Buy HCL Technologies: Edelweiss

How will the appreciating RS bear down on earnings?

 

We believe that hedging has protected EPS for FY08E but FY09E is still vulnerable to the appreciating RS. Our FY09E EPS assumes a base-case RS-USD equation of 40.5. We have laid out the scenario table outlining our estimated impact on FY09 EPS for various RS-USD exchange rates. We can see that if the RS were to strengthen to 39.0 vis-àvis the USD, the downside to our FY09E EPS estimates from the base case is the range of 8%. This does not include hedging income which we cannot forecast and therefore an upside risk is inherently present. In such an appreciating RS environment there will likely be an accompanying de-rating of our FY09E target P-E by at about 3-4%. So taken together, there could be a downside of about 11-12% to our appraised return of near-30% over a 12-month horizon on account of the appreciating RS. In other words, a 12 month price target of RS 350-355 stands reduced to about RS 315-320. We must be cognizant of the risk to earnings and our target price of an appreciable strengthening of the RS. This should a constant watch point for the investor.

 

HCLT has strengthen its execution capability by aggressively recruiting quality middle-tosenior management talent

 

One of the company's success factors in the recent past has been its improved execution and a good reason for that has been its ability to aggressively hire senior managers from firms such as TCS, Satyam and Infosys (Indian peers) and IBM among the global names. This has helped HCLT close the gap between peers with respect to the enterprise application portfolio.

 

HCLT unveils its progress on its innovation initiatives but it is premature to predict success yet.

 

HCLT has focused its mindshare in the last couple of years to move towards a business model driven by IP. It has commercial offerings to address areas such as SOA, MDM, WIMAX etc. These emerging services have not yet turned mainstream but the company is betting on their taking off in the near future. We believe that while such initiatives serve to differentiate HCLT from the Indian IT pack, it is far too early to declare success here. To impact a company of HCLT's size positively in a meaningful manner, we believe that we will have to wait till FY10E.

 

What's noteworthy is that clients have already been signed up for HCLT's proprietary offering in SOA (called Penstock) and this quickens the pace with which HCLT signs up transformation deals. HCLT is striving to bring differentiation to its pricing model to delink revenues and manpower As part of its efforts to drive an increasing proportion of incremental revenues from outputbased measures as opposed to input-based measures, the company has begun to deploy several pricing models such as risk-reward, outcome-based pricing, gain sharing mechanisms etc. We believe that these still largely remain in the paradigm phase and HCLT's largest peers such as Infosys and TCS are also articulating such possibilities equally seriously. HCLT is winning its fair share of large deals on the back of its three-pronged business model The company is increasingly on the final stage shortlist in deals that other Indian vendors do not make it to. In those instances it faces Indian vendor competition at the final stage; the most common player it runs into is TCS.

 

We believe that this is due to the fact that apart from HCLT, the only other Indian vendor with comparable maturity on the Infrastructure Management Space (specifically, remote infrastructure management) and bundling it with application management/optimization is TCS. This strength enables HCLT to win a good proportion of multi-service client deals and the frequency of such client wins is on the rise. Is HCLT diversifying its growth sufficiently and quickly enough? Yes, we believe so. Growth is deriving from investments already made in emerging sub-verticals such as media & entertainment, Consumer Products Group, life sciences and healthcare and telecoms. The company has been following a micro-vertical strategy identifying pockets where it should dominate versus those pockets where it should differentiate. Many of these sub-verticals will grow at least 50% in FY08 over FY07 in USD (admittedly over a smaller base).

 

In addition, there is low-hanging fruit to be profitably captured in these less penetrated verticals being in the initial stages of the adoption curve. In our view, HCLT's broad-based multi-service existing model with its top 30 clients (most of them USD 10 mn plus clients) gives the company further flexibility in managing its order books and ensuring that its q-o-q revenue momentum can absorb the impact of incremental investments. Our outlook on valuations From the chart below, we see that excluding that quick aberration in May 2006, HCLT's valuations are reaching near 2 year-lows. HCLT has lost much of the P-E gains that it has accomplished over the past 20-24 months.

 

We believe that stock prices will continue to be volatile in the short-term. Observers are trying to assess the multiplier impacts of developments in the US. We believe that HCLT's valuations have become fairly reasonable for investors at this point in time within the Re contained within 39.5 to the USD. It currently trades at 14.5x FY08E and 11.3x FY09E, and we maintain our 'BUY' rating on the stock.