HCL Technologies' Q2FY18 results (Neutral) - Organic growth stays the weakest among peers

Q2FY18 result highlights

• Another revenue miss, but margin beat: Revenues grew by 2.3% qoq to US$1,928m (IDFCe: $1,948m, Cons.: $1,956m) aided by contribution from UFS BPO (2 months) and 0.9% in CC terms. EBITDA margin expanded by 10bp at 22.2% (IDFCe: 21.4%, Cons: 21.6%), despite wage hike and INR appreciation offset by partially offset non-occurrence of visa cost and G&A efficiency. EPS grew by 3.6% qoq to Rs15.68 (IDFCe: Rs14.36, Cons.: Rs14.90) partially aided by other income.
• Investment in IP continues: HCL Tech continues to invest cash for IP partnership. Management invested ~US$50m in IP partnership with DXC Technologies after terminating the previous engagement. The company has so far invested ~US$825m (350+50+155+80+140+50) in six tranches that is ~10% of revenue and ~4+ years of capex. The revenue stream expected from the investments is ~US$200m. Management look for more IP-led partnership that may require cash investment. The company’s investments in IPRs are 52.4bn higher than net block PPNE Rs50.4bn. We see accelerated pace of investments in IPR as risk. Weakened outlook for IMS is key reason for accelerate inorganic strategy as organic revenue growth of is correlated with IMS outlook. We see downside risk to our ~10% revenue CAGR over FY17-19E, which is lower than FY18 guidance of 12.1-14.1% yoy growth.
• Revenue drag in H2 to restrict growth to lower end of guidance: Management highlighted that impact of project closure in India and termination of DXC contract to impact H2FY18 revenue by ~US$100m.   Hence, FY18 revenue growth is likely to be towards the lower end of the guidance, which may include inorganic contribution also.
• Is IMS service under competitive threat?: HCL Tech reported IMS revenue growth of 25% yoy in FY17, but excluding Volvo IT revenue growth was ~5% yoy, whereas in FY18 it would report mid-single digit revenue growth in the service line. The company has reported one of the weakest revenue additions. Larger peers like TCS and Infosys is growing in low-double digit. We continue to see challenges for the existing IMS portfolio of HCL Tech on account of (i) increasing competitive intensity, (ii) pricing pressure on existing revenue stream when it comes for rebid, and (iii) migration to cloud. We continue to see downside risk on the legacy portfolio of HCL Tech that got further bloated by legacy acquisition.

Key positives: Margin performance

Key negatives: Anaemic organic growth guidance

Impact on financials: FY18-19E revised up by 0-2%.

Valuations & view

In-line with our expectation, HCL Tech organic revenue growth remains restricted to mid-single digit (Q2FY18: ~0.5% qoq). We believe sustained deceleration in IMS growth momentum, heightened risk of accelerated IP investments, and risk of revenue erosion of acquired legacy portfolio exposes downside risk to earnings. Also, limited margin levers and sustained pricing pressure leave limited room for positive surprise on earnings. We expect ~8% EPS CAGR for FY17-19 despite ~10% revenue CAGR (organic closer to mid-single digit). Maintain Neutral.