HCL Technologies' Q2FY20 results (Outperformer) - Retain top pick status

Q2FY20 result highlights

• Organic growth and guidance raise a positive: HCLT CC revenue growth of 6% q-q (vs est. of 6.5%) was a tad lower due to accounting treatment of product & platform revenues but was better on organic growth at ~1.6% q-q. Company raised overall FY20 revenue growth guidance to 15-17% (vs 14-16% earlier) and organic growth guidance to 10-11% (vs 8-10% earlier). Ask rates to meet the guidance are reasonable at -0.6 to 1.6% q-q in 3Q/4Q. The company announced a 1:1 bonus.
• Margins above expectations: HCLT posted EBIT margins of 20% up 290bps q-q (vs est. of 18.2%). The beat was driven by higher margin product revenues, productivity benefits in E&RD and SGA reduction. Company reiterated EBIT margin guidance of 18.5-19.5% (1H at 18.6%), with likely improvement in 3Q as better product seasonality aids margins. 
• Outlook suggests growth closer to higher end of its guided range: Company indications of likely positive sequential organic growth in 3Q/4Q and progressively better revenues in products & platforms suggest better than mid-point of its guided range on growth. We look for growth towards high end of its guidance at ~17% y-y.

Key positives: strong E&RD growth (5.4% q-q), strong deal wins (15 large deals won) and margin performance.

Key negatives: Weak cash generation (CFO/EBITDA of 44% in 2Q, partly depressed by receivables from IBM) and softness in manufacturing & retail/CPG. 

Impact on financials: ~4/1% EPS increase in FY20/21E driven by margin beat in 2Q. We raise EBIT margin est. by ~60-90bps to ~19.5% levels over FY20-22E.

Valuation and view

We retain Outperformer on HCLT and reiterate it as our top pick on 1) Best in class organic growth among tier 1 IT and comfort in light of strong positioning in IMS and E&RD – both large spend areas, with low Indian IT penetration 2) Comfort on margins as higher margin product business cushions legacy business pressures 3) Attractive valuations at sub 13x FY21E EPS (discount of 40% to TCS). We look for USD revenue/EPS CAGR of 11/9% over FY19-22E, with stable IT EBIT margins at ~19.5% levels over this period. Our TP of INR1255 is based on 14x 1 yr forward EPS upto Sep-21E of INR89.6.