Stock Review: HCL Technologies

LIKE in the previous quarters, HCL Technologies' sequential revenue growth has been robust in the September 2010 quarter, too. Investors, however, have been concerned about its falling profitability in the past four quarters. It seems the company's short-term strategy is to take a hit in its profitability to secure higher growth in the coming quarters. The company is expected to face margin pressure in the December quarter, but the management is confident that profitability will improve from the March 2011 quarter.

   On Wednesday, HCL Tech, the fourth-largest IT exporter listed on the Indian bourses, said its dollar denominated revenue rose by 9% sequentially in the September quarter. A strong traction across its various verticals and geographies, including Europe and emerging markets, boosted its topline. Despite this, its stock price fell by nearly 1% following concerns over its falling operating margin. The company has seen significant erosion in its margin from 18% a year ago to 15% in the September quarter. This is because the company has stepped up its expenditure on revenue-generation activities. Its selling and general administrative (SG&A) costs relative to revenue have increased by 140 basis points (bps) within a year.

   Another factor that pulled the margin down was the ramp-up in the headcount. HCL has added over 10,000 people in the last two quarters, much more than Infosys's net addition of 8,672 employees. A higher jump in workforce in a short span reduced HCL Tech's utilisation level by 600 basis points, impacting margin. Wage hikes at the beginning of the quarter also impacted the margin. But, the pressure on the margin is expected to ease given that the salaries have already been hiked. The fresh recruits are expected to be made billable by the December 2010 quarter, thereby increasing utilisation level. This, according to the company's deputy CFO Sandip Gupta, will also rationalise in the coming quarters the otherwise higher SG&A expenditure.

   The company has continued to report better growth in Europe unlike its peers, who are witnessing sluggish demand in the region. This can be attributed to a strong presence of Axon PlC in Europe, which HCL Tech had acquired in 2008. Another factor that goes in favour of HCL Tech is the faster-than-expected turnaround of its BPO operations. The division has shown sequential revenue growth for the first time in the last three quarters. "The traction is back in BPO. We have already seen a number of non-voice deals there," says Mr Gupta. But, it will take another five quarters for the operations to return to profitability, he says.

   At the current level, HCL Tech's stock trades at a trailing 12-month P/E of 22.5. Its current valuation seems to reflect the future growth prospects.