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Strong growth in Services to cushion product softness

Expect strong growth momentum in FY23E, maintain Buy

* HCLT delivered a 2QFY22 revenue growth of 3.5% QoQ (CC), 40bp below our estimate. While the decline in the Products and Platforms vertical (-8% QoQ CC) due to a delay in deal closure was disappointing, Services (IT + ER&D, 5.2% QoQ CC) came in better than expected. EBIT margin fell 60bp QoQ to 19% and was in line. The management reiterated its guidance of double-digit USD revenue growth and 19-21% EBIT margin for FY22, although it lowered its Products and Platforms growth to 0-1% (from low-single digits).

* New deal TCV of USD2.3b (+38% YoY, 14 large deals) in 2QFY22 was better than expected.

* We are encouraged by the strong performance in the Services business, especially the ER&D vertical, where the demand environment remains favorable. With the management expressing confidence in continued growth momentum in the business in 2H, this should drive growth in FY22.

* There is a big divergence between revenue growth and employee addition at HCLT over the last four quarters (Exhibit 1 and 2), which stands out v/s its peers. We view HCL’s pre-emptive employee additions (~35k over four quarters, +22% YoY) as a smart move and a safeguard against the current supply crunch. It also points to the management’s confidence in growth acceleration in the Services business over the next few quarters, which should help usher revenue growth and employee productivity back to its historical levels. We expect HCLT to deliver USD revenue growth of 14.1% in Services over FY21-23E.

* While we continue to see potential in HCLT’s Products and Platforms business and expect it to return to high single-digit growth in FY23E, we view the guidance cut to be a drag on valuation in the near term, due to elevated uncertainty in the business and relative lack of comfort in its business potential.

* On a combined basis, HCLT should deliver FY21-23E USD revenue growth of 13.1%. We expect the EBIT margin to stabilize at 20% in FY23E, which should help it deliver a 14.3% PAT CAGR over FY21-23E.

* We positively view the revision in HCLT’s payout policy (at least 75% of net income, up from 50%) over FY22-26 and expect it to be welcomed by shareholders. A higher payout should improve the return metrics for the company as well as help total return generation in the stock.

* We tweak our FY23E EPS estimate by 2% due to a slower pickup in high margin Products and Platforms business. We maintain our Buy rating as we expect traction in the Services business in 2HFY22E and FY23E, driven by higher IMS/Cloud-focused deals. Our TP of INR1,430/share implies 25x FY23E EPS.

Valuations offer a safety margin

* Higher exposure to IMS (~37% of revenue), comprising a larger share of nondiscretionary spend, offers a better resilience to its portfolio in the current context, with increased 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. While the Products business will be soft in FY22E, we expect high single-digit growth for FY23E led by HCLT’s capabilities to rightly align and sell these products in the long run.

* 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 ~22x FY23E EPS, which offers a margin of safety. Our TP is based on 25x FY23E EPS. We maintain our Buy rating.

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