Event update: HCL Technologies (Outperformer) - Takeaways from call on products & platforms

We organised a call with HCLT Head of Products - Darren Oberst and CFO - Prateek Agrawal on HCLT’s products and platforms business. 

Key takeaways

• The company has focussed on stabilizing the team, conveying its value proposition to customers and partners and transformation/ modernisation of products acquired, since the IBM deal.
• The key product focus areas are 1) App security and IT operations & end point security 2) Marketing and commerce 3) Digital solutions 4) Devops. The company believes that the products are self-sufficient with limited need to augment its portfolio through inorganic means and is looking to consolidate its investments. Though it still remains open to considering any other compelling opportunities. 
• The company sees revenue uplift opportunities through 1) addressing the large backlog of client requirements, 2) modernising the products through containerization, applying a micro-services approach and launching SaaS versions of products and 3) Bringing innovation to products, which should be visible in significant version releases over the next 2-3 quarters. The company believes the growth will come from existing customers through a combination of improving renewal rates and yields, additional licenses for new functionality or pricing increases in certain products. In addition, it would target new customers.
• The company addressed concerns around 1) Revenue declines in products by indicating that they are mix of consistently growing products and some declining ones, but all are in large addressable markets with an enduring appeal 2) On-premise to SaaS shift not being a blanket threat as SaaS is not a natural choice for a number of products and industries (especially regulated ones like BFSI, healthcare, Govt. and public services). Further, shift for perpetual license holders to SaaS might be more expensive. So looking at providing SaaS as an option but not forcing customers towards it and 3) IRR in products by indicating that it generated 18%+ IRR in licensed IP versus base case of 12-15% and hopes to generate similar IRRs in recently acquired IBM IP. Also it expects to maintain 50% EBITDA margins over next couple of years despite investments.
• The company cited examples of Informix, OneTest, Domino and Unica where new releases have seen responsive take-up from customers.

Valuation and view

View on IP initiatives: We see limited financial risk from the IBM IP acquisition as even a scenario of double digit CAGR declines for the next 15 years and EBITDA margin declines of 1% every year with a salvage value of 1x sales post this period, the IRR generated would be in excess of post-tax cash yield.  We believe if this decline were to be reduced to half, double digit IRR can be generated, which in our view is a realistic possibility. In terms of products, we believe there is synergistic value in products in Security (Appscan, BigFix) and marketing & commerce (Unica, Commerce and Digital experience), even though certain other products like Lotus and Domino could be legacy where the end game could be to reduce client attrition, reduce feature gap and sweat assets, which are significantly cash generating. Successes in its IP initiatives could drive stock re-rating in our view. Currently the market is according minimal value to HCLT’s IP investments.

We reiterate Outperformer on HCLT. Our positive stance is driven by 1) Likely improvement in organic growth on strong deal wins, newer technology demand and lower cannibalisation in IMS deal renewals post FY20E, 2) Possibility of raise in growth guidance, as the top-end of FY20 guidance (16% yoy in CC) implies flattish organic revenues over Q2-Q4, 3) Likely margin stability, aided by higher margin IP business, and, 4) Attractive valuations at ~12.5x FY21E earnings, according almost nil value to its IP investments. We look for USD revenue/EPS CAGR of 11/8.5% over FY19-22E.