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Services strength to cushion any Product softness

Maintain Buy

* We expect the robust performance in HCL’s Services business, especially the ER&D vertical, to continue as the demand environment remains favorable. We also draw comfort from improving management commentary on continued growth momentum in the IT Services business.

* Sustainable demand momentum for Cloud and Digital Engineering benefits HCLT, given its large presence within IMS and ER&D and continued investments in capabilities. Strong headcount additions and deal wins reflects the management’s confidence on a sustainable growth momentum.

* We continue to see potential in HCLT’s Products and Platforms business. While, the recent departure of the head of Products has elevated concerns on business recovery. However, we don’t see a meaningful risk of a further hit from this event, our sensitivity analysis (Exhibit 7) suggests limited impact on EPS even in a bear case (4% decline in revenue for the Products and Platforms business in FY23E would lead to a 2.6% drag on our EPS estimate).

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

* HCLT’s recent revision in payout policy (at least 75% of net income, up from 50%) over FY22-26 is a positive. A higher payout reflects a strategic shift to focus on organic growth and limit inorganic investments to bolt-on and capability based acquisitions (v/s large revenue accretive acquisitions).

* We maintain our Buy rating as we expect traction in the Services business in 2HFY22E and FY23E, driven by higher IMS/Cloud-focused deals.

Services business – headcount addition illustrates strength

* 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 the front ending of employee addition (~35k over the last 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.

* Fresher hiring has seen an acceleration and is expected to rise further. HCLT hired 5.5k freshers in 2Q (v/s 3.5k in 1Q) and intends to hire 20k freshers in FY22. 

* We expect HCLT to deliver USD revenue growth of 14.1% in Services over FY21-23E.

Beneficiary of Cloud transformation led by IMS leadership

* Cloud transformation is the backbone of the current acceleration in technological demand. As per Gartner, end-user spending on Cloud services is ~USD330b in CY21E, and is growing at more than 20% CAGR over CY20-23E (Exhibit 8). Moreover, IaaS will see the highest growth at 34% CAGR.

* HCLT’s strong IMS capabilities (over 30% of revenue) and partnerships with leading hyperscalers, strategically positions it to capture the high growth opportunity in Cloud.

* It has been one of the early movers in the Cloud ecosystem and is one of the first large system integrators in the world to design dedicated business units for each Cloud hyperscaler, some as far back as two years ago.

Large engineering presence to benefit from demand momentum

* HCLT has one of the largest global ER&D practices. This includes client relationships with 65 of the top 100 global ER&D spenders.

* It has a balanced mix of asset heavy (Aero, Auto, Industrial, Telecom, etc.) and asset light verticals (Software and internet, Healthcare, etc.). 

* The management has laid down an investment plan for new emerging technologies like Softwareization within Digital Engineering, IoT, 5G, etc. A significant part of this investment would focus on training its employees, besides enhancing its digital Centers of Excellence for deeper capability incubation. It currently has more than 80 engineering labs (v/s over 50 labs for LTTS).

* The demand momentum within ER&D is strong, with demand for full scale digital engineering solutions steadily increasing. Deal sizes and visibility for ER&D services has been increasing. Its large ER&D presence and capability enhancing investments will drive continued growth for this business.

Products and Platforms – a bumpy ride ahead

* HCLT’s Products and Platforms business, which also houses software acquired from IBM, has been witnessing multiple challenges like: 1) discontinuation of certain products, 2) decline in 2QFY22 revenue led by end of quarter delays in deal signings, and 3) resignation of Mr. Darren Oberst, CEO, HCL Software.

* Leadership attrition in an already challenged business increases the risk to a sustainable recovery. The management’s guidance and commentary for the P&P business has gradually become cautious (Exhibit 6). We have created a sensitivity analysis (Exhibit 7), which depicts that even in a bear case (4% decline in P&P revenue in FY23E), the EPS impact is restricted to 2.6%.

Higher shareholder payouts depict a strategic shift

* HCLT’s acquisition intensity in the past has led to lower shareholder payouts v/s larger peers.

* The company has been constantly improving its shareholder payouts. It has recently announced a dividend payout policy, which implies a distribution of at least 75% of net income over a five-year period.

* The management has revised its quarterly dividends to INR10/share (from INR6/share) for FY22. The quarterly DPS has been continuously moving up to INR10/share in 2QFY22 v/s INR1/share (adjusted for the stock split) in FY19.

* The 75% payout ratio would be the highest in the past 15 years. We see this commitment as a strategic shift to focus on organic growth and limit inorganic investments to bolt-on and capability-based acquisitions (v/s large revenue accretive acquisitions).

Valuations offer a safety margin

Given its deep capabilities in IMS 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 ~20.1x 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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