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MOSL: HCL TECHNOLOGIES (Neutral)-Strong organic revenues but margins weak

HCL TECHNOLOGIES: Strong organic revenues but margins weak

(HCLT IN, Mkt Cap USD19.6b, CMP INR1022, TP INR1150, 12% Upside, Neutral)

 

• Mixed performance - strong revenue but weak margins: Constant currency (CC) revenue grew 17% YoY (our estimate: 14%), EBIT was up 2.7% YoY (our estimate: 8%), while PAT declined 7.7% YoY (our estimate: +1% YoY) in 1QFY20. EBIT margin shrank 180bp QoQ to 17.1% (a 130bp miss) v/s the full-year guidance range of 18.5-19.5%. Multiple factors contributed to the contraction, but the miss was led by weak margins in Engineering Services, where the company had one write-off, investments and also onsite-centric deal ramp-ups. PAT declined 13.5% QoQ/7.7% YoY to INR22.2b (8% miss v/s our estimate of INR24.2b) due to a higher tax rate (24% v/s estimate of 19.3%) and lower operating income.
• What drove better organic revenue momentum? HCLT had anticipated headwinds from three clients: Two in Financial Services (FS) and one in Manufacturing. Against these, there was a large deal ramp-up expected to happen later. However, HCLT was able to transition sooner and book revenues from the deal. On the other hand, in one of the troubled accounts, it saw a turnaround and the ramp-down in the other two was lower than expected.
• Upped organic growth outlook still bakes in cautious macro: HCLT kept its overall revenue growth guidance of 14-16% YoY CC unchanged for FY20. However, it now expects organic growth to be 8-10% (1pp higher), offset by lower inorganic contribution due to one month's delay in the integration of IBM IP purchases. Organic growth still appears conservative, considering 14% YoY CC clocked in 1QFY20. The reason for not increasing it any further is the macro and the trade situation, which can spring in surprises.
• Valuation view: Earnings cut largely on higher tax rate: Despite a strong top-line performance, our EPS estimates are down by 6.5-8% for FY20/21, of which 6pp is on account of the higher effective tax rate at 24% (v/s 19-20% earlier), arising due to goodwill from IBM's IP purchases. Barring that, 70-80bp moderation in the EBIT margin estimate was partly offset by a 1.6% upgrade in our revenue estimate. We continue to separately value IPs (~USD3b in total) at 8x - a multiple that assumes no growth in the portfolio of IPs. This contributes INR100/share to HCLT's value. For the remaining IT Services business, our target price of INR1,050 discounts forward earnings by 14x as the organic growth trajectory inches up. Consequently, our TP of INR1,150 implies an upside of 12%. Maintain Neutral as we watch out for the revenue performance from IPs post the integration next quarter.