HCL Technologies Ltd’s results for the December quarter were better than expected, with revenue growing by 7.5% and earnings before interest and tax (Ebit) by 9.5% in dollar terms. Volumes grew by around 6.5%, better than the 5.7% growth in volumes reported by Tata Consultancy Services Ltd (TCS) earlier in the week.
Revenue has grown at a healthy pace for four quarters in succession, at compounded quarterly growth rate of 7.3%.
Thanks to its high revenue growth, HCL shares have re-rated to some extent lately. Just in this calendar year, its shares have outperformed the National Stock Exchange’s CNX IT index by 16%. Compared with the lows of March 2009, the shares are up about 5.5 times, against a rise of 3.6 times in the CNX IT index.
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This is not to say that everything’s hunky-dory. Maintaining margins have been a challenge in the past year, thanks to investments made by the firm to support the high growth. On a year-on-year basis, Ebit margins have fallen by 350 basis points. So even though revenue grew by 32.6% on a y-o-y basis, Ebit grew by just 5.1% last quarter. One basis point is one-hundredth of a percentage point.
A reason for the large drop in margins is that employee utilization levels (including trainees) have fallen to around 70% on the back of large-scale hiring by the company. According to chief financial officer Anil Chanana, utilization rates should rise to around 75% in a few quarters, which would result in an improvement in margins. He adds that selling, general and administrative expenses, too, should decline as a percentage of sales and that margins should rise by about 200 basis points against the previous quarter, by the June quarter.
In the September quarter results, a concern was the large drop in cash flow generated from operations and the negative free cash flow. Things have bounced back smartly on the cash flow front, with HCL reporting free cash flow in the December quarter.
Even so, the firm’s cash flow generation is quite a few notches below peers. Free cash flow as a percentage of sales stood at only 3% last quarter. In the previous two fiscal years ended June 2010 and June 2009, this metric stood at 9.3% and 4.4%, respectively.
In comparison, Infosys Technologies Ltd’s free cash flow as a percentage of sales stood at 27% and 24%, respectively, in the fiscal years ended March 2010 and March 2009, and in the case of TCS, it stood at 22% and 16%, respectively.
One may argue that the company is spending relatively higher amounts on capital expenditure (capex) and so its free cash flow will tend to look lower in comparison. But even if one were to add back capex, its cash flow from operations is relatively lower. Given its relatively lower margins and cash flow generation, upside to its stock should be limited. In any case, it has outperformed peers by a wide margin.
Graphic by Ahmed Raza Khan/Mint
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