QoQ CC) in Services – IT Services (+5.2% QoQ CC) and ER&D (+3.9% QoQ CC) – was ahead of our estimate of 4.4% QoQ.

P&P declined by 24% QoQ on seasonality, higher than our estimate of 20%. The vertical delivered flat growth in FY22, at the lower end of the management’s guidance of 0-1%

Mode 2 (+7.8% QoQ) drove growth, while Mode 3 (-20.1% QoQ) acted as a drag on its overall performance.

TCV of new deal wins grew 6% QoQ to USD2.26b in 4QFY22, led by 10 large Service deal wins and a significant amount of small deals.  The management guided at a 12-14% YoY CC growth in revenue terms and EBIT margin in the 18-20% range in FY23.

EBIT margin was in line at 17.9%, down 110bp QoQ and 20bp below our estimate. EBIT margin in IT Services/ER&D was up 90bp/50bp QoQ, but the same for the P&P vertical fell 12.9pp QoQ.

PAT rose 4.4% QoQ to INR35.9b, ahead of our estimate, due to a lower tax rate in 4QFY22.

Cash conversion stood at an OCF/NI of 155% and a FCF/NI of 144%. In FY22, cash conversion stood at an OCF/NI of 125% and FCF/NI of 113%.

Attrition (LTM) in IT Services stood at 21.9%, up 210bp QoQ. Net additions remained elevated ~11.1k in 4QFY22.

The company declared a dividend of INR18/share.

Key highlights from the management commentary

P&P registered a massive 24% QoQ decline after a strong 3QFY22. Changes to its subscription model from the current perpetual model can make the P&P revenue more predictable. The company has started to see this shift, though these are still early days. This transformation to SaaS from an on premise model is a multi-year phenomenon.

New deal TCV grew 6% QoQ to USD2.26b, led by 10 large service deal wins and a significant amount of small deals.

The Life Science vertical is seeing good traction in remote patient monitoring and medical devise provisioning. The Telecom segment is seeing good demand from 5G and telecom modernization. The Manufacturing vertical is seeing good traction in next-gen tech and smart manufacturing. The Financial Services segment remains strong for the company.

Customers are more receptive to pricing conversation, especially in Mode-2.

The management guided at a margin band of 18-20% for FY23 and said that margin should improve from current levels.

Valuations offer a margin of safety

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

Strong sequential growth within Services, robust headcount addition, healthy deal wins, and a solid pipeline indicates an improved outlook.

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 trading ~18x FY24E EPS, which offers a margin of safety. Our TP is based on 21x FY24E EPS. We maintain our Buy rating

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