HCL Tech keeps up the growth pace, margins remain a bugbear

  • HCL Tech beat the Street with a sequential growth of 3.3% in the March quarter
  • Its FY20 guidance suggests organic growth is likely to pick up on the back of large order wins

HCL Technologies Ltd maintained its growth momentum of recent quarters, reporting 3.3% sequential revenue growth in constant currency terms for the March quarter.

It also guided for 14-16% in constant currency growth for FY20. This is higher than 11.8% constant currency growth the company saw in FY19.

But note: Close to half of the estimated growth will come from past acquisitions. Even then, the organic business is getting along well. The management expects organic growth to be 7-9% in FY20, which is higher than the 6-6.5% expansion the company reported in FY19.

Growth is expected to improve on the back of a ramp-up of large deals HCL Technologies won in the past one year.

The management said it had another quarter of record order bookings, adding that its order pipeline is strong and is better than what the company saw at the end of the December quarter. The share of new businesses, such as digital, increased to 28.4% of the total revenue. The management expects it to rise further.

But this momentum is coming at a cost. Operating profit margins softened 70 basis points to 18.9% last quarter, below Street estimates. The margin compression reflects the elevated cost of doing business in new technologies. The management guided for an operating margin of 18.5-19.5% in FY20. The midpoint of this range will mean a 50 basis points fall in FY20 over FY19.

Needless to say, a contraction in margins will mean earnings growth lags revenue growth. Prateek Aggarwal, chief financial officer of HCL Technologies, maintains that the upper end of the margin guidance implies stable profitability.

But investors need to factor in risks emerging from currency volatility, tight talent supply in new technology businesses and rising visa costs. Of course, these cost challenges are not confined to the company alone.

The HCL Technologies stock, meanwhile, outperformed the Nifty IT index this year, rising by about 20%, against an 11.2% rise in the index. Even so, it is still trading at a valuation discount to its larger peers.

A rerating will depend on how well the company navigates profitability challenges and builds its organic business. Much of the positive news on the organic growth is due to the inflow and ramp-up of two large deals HCL Technologies had won in FY19.

Investec Capital Services (India) Pvt. Ltd warns about the sustainability of such large deal wins. There are fears that deal momentum may slow this calendar year.

“Non-recurrence of a large deal like Xerox alone would imply a 2% headwind on revenue growth for FY21E," analysts at Investec said in a note. How well HCL Technologies addresses this will determine the stock returns.

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