HCL Tech Q3 FY16

CMP: Rs838   1‐yr Target: Rs998   Upside: 19.1%

²  Revenue growth was modest as expected; growth in IMS improves

²  Execution on order backlog to uplift growth trajectory

²  Operating margin improved by 80bps qoq; recovery likely to be gradual over medium term

²  Investment risk‐reward favourable; Retain BUY

Result table

(Rs cr)		Q3 FY16	Q2 FY16	% qoq	Q3 FY15	% yoy
Net sales	10,341		10,097	2.4	9,283	11.4
Operating profit	2,225		2,092	6.4	2,319	(4.1)
OPM (%)	21.5		20.7	80 bps	25.0	(347) bps
Depreciation	(153)		(135)	13.3	(109)	40.4
Other income	355		241	47.3	216	‐
PBT	2,427		2,198	10.4	2,426	0.0
Tax	(508)		(472)	7.6	(510)	(0.4)
Effective tax rate (%)	20.9		21.5	‐	21.0	‐
Reported PAT	1,919		1,726	11.2	1,916	0.2
PAT margin (%)	18.6		17.1	146 bps	20.6	(208) bps

Revenue growth was modest as expected; growth in IMS improves

In‐line with our expectation, HCL Tech delivered a modest constant currency (CC) dollar revenue growth of 2.1% qoq. The annual revenue growth moderated to 9.3% from 13.5% in the previous quarter. Growth in IMS services (35.5% of company revenue) improved to 3.4% qoq v/s 0.9% qoq in the preceding quarters and for the period CY15, it stood well ahead of the company at 16% yoy. Traction in BPO (5.5% of revenue) continued to be strong with revenues increasing by 8% qoq in Q3 FY16 and 24% yoy in CY15. Growth in Engineering and R&D services (18.6% of revenue) was weak this quarter at ‐1.5% qoq; however, the service line grew by strong 23% yoy during the past 12 months. Application services (40% of revenue) remain a soft spot for HCL Tech; revenues grew by only 6% yoy in CY15 dragging down overall growth of the company. Growth was disparate within verticals with Retail & CPG (up 10.3% qoq), Public Services (up 8.4% qoq) and Telecom/Media (up 3.4% qoq) growing at faster pace. Regionally, America grew by robust 5.5% qoq while Europe declined by 2.4% qoq.

Operating margin improved by 80bps qoq; recovery likely to be gradual over medium term

Q2 F6/16 operating margin of HCL Tech stood at 21.5% representing an improvement of 80bps qoq. This was mainly driven by significant 140bps qoq expansion in gross margin on the back of uptick in employee utilization (ex‐trainees improved by 110 bps qoq) and currency benefits. The company is also likely to have extracted benefits in fixed price/managed services contracts, the share of which has been increasing in revenues. Investment in the area of sales and marketing led to SG&A level rising by 60bps qoq to 13.1%. The business investments incurred related to large deals in recent quarters would likely be leveraged over the medium term thus enabling HCL Tech to improve its margin profile.

Investment risk-reward favourable; Retain BUY

In our view, a combination of healthy dollar revenue growth and small margin expansion should drive a decent 13‐14% pa earnings growth for HCL Tech in F6/17 and F6/18. With the stock having underperformed in the past 6‐9 months, valuation at near 12x FY18 P/E is undemanding and represents an attractive investment risk‐ reward for long term investors. Retain BUY recommendation on HCL Tech with a 12‐month target of Rs. 998.