Strong earnings growth drives HCL Tech’s sharp re-rating

HCL Technologies Ltd’s shares have risen by 50% this year while those of Infosys Ltd and Wipro Ltd have fallen by 14% and 12%, respectively. As a result, for the first time the company’s valuation is on par with those of Wipro and the discount with Infosys shares has narrowed considerably.

Based on fiscal year 2012-13 earnings estimates of Citi Research and Kotak Institutional Equities, HCL Tech now trades at a discount of only 8-10% to Infosys. Based on past 12-month earnings, the discount is merely 5%.

This re-rating has been driven by strong earnings growth. On Wednesday, the firm announced a 78% annual jump in net profit in the September quarter. Infosys’s profit grew 24% in the same three months. On a quarterly comparison, volumes grew by an impressive 4.5%, although a change in revenue mix resulted in a lower 3.2% growth in dollar revenues.

The proportion of offshore revenues increased by 150 basis points (bps) as a percentage of sales. Besides, discretionary spend continued to be under pressure—the enterprise application services segment declined by 2% in constant currency terms. A basis point is 0.01%.

Even so, profit margins were strong and came as a big positive surprise. The company increased wages for some of its employees, which hit margins by 80 bps. But it was offset by the shift in work offshore as well as an increase in employee utilization. Earnings before interest, tax, depreciation and amortization margin ended up rising by 20 bps, against a 150-250 bps decline in margins most analysts were expecting.

On a year-on-year (y-o-y) basis, margins are higher by as much as 500 bps, implying that a large part of the benefit from the depreciation of the rupee is flowing into the company’s books. Additionally, while there were concerns that some of the company’s large deal wins earlier in the year will deal a blow to margins, HCL Tech seems to be managing overall margins well.

Growth as usual was driven by the infrastructure services division, which now accounts for one-fourth of revenues. Its revenues grew by 10.4% sequentially and by 20.1% y-o-y. Of course, the company-wide y-o-y growth of around 11% is not exciting. But investors have no reason to complain if HCL Tech is able to sustain margins. The jump in margins is leading to an upgrade in earnings estimates. What’s more, the company has managed to increase return on equity, which now stands at 27%. Cash flow was decent in a traditionally weak quarter.

The HCL Tech stock has also been helped by the fact that Infosys and Wipro haven’t yet got their act together. When these firms return to industry growth levels, the stock may well give up some of its relative gains.