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Growth acceleration to compensate for margin hit

Scope for upside surprise in P&P guidance

* HCLT delivered an exceptionally strong revenue growth of 7.6% QoQ CC in 3QFY22, 310bp above our estimate, led by its troubled Products and Platforms (P&P, +24.5% QoQ) vertical, which did exceptionally well despite benefitting from seasonality and deal spill over from 2QFY22 (600bp impact). Its Services verticals (IT Services/ER&D up 4.7%/8.3% QoQ CC) continued to clock strong growth and was ahead of our estimate. HCLT reported strong new deal TCV of USD2.1b (flat QoQ, +64% YoY).

* EBIT margin at 19% (flat QoQ) missed our estimate by only 40bp, but was impacted by large variance in the margin of IT Services (down 220bp QoQ) and P&P (up 12.5pp). The management reiterated its double-digit USD revenue growth guidance (including P&P growth of 0-1% YoY), but reduced its margin guidance to the lower end of 19-21% band (with a 10-20bp downside buffer).

* Its topline delivery in 3QFY22 is encouraging and supports our view that its three business lines are well positioned in a strong demand environment. Its Services business (IT+ER&D) – up over 5% QoQ for the second straight quarter – should gain from the strong momentum in Cloud migration and R&D outsourcing. TCV growth of 45% YTD and front ended employee addition (up 5.3% QoQ in 3QFY22) also point to robust growth.

* The performance of its P&P vertical in 3QFY22 was much better than our estimate of 12.5% QoQ growth. Besides the deal spill over, it also saw a good software renewal rate and new product sell through. The implied degrowth (-20% QoQ) in 4Q to meet the upper end of its FY22 guidance is conservative and is driven more by timeline (quarter-end dependency) than seasonality. Hence, there is a high likelihood of HCLT again beating expectations on P&P growth in 4QFY22.

* The margin outlook on IT Services was below our estimate as HCLT continues to struggle to absorb the impact of an adverse supply scenario. While it will be raising prices across accounts, we expect margin to stay at the lower end of its current guidance for FY23 before recovering in FY24.

* On a combined basis, HCLT should deliver an FY22-24E USD revenue growth of 15.1%, with growth almost doubling from FY20-22E levels. With profitability improving by FY24E (up 100bp v/s FY22E levels), the corresponding PAT CAGR will be 17.7%.

* USD revenue/INR EBIT/INR PAT grew 13.5%/0.1%/4.5% YoY in 9MFY22.

* We lower our FY22E EPS estimate by 1% due to a margin hit, but raise the same for FY23 by 2% due to growth acceleration. We maintain our Buy rating and marginally tweak our TP to INR1,690/share (25x FY24E EPS).

Very strong growth in 3QFY22, margin in Services below our expectation

* Revenue grew 15% YoY CC, INR EBIT fell 4%, and INR PAT was flat YoY in 3QFY22.

* In USD terms, revenue grew 7.6% QoQ CC (6.7% QoQ reported), 310bp above our estimate.

* HCLT clocked strong, broad based growth in IT Services (+4.7% QoQ CC), ER&D (+8.3% QoQ CC), and P&P (+24.5% QoQ/+8.2% YoY).

* Mode 3 (+21.6% QoQ) drove growth, while Mode 1 (+5.1%) and Mode 2 (+6.1%) also saw good growth.

* Growth was driven by double-digit sequential growth in Technology and Services (+14% CC), Retail and CPG (+11.5%), and Technology and Services (+11.3%). Financial Services/Public Services/Manufacturing/Life Sciences/ Healthcare grew (+6.3%/+6.1%/+5.7%/+0.9%).

* TCV of new deal wins grew 64% YoY to USD2.1b in 3QFY22, led by eight large service deal wins and an equal number of significant product deal wins.

* EBIT margin stood flat QoQ at 19%, 40bp below our estimate, but the mix was unfavorable.

* EBIT margin in IT Services was down a surprising 220bp QoQ. The same for ER&D fell 70bp QoQ, but rose 12.5pp for P&P.

* PAT rose 5.5% QoQ to INR34.4b, in line with our estimate.

* The management maintained its double-digit revenue growth guidance in CC terms for FY22.

* EBIT margin is expected to be in the 19-21% range in FY22.

* In 3QFY22, Operating/Free Cash Flow stood at USD584m/USD521m. Cash conversion was at an OCF/NI of 128% and a FCF/NI of 114%. On a LTM basis, cash conversion was at an OCF/NI of 117% and FCF/NI of 102%.

* Gross/net cash stood at USD2.7b/USD2.1b at the end of 3QFY22.

* Attrition (LTM) in IT Services stood at 19.8%, up 410bp QoQ. Net additions remain elevated at 10,143 in 3QFY22.

* The company declared a dividend of INR10/share.

Key highlights from the management commentary

* HCLT reported strong growth (+7.6% QoQ CC) in 3QFY22 – the highest in the last 47 quarters. Growth in 3QFY22 was aided by strong growth in IT Services/ER&D/P&P (+4.7%/8.3%/24.5% QoQ CC).

* P&P registered a massive 24.5% QoQ growth after a soft 2QFY22. The growth was led by commerce, Digital experience, marketing, and security services. The P&P business saw a gain of ~USD20m from deals pushed out from 2QFY22 along with new wins. The management maintained its 0-1% guidance due to the volatile nature of the business.

* New generation services like ER&D, Cloud, and data modernization drove growth. The management is seeing traction in the Cloud, with the migration of existing workloads, data modernization, and innovations once the data are in the Cloud.

* New deal TCV grew 64% YoY to USD2.1b, led by eight large service deal wins and an equal number of significant product deal wins.

* The deal pipeline remains strong and broad based across geographies, verticals, and service lines. Though the pipeline remains fairly balanced between small and large deals, the company is seeing more small deals (especially in front office transformation). This would result in faster revenue accretion for HCLT.

* The management has maintained its margin guidance band of 19-21%.

Valuations offer a safety margin

* Higher exposure to Cloud, comprising 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 ~23x FY23E EPS, which offers a margin of safety. Our TP is based on 25x FY24E EPS. We maintain our Buy rating.

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