HCL Tech – Performance and

valuation make it compelling

Given the large opportunity size, we draw comfort from HCL Tech’s
current valuation which is at a discount to top performing peers

Highlights

o Strong overall quarter, revenue beats mid-quarter guidance

o Significant margin improvement

o Ups guidance for full year, to end the year with growth

o Strong deal win and positive commentary on future pipeline

o Cloud and digital transformation provide strong tailwinds

o Relative valuation extremely attractive

We had strongly recommended HCL Tech (CMP: Rs 827, Market cap: Rs 224,447
crore) as the stock with the highest margin of safety and the second-quarter numbers
only deepen our conviction. The company had initially estimated a revenue increase
of 1.5-2.5 per cent in constant currency in Q2 and a margin in the band of 19.5-20.5
per cent. However, the strong momentum in the quarter had prompted the company to
revise its guidance mid way to a revenue exceeding 3.5 per cent sequential growth and
an EBIT margin between 20.5-21 per cent. The actual outcome turned out to be even
better, with strength visible across the board. While the stock had a great run in the
past three months and rallied 32.4 per cent, outperforming the Nifty return of 8 per
cent and IT index return of 28 per cent, the valuation at 15.7X FY22e earnings
continues to remain compelling and offers high margin of safety.

Key positives

The revenue for the quarter at $2506.6 million showed a sequential growth of 6.4 per
cent in reported currency and 4.5 per cent in constant currency. However, on a year-
on-year (YoY) basis, there was a slight contraction of 0.4 per cent in constant
currency terms.

The company is, however, on the right track. The share of its Mode 2 (largely digital)
and Mode 3 (largely products) services is now at 37 per cent with a strong sequential
growth driven largely by Mode 2 that showed an increase of 6.9 per cent in constant
currency, much ahead of the company’s overall performance.

Turning to geographies, strong traction was seen in rest of the world. The key market
of Americas (with a share of 63 per cent) grew strongly as well.

HCL Tech has a well-diversified industry exposure and, post the drop in the previous
quarter, all the seven industry verticals of the company have showed positive
sequential growth. The better performers were life science & healthcare, retail and
technology & services.

Another highlight of the quarter was the strong improvement in the EBIT (earnings
before interest and tax) margin at 21.6 per cent, up 108 basis points sequentially.
While forex had a negative impact of 24 basis points (bps) and investment in product
and platform business consumed 32 bps, there was a 7-bps savings in depreciation and
amortisation. Finally, productivity improvement contributed close to 157 bps. The
traction in revenue coupled with margin improvement in its Mode 2 business aided
the overall margin.

The order booking and pipeline also lend confidence. The order booking in Q2 was
similar to the year-ago quarter and 35 per cent higher than the preceding quarter. The
company signed 15 net new transformational deals and had robust renewals. From a
pipeline perspective, the company is seeing good deal creation activity across all
verticals and geographies and a good momentum in the cost transformation and
vendor consolidation deals. Overall, HCL Tech’s Q2 pipeline grew by 20 per cent
sequentially and, at present, stands at an all-time high.

The strong show and robust pipeline prompted the company to revise its guidance
upwards. Revenue guidance for Q3 and Q4 in constant currency is in the range of 1.5-
2.5 per cent, translating into a 0-0.7 percent growth for FY21 against an earlier
guidance of a contraction in the range of 0.8-2.3 per cent. The EBIT guidance has
been revised to 20-21 per cent from 19.5-20.5 per cent earlier.

Cash conversion was extremely strong with cash position at $1.83 billion. Client
matrix was stable and attrition showed a sequential decline of 240 basis points to 12.2
per cent.
Source: Company

Key negatives

In terms of geographies, Europe is yet to pick up. The performance of HCL Software
was weak as well.

Turning to industry verticals, manufacturing, financial services, telecom and public

services continue to remain soft.

After the strength exhibited in this quarter, the guidance points to a softer Q3 on the
back of seasonality.

The company is affecting a salary hike in October and January quarters, which might
impact margin.

Outlook

The intensity of technology spend as companies calibrate their business models to the
new normal is increasing. The significant modernisation and digital transformation
initiatives of enterprises and the importance of digital foundation, enabled by hybrid
cloud, digital workplace, networks and cyber security, are becoming super critical for
enterprise transformation.
Buoyed by the strong momentum in the cloud business, HCL Tech is continuing to
invest in its partnerships with Google Cloud, AWS, Azure and IBM. This is an area of
sustained traction in the future.

Given the large opportunity, we draw comfort from HCL Tech’s current valuation,
which is at a discount to its top performing peers.