HCL Technologies Ltd is the only top-tier information technology (IT) stock that is trading close to the high it reached earlier this year. Shares of Tata Consultancy Services Ltd (TCS), Wipro Ltd and Infosys Ltd are 7%, 17% and 20% lower, respectively, compared with their highs in 2001.

HCL Tech’s shares are just 3.6% lower than the highs they had reached soon after the March quarter results announcement, when the company had reported a 130 basis points (bps) improvement in operating profit margins. One basis point is one-hundredth of a percentage point.

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It has followed that up with another 110 bps improvement in margins in the June quarter, and has achieved its target of an earnings before interest and tax (Ebit) margin of 15.4% by the end of the fiscal ending June. But this time around, investors are not all that impressed. The stock fell by 2% after the results were announced. After the March quarter results announcement, the stock had jumped by 10%.

The margin improvement in the March quarter was driven by both an improvement in gross profit as well as savings on selling, general and administrative (SG&A) expenses. In the June quarter, SG&A expenses fell by 80 bps, accounting for the majority of the increase in margins. This has led to concerns whether the improvement in margins is sustainable. After all, if SG&A expenses are kept at low levels, it will affect growth in the future and ultimately affect margins. At June quarter levels, SG&A expenses as a percentage of revenue are at a six-year low of 13.9%.

Besides, the company’s shares had already been outperforming, and the likelihood of a further rise was low.

On the revenue front, the company reported a decent 5.3% growth on the back of a 3.9% increase in volumes. In the past four quarters, it has managed a compounded quarterly growth rate of 6.8%, among the best in the industry. But declining margins have been a concern.

Revenue grew by 31.1% in the year ended June in dollar terms, but Ebit rose by just 11.8% due to a 250 bps reduction in operating profit margins. Gross margins declined by 280 bps in the same period.

Some analysts believe that these point to structural issues, which seem to be resulting in lower margins. In comparison, peers such as TCS and Infosys reported a much lower drop in gross margins, of 120 bps and 87 bps, respectively.

HCL Tech has said margins will drop in the September quarter mainly because of wage hikes, but that it will recoup those losses and end the year with margins similar to those in fiscal 2011 (FY11). HCL Tech had ended FY11 with Ebit margins of just 14%, and gross margins of 32%, considerably lower than top-tier firms.

Even Cognizant Technology Solutions Corp., which invests heavily in SG&A and deliberately operates at low margins, manages Ebit margins of around 19%.

The three above-mentioned firms operate at gross margins of 42-45%, about 10 percentage points higher than that of HCL Tech. This is one of the reasons HCL Tech continues to trade at the lowest valuations among top-tier IT stocks.

Graphic by Sandeep Bhatnagar/Mint

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