HCL Technologies: Buy

Investors with a one-to-two-year horizon can buy the shares of HCL Technologies (stock), which currently trades at Rs 277, given the strong growth prospects for its business and reasonable valuations. The stock trades at 16-17 times its trailing 12-month earnings which is a discount to its Tier 1 peers such as Satyam and Wipro. Despite being among the top five IT services companies, it has maintained a relatively low profile. The recent fall in the markets has rendered the HCL Technologies stock a potentially attractive investment, capable of providing long-term capital appreciation.

Business Analysis

Strategic business approach: HCL has taken a holistic approach towards its service offerings. It is focusing on acquiring multi-million dollar clients, with multiple service offerings to these clients over many years. This means that i nstead of taking up one-off engagements HCL is attempting to win high-value clients to whom it can offer an entire gamut of services.

This will provide sustained revenue streams over several years with the potential for maintenance and support revenues as well. This will also mean that its execution capabilities will be substantially honed over time and will give it the edge in approaching new clients. The company signed seven such multi-million, multi-service, multi-year contracts recently (one of them being a $35-million deal with New Zealand's Fonterra), which augurs well for revenue growth.

Tactical approach to IMS: Infrastructure management services (IMS), a key offering of the company (generating $200 million revenue and growing at over 70 per cent), has seen HCL adopt a different approach. It has adopted an 'ass et light' and 'vendor neutral' approach. This implies that the company will focus on management and support services rather than provide equipment for IT infrastructure.

IMS being a key, high-revenue earning service for the company, separating the hardware aspect (which is a low-margin business) was necessary. This focus on the services part could help HCL improve its profit margins. The company has strong relationships with major IT hardware providers with whom it can partner when clients insist on a bundled service.

Verticals in focus: HCL is experiencing strong growth in its high-tech vertical, which comprises aerospace and automotive clientele, among others. This vertical has contributed 28.7 per cent of its revenues (2006-07), the same proport ion as the Banking and Financial Services, Insurance (BFSI) vertical. The telecom vertical is also contributing substantially to revenues (17.2 per cent). These two verticals have seen growth in excess of 50 per cent over the past year.

This is important on two counts. One, these two verticals are seeing increasing spends on technology upgrade, value-added services and so on, especially in Europe, and HCL, with its integrated player status, appears well-placed to translate a part of it into business.

Two, this implies a lowered dependence on the BFSI vertical, which could experience turbulence due to the sub-prime crisis, with possibly lower or delayed IT spends. The company is also adopting, albeit at a lower scale, next-generation services with high revenue-earning potential, such as services-oriented Architecture, Web 2.0 and Master Data Management.

Operational metrics: HCL has seen increasing business from New Zealand and Australia as well as the Asia-Pacific region (combined 15.3 per cent of revenues). This, along with the fact that the European clientele has become an important contributor to its revenues (30.5 per cent), could not only give the company a geographical spread but also act as a possible mitigating factor against rupee appreciation.

In terms of client profile, HCL now has two clients who contribute over $100 million each, and all the multi-million dollar client categories have seen strong additions over the past year, pointing to good revenue prospects. The repeat business, at 94 per cent, indicates good service execution. This also helps reduce SG&A (Sales General & Administrative expenses) costs by reducing the need to spend on acquiring new clients.

Risks: Any appreciation of the rupee is a potential realisation risk. But the company has been one of the early adopters of a hedging strategy and has hedged $1.16 billion (about 85 per cent of its revenues, a high proportion among th e Tier I companies), which should partly help mitigate this risk.

Any cut in IT spend by the US clientele or a general slowdown in IT spends in financial services, which still account for 28 per cent of revenues, are risks to earnings. In its strategic move towards winning mega deals in the $50-100 million category, the company is likely to face stiff competition from national as well as international players, with a possible strain on margins. Attrition at 17.2 per cent, which is on the higher side, is a key execution risk. Wage inflation could also put pressure on margins.