Event update: HCL Technologies (Neutral) - HCLT to acquire select IBM products for $1.8bn

IBM and HCL Technologies today announced a definitive agreement under which HCLT will acquire select IBM software products for $1.8 billion. The transaction is expected to close by mid-2019, subject to completion of applicable regulatory reviews.

Key Highlights of the Conference Call

Financials of the Deal

• Incremental Revenue of ~$650 M on a run-rate basis in Y2 after close, Y1 will be soft due to transition. Y1 expected to be ~$25 M lower due to transition.
• Management mentioned EBITDA margin (%) expected to be over 50% on a run-rate basis (slightly lower in Y1).
• Management mentioned that they continue to pay-out ratio 50% of net income.
• Valuation of 3x sales and 6x EV/EBITDA is not expensive.
• Management have maintained their revenue guidance of 9.5% to 11.5% for FY19

Investment:

• Total investment of $1,775 M including earn-out
• Approx. 48% to be paid at close, most of balance to be paid after Y1
• Financed largely through internal accruals and a debt of $300 M at close. HCLT has net cash of $1.1bn.

Our view

This is big departure for HCLT from having licensing based product partnerships to now owning the products completely. The EBITDA margin are healthy but we think that this will also now require investments and they remain at the risk of cannibalisation from new innovation. From a financial impact perspective, we have been of the view that HCLT is amortising lower than typical product companies. (: Insights into technology intangibles versus global tech) Given the product ownership now, we do believe that D&A should move up and thus we don’t think this deal will be materially EPS accretive on a reported basis.  We think that the revenue and business profile of HCLT is getting more risky, introduction of product business mix will likely drive more earnings volatility and requires superior execution. Maintain Neutral.