HCL Technologies: Hold/Buy on declines

Recommendation: Hold/Buy on declines

Krishnan Thiagarajan

``Our strategic focus on high-value-added services in technology development, the Internet and e-commerce market space has yielded significant results...

To cater to the evolving netcentric world, we will continue to invest in emerging technologies. Towards this end we have taken a unique initiative and set up technology cradles at our offshore centres. Nine per cent of our offshore manpower is focussed on identifying emerging technology opportunities and in-house R&D... To consolidate our growth further and establish long-term customer relationships, we have strategically focussed on alliances and partnerships in diverse geographical and technological domains... Yet another unique initiative has been our value acquisitions strategy, wherein we propose to make equity investments in strategic companies working in cutting-edge R&D segments to capture value from the commercialisation of such technologies. -- Mr Shiv Nadar, Chairman, President and CEO, HCL Technologies in a Letter to Shareholders in the Annual Report for 1999-2000.

For investors seeking exposure in the software sector, HCL Technologies is one of the most promising investment candidates. Given the strong financial performance of HCL Technologies for the year ended June 30, 2000, and the first quarter of 2000-01, the medium term outlook is healthy.

FROM an investment perspective, at the current market price of Rs 587 (post-stock split), shareholders can stay invested for fair capital appreciation in the medium term. The company had approved a 2:1 stock split (sub-dividing each existing equity share of Rs 4 each into 2 equity shares of Rs 2 each) and the split came into effect in the first week of December.

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However, fresh investments may be built up at declines and in a staggered fashion over the next few months. The only investment caveat is the proposed ADR (American Depository Receipt) offer of $500 million in one or more tranches. Risk-averse investors can wait for the SEC Registration Statement to be filed and get a clearer idea of the future plans of HCL Technologies before taking an exposure in the counter. Obviously, since this hypothesis is based on assumptions, individual investors may have to monitor developments closely and exercise greater caution.

However, it needs to be reiterated that investors will be better off spreading their portfolio risks by taking investment exposure in sound sector-specific mutual funds or tech-heavy equity funds.

Covering the flanks

As Mr Shiv Nadar's letter reiterates, HCL Technologies is working to optimise the revenue/earnings potential of the company and mitigate the risks involved in a highly volatile technology sector. Confronted with the prospect of a slowdown in the US information technology and telecom sector, ``selectivity'' and ``relatively risk-averse investment strategies'' have come into play among foreign/domestic institutional investors and fund managers of key mutual funds. Clearly, the ``flight towards quality stocks'' has dictated much of the portfolio churning in the past six months or so.

The logic behind their moves appears to run like this: First, if the IT spending in the US suffers a slowdown, there is likely to be growing pressure on the US companies to enhance their competitive edge in the global market. Apart from downsizing employees, the only way the competitive edge can be enhanced/maintained is by ``outsourcing'' mission critical IT applications to developing countries such as India, which enjoy a cost advantage (the wage differentials) vis-a-vis the US. If this were to happen, the US companies would be likely to entrust the high-end work to only frontline companies which have focussed on emerging technologies in the past few years.

Second, through consistent and rapid investments in offshore infrastructure and manpower over the past couple of years, the frontline companies are best positioned to ``scale up'' their operations to cater to the offshore requirements of these customers. As software exports from India account for just under 2 per cent of the global IT services market, the growth potential, even in a slowing US market is immense. Finally, the shortage of talented manpower in the US, which forced the US to enhance the H1B visas from 1.15 lakh to 1.95 lakh beginning October 2000 is a positive sign. This is expected to help Indian companies use a combination of onsite-offshore initiatives to attract US-based clients.

HCL Technologies corporate strategy is founded on five pillars articulated and executed over the past few quarters. These also have risk mitigation strategies built into them and four of these are discussed below:

Quality revenue mix

Making the transition from a predominantly onsite player to an offshore player, the offshore-centric revenues of HCL Technologies accounted for 60 per cent of the consolidated revenues (including its subsidiaries) in the first quarter ended September 30, 2000. The Internet/e-commerce revenues accounted for 51 per cent of the revenues, probably the highest in the industry from this source. Despite the Internet/e-commerce scene suffering sharp reversals since April, the proportion of revenues from this source steadily rose over the past few quarters. Similarly, the contribution of technology development services (namely software services rendered to hardware product companies) continues to ramp up and was 41 per cent of the total revenues in the first quarter of 2000-01.

With many hardware companies issuing profit warnings, it remains to be seen if there will be an impact on this service line for HCL Technologies. However, two factors are slated to help HCL Technologies in the long run.

ALow client concentration: Client concentration was well balanced with the top 5, 10 and 20 customer contributions at 23, 35 and 46 per cent of revenues respectively in the first quarter. This compares favourably with the client concentration levels of Infosys Technologies and Wipro, the two key frontline software service companies in India. HCL Technologies also has a fairly diversified clientele, adding up to 286 as on September 30, 2000.

A Geographic reach: With nearly 15 subsidiaries spanning UK, Germany, France, Sweden, Belgium, Japan, Hong Kong, Australia and New Zealand, HCL Technologies is best positioned to spread its client base away from the US, in the event of a slowdown towards Europe and the Asia-Pacific.

High margin earnings growth

With the contribution of high value-added services (technology development services, software product services and networking services) rising to 72 per cent of the total revenues in the first quarter ended September 30, 2000, the margins of HCL Technologies have been on a high growth path. The operating profit margin (earnings before depreciation, interest and tax) grew to 29 per cent in the first quarter of 2000-01 from 20 per cent in the corresponding previous period.

Focus on emerging technologies

HCL Technologies has been consistently striving to move up the software value chain and the quality of projects reflect the technological skills and competence of its employees. It has been providing high value-added solutions to its clients in Internet/e-commerce, networking and embedded systems. According to the management, 9 per cent of its manpower is dedicated towards in-house R&D in developing soft cores and other high-end technological capabilities. This is being catered to by five fully-fledged centres operating in specific horizontal technologies in Gurgaon, Noida and Chennai.

Non-linear growth model

As part of its value acquisition and technology acquisition strategy, for the year ended June 30, 2000, HCL Technologies made investments in technology funds focussed on funding emerging technologies.

*Investments of Rs 39.40 crore were made in five strategic funds and covering three continents to enhance geographic spread -- Diamondhead Ventures, Arena Capital in the US; Carlyle Internet Europe and Viventures II in Europe and Carlyle Internet Asia.

* Equity investments of Rs 8.90 crore in strategic companies in R&D segments to capture value from commercialisation of technologies. One such investment is of Rs 8.9 crore in Harmony Inc, US.

This is in addition to HCL Technologies earlier unique strategy of turning potential clients into business partners over the long term. Towards that end, HCL Technologies had entered into long term contracts with clients and giving stock options to clients on meeting revenue milestones on a yearly basis. At the time of its IPO, it signed the first two contracts worth revenues of $75 million and $100 million with KLA-TENCOR and G-TECH for a five-year period starting January 1, 2000. The company has an order book of over 350 million, which is to be executed over a five-year period. Besides this, HCL Technologies also has five strategic alliances with companies such as NTT Data (Japan) and VDO Mannesmann (Germany) and a joint venture with Perot Systems Corporation (US), aimed at broadbasing its client profile and geographic reach. All these point to a company that has the resilience to cope with any big opportunities and ride out a rough patch without much damage.

Pic.: Mr Shiv Nadar, Chairman, President and CEO, HCL Technologies.