HCL Tech sums up its winning formula very well on its website. There are more than 3,000 technology companies in the Bloomberg database, but only seven with revenues of more than $2.5 billion, a market capitalisation of over $5 billion, and a sales CAGR higher than 23% over the past five years. HCL Technologies is one of those seven companies. What has been the source of HCL’s success in this period of economic turmoil? Its website describes it like this: “‘Employees First’, a unique management approach that unshackles the creative energies of our 85,335 plus employees, and puts this collective force to work in the service of customers’ business problems.” There’s no denying it has been a remarkably successful approach. HCL Tech’s management has been able to deliver one of the strongest revenue growth rates in the Indian IT sector over the last eight to 10 quarters.
The key to this achievement could be the company’s relentless focus on large contracts, the strong positioning of its IT infrastructure business and its good execution capabilities. HCL Tech also announced new contracts totalling $2 billion in the first half of CY12, which is good evidence that the company’s business momentum remains favourable. Now that the rebid (old outsourcing contracts coming for renewals) market is opening up and infrastructure features prominently in all these deals, HCL Tech is strongly positioned to reap a healthy share of the pipeline. In fact, the company has so far been a leader in the global IT services market. HCL Tech’s market share has moved up from 0.17% to 0.43% over 2006 to 2011, the highest growth after Cognizant Technology Solutions in the Indian vendors’ space.
The management side, too, is looking sorted. Vineet Nayar, CEO, will focus on HCL’s large clients, and on incubating the next $1-billion business opportunity apart from overseeing operations, which are now headed by Anant Gupta, COO and head, infra services. Nayar is parking himself in the US for the next six months as the hunting season begins. He decided, in 2005, that HCL Tech will pursue multi-million dollar contracts instead of chasing small deals that are not scalable. This meant creating an integrated sales and delivery mechanism geared to garner such deals.
The company won its first set of multi-million dollar deals in 2005 itself (Autodesk, DSG International, Teradyne) with a total contract value of $700 million. This was followed by the acquisition of Axon in 2008, and a revamp of its BPO business. The company has been at the top quartile of growth in its peer set since then, although HCL’s margins declined after its strategy of targeting larger deals.
The decline in margins can be explained by three reasons: the margin lifecycle of large deals improves over the tenure of the deal; HCL Tech’s strategy of hiring more laterals to quickly execute such deals and reduce risk; a loss-making business process outsourcing division undergoing restructuring. However, as the business matures, the company will also move at a fast pace towards leadership in margins.
The acquisition of Axon in 2008 allowed HCL Tech to enter the lucrative market of enterprise solutions and, even though the uncertainty of the current market could keep this business muted for a while, we believe that any recovery in it would lead to significant growth for HCL Tech. The other good news is that the BPO restructuring is also through and Ebitda margins are returning to positive territory again. The increasing trend of integrated IT BPO deals should also influence the BPO to perform in line with the rest of the business and provide it with a leg-up.
HCL Tech’s cash generation over the past three years has also shown a marked improvement. Cash generation metrics such as cumulative free cash flow (excluding acquisitions) to cumulative Ebitda have improved from 20% three years ago to 40% now. The reduction in receivable days has been a key reason for the improvement in cash flows. It stands out when compared with larger vendors such as Infosys and TCS, which saw their ability to generate cash deteriorate.
Currently, global public spending on IT as well as dollar value of discretionary IT budgets are seeing cuts worldwide. There is industry reiteration that while infra deals are dominating the churn, vendor consolidation is the theme in the application development and maintenance space.
It is estimated that deals worth $60 billion are coming up for restructuring. So, HCL Tech is looking at a sizeable opportunity in the next two quarters, assuming a 30% vendor churn. The company has ably demonstrated that the deals won last year can be delivered at better margins, which is comforting for its future. There can be some q-o-q variations in margins on deal transitions, wage hike impact and sales and marketing spends, but I feel confident that HCL Tech will move to a new margin profile. I have raised my FY13 and FY14 estimates and now value HCL Tech at 14 times FY14 numbers, taking the 18-month target price to ₹750.
The stock’s history is very interesting. Today, its price is closer to the all-time high it hit when it listed during the peak of the tech boom. We are hopeful that company will hit new peaks after the pain and consolidation of 12 years. Clearly, it’s a breakout story.