HCL Technologies: Hold/Avoid fresh exposures

Recommendation: Hold/Avoid fresh exposures

Krishnan Thiagarajan

TRADING at a price earnings multiple of nine times the per share earnings (on a consolidated basis for 2000-01) and 7.5 times for 2001-02, the valuation appears attractive relative to its frontline peers.

Given the spending freeze and lengthened sales cycle witnessed by the entire technology industry and uncertainty plaguing fresh capital spending after the September 11 attacks, the sequential revenue and earnings growth prospects in the first two quarters of 2001-02 will be flat or maybe in single digits for HCL Technologies.

Any sustainable momentum is likely only in the second half of 2001-02 in a best case scenario. Despite a slew of investment concerns and lower management guidance for 2001-02, HCL Technologies represents a good investment exposure at the current price levels for investors with a medium-term perspective (of at least a year) or those aiming to broadbase their exposure to technology stocks, with sizeable investments already in frontline stocks such as Infosys, Wipro or Hughes Software.

Management guidance

Backed by a string of key operating parameters -- quality revenues (and a good order book), earnings led growth, focus on emerging technologies, non-linear growth model and concentration on a strong management team/employees -- the HCL Technologies stock touched euphoric heights of investor fancy in 2000 and early 2001.

This strategic and consistent focus on these variables had helped it attain the status of the third largest listed software exporter from India since its IPO in November 1999.

But the inexorable intensity of the Nasdaq meltdown, the sharp drop in capital spending in the technology sector and the long-drawn process of layoffs and consolidation (which has just begun) finally made HCL Technologies reconcile to the ground realities.

Appearing almost as the last in the long list of frontline software peers to downgrade its revenue and earnings guidance, the HCL Technologies management revised it lower to 25 per cent plus for 2001-02.

The company provided this management guidance in early August alongwith the announcement of the financial performance for the year ended June 30, 2001. And the senior management reiterated that it proposed to stick to the management guidance of 25 per cent after the September 11 attacks on the US, making any scope for any near-term review unlikely.

After the attacks, it has become obvious that the US economy is already heading towards a recession with a recovery unlikely till the second half of 2002 and its impact on the technology slowdown may intensify at least in the near term.

In this backdrop, from an investment standpoint, Business Line attempted to examine whether some of the key operating parameters of HCL Technologies will stand the test of the management guidance of FY 2002 and are conservative or realistic in the light of the existing fundamentals of HCL Technologies.

*Huge order backlog: Combining its unique strategy of turning potential clients into business partners in the long run, HCL Technologies has entered into long-term contracts with clients, involving offering stock options to clients on meeting revenue milestones on a yearly basis.

In addition to these annuity contracts, with 71 new customers added in 2000-01 and 35 dedicated offshore centres, the revenue order backlog of for 2001-02 stood at $600 million, to be executed over the next five years. This was the biggest strength of the company, with at least 40 per cent of these revenues to be executed over 2001-02.

And this high degree of revenue visibility and predictability was expected to result in lower selling expenses and higher margins in the long run. However, events of the first half of this calendar year have led to the need for a drastic re-evaluation of revenue. The revenue churn points to only two directions -- either a freeze or slowdown in volume growth in new business or pressure on billing rates going forward.

*IT service portfolio: HCL Technologies has all along derived its revenues from four key sevice offerings -- technology development, software product engineering, network services and IT services.

As a long-term strategy, HCL Technologies had consistently moved up in the software value chain, with technology development services accounting for 45 per cent of revenues in 2000-01, up from only 19 per cent in 1998-99.

Technology development services consisted mainly of outsourced components by technology and hardware vendors, soft cores and protocol stacks, systems software and new technology development. But given the nature of the spend, with a sharp drop in capital spending in the technology domain, this offering is likely to suffer the biggest drop in revenues, as the market shrinkage may be the highest in this segment.

Similarly, the software product engineering offering involving new product engineering, e-commerce, enterprise application integration and product re-engineering and maintenance have already suffered sharp dips.

A good chunk of its third offering -- networking services -- appears to be confined to most large Indian companies and the scope for growth abroad may take greater time and efforts.

Which leaves only the IT services, which is already subject to fierce competition among both the frontline and second rung IT peers in India. In addition, the company's unstinted focus on emerging technology made through 14 technology development centres set up across the country may not pay off at least in the near term.

It appears that HCL Technologies has fallen prey to wrong timing in positioning itself on the higher end fo the value chain. Although offshore outsourcing opportunities abound, from the management guidance, the only inference which can be drawn is that new volume growth in service offerings of the company may be tough to acquire, going forward.

A Pressure on billing rates: The reality maybe that HCL Technologies is slated to suffer on both the volume and billing rate front. First, in building volume growth for high-end service offerings, it may have to make a big compromise on billing rates.

Second, in the highly competitive field of IT application services and maintenance, the fierce competition may drive the billing rates downward.

*Retarded earnings growth: A combination of limited volume growth and pressure on billing rates will keep the operating margins under a tight rein, which is even at present lower than its frontline peers such as Infosys.

The annuity contracts and repeat business which was expected to reduce the selling expenses and enhance margins may not be fully relevant in this tough and challenging environment. In the fourth quarter of 2000-01, HCL has indicated that is has recruited 73 management graduates mainly for aggressive marketing efforts.

So, it is likely that the selling expenses may step up in the near future, which it will be hard pressed to neutralise with lower general and administrative expenses. With 4,652 employees -- almost half that of its frontline peers -- it probably has limited leeway in reducing expenses on the manpower front.

In this turbulent environment, with two tough first quarters of 2001-02, a 25 per cent growth target may seem realistic. But much will hinge on the company's execution capabilities of its huge order backlog, the financial status of the clients and their need to scale up their revenue milestones linked to those contracts.

Non-linear growth

On the joint-venture front, its 50:50 joint venture with Perot Systems Corporation has been working extremely well. Carrying this strategic initiative forward, in end-September, HCL Technologies entered into a joint venture with Deutsche Bank AG by acquiring a 51 per cent equity stake in the holding company of Deutsche Software, Deutsche Banks IT subsidiary in India.

This joint venture will also dictate the future course of HCL Technologies valuation on a consolidated basis.

Similarly, as a part of the non-linear growth model, investments of $16.55 million (or Rs 78 crore) **were made by the company in venture capital funds and strategic investments. A close monitoring of these investments along with its overall investment portfolio of Rs 191.10 crore, as of June 30, 2001, is a must to have an idea of the fundamentals and future growth potential of HCL Technologies.

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