HCL Technologies had acquired the UK-based Axon Group plc last year for £441.1mn ($658million).
While the strategic rationale of the deal is well understood, in the medium-term, owing to lower Margins of Axon, debt of $585 million taken and goodwill write-offs, HCL Tech’s margins and bottomline are expected to remain under pressure. We expect the Axon deal to become EPS-accretive only post-FY2011.
The company had a significant $1.6 billion as outstanding hedged positions at the end of 2QFY2009, which amounted to nearly 75% of FY2009E revenues.
In an environment of currency volatility and Rupee depreciation, this subjects the company to significant risks. Accumulated losses in ”Other Comprehensive Income” in the Balance Sheet stood at $210 million.
With the Rupee expected to remain weak, forex losses could continue to negatively impact Earnings, even as the company is not taking fresh hedges.
It should be noted that the Government has given relief to corporates on Accounting Standard 11 (AS-11), which deals with accounting for foreign exchange movements.
This move, which will positively impact FY2009 numbers, will not impact our FY2010 estimates, as we have taken a lower Rupee-Dollar rate as compared with the current exchange rate, which does not lead to any forex losses in that fiscal, thus leading to no major changes in EPS for that fiscal.
We await further clarity on details about the implementation of this move.
Outlook and valuation
We expect HCL Tech to record a CAGR of 16.5% in topline over FY2008-10E, while bottomline is expected to register a 1.4% compounded decline over the mentioned period.
Axon acquisition is expected to pressurise EBITDA margins, which are estimated to decline by 240bp over the period to below 20% levels (19.8%) by FY2010.
On account of higher Interest costs due to the debt taken on to finance the Axon acquisition and goodwill amortisation, apart from a higher tax rate, we expect the company’s EPS to grow at a subdued pace, particularly on account of an over-18% y-o-y decline in FY2010.
At Rs107, the stock is quoting at 6.7x FY2010E EPS, which is close to lifetime lows. However, as we have mentioned, we do not expect the stock to get a major re-rating on account of the various headwinds being faced by the company, even as the dividend yield of 8.4% provides a downside cushion.
We initiate coverage on HCL Technologies with a REDUCE recommendation and 12-month target price of Rs96, implying a P/E of 6x FY2010E EPS.