Stock Review: HCL TECH

OVER the last three quarters, HCL Technologies has been able to pull back its volume growth to the higher single digit zone. But this improvement is largely at the expense of profitability. Though its stock has outperformed the benchmarks and its peers in the past few months, a further jump in its valuations looks limited unless its margins improve substantially. HCL Tech, the fourth-largest IT exporter listed in India, has the lowest margin compared with its bigger peers. This, according to its CEO Vineet Nayar, was due to the management's past decision to invest more in resources, thereby increasing the quarterly growth rate in revenue. HCL Tech's growth in its dollar denominated revenue over the last three quarters was between 7% and 9% sequentially, either in line with or slightly better in some cases than its peers. Given this, the company seems to have achieved its short-term objective.

   But, mere top line growth will not help unless it is supported by higher operating efficiency, since a company's capability to generate cash from operations depends on both the factors.

   HCL Tech's larger peers, TCS and Infosys, have demonstrated a greater control over profitability. Both the companies operate at above 28% margin compared with 16% for HCL Tech. This means, in times of higher demand traction, TCS and Infosys generate better profits and, hence, higher operating cash flows than HCL Tech even if the latter tends to grow its topline at a faster rate. For instance, HCL Tech contributed over 20% to the incremental aggregate sales of the three IT players (Wipro's latest results will not be available until Friday) over the last four quarters. But it was still not able to earn incremental operating profit. The fact would also limit the possibility of a re-rating in HCL Tech's stock valuation despite the improved growth rate of its topline. On a trailing four-quarters basis, HCL Tech's P/E has improved from about 22 to nearly 25 in the last six months. But it still lags behind TCS and Infosys, which trade at P/Es of around 29.

   HCL Tech's CFO Anil Chanana said it would improve operating margin by at least 200 basis points by the time it declares its June 2010 quarter results. This will be achieved through higher employee utilisation and better deal pipeline.

   At Thursday's close of . 512, HCL Tech's stock traded at FY 12 estimated P/E of 19 assuming that the company would beat the average growth in industry profit of 20% on better margins. The valuation fairly takes into account its future growth expectations.