Wednesday, August 22, 2012


We hosted HCL Tech on an NDR in Asia last week. The management team was represented by Mr Anant Gupta (President & COO), Mr Anil Chanana (CFO) and Mr Sanjay Mendiratta (Head of IR). The key takeaways from the NDR were: 1) significant market-share shift opportunity over the next 2.5 years, when ~USD140bn worth of deals come up for renegotiation, 2) overall spending remains soft, however, market-share gains are possible from vendor churn (which has increased from ~15% to ~35% over the past 3-5 years towards newer players), 3) expects significant deals to be decided in 2Q/3QFY13F and 4) confidence in maintaining EBIT margins at FY12 levels of ~16%. HCLT remains our top pick in IT, we maintain BUY. Continued outperformance on revenue growth and margin stability, in our view, can lead to a further re-rating.

Big window of opportunity over next 2.5 years from vendor churn
The company sees ~USD140bn worth of deals coming up for renegotiation in the total outsourcing space (source TPI) over the next 2.5 years. This is coupled with vendor churn increasing from 15% to 35% over the last 3-5 years. This, in our view, lends a USD40bn+ opportunity for HCLT to target. The company has seen successes in the past in winning large deals (USD2.5bn+ over last 3 quarters) with Astra Zeneca, Statoil, UPM, Blue Cross and Blue Shield Association etc. The company, in conjunction with participating in churn, is also focussing on cross selling and tracks the service adoption at its clients very closely.

Vendor churn in BFSI an opportunity
While overall spending in BFSI remains constrained, the company sees vendor churn opportunities over the next 6 quarters (HCLT signed USD1b+ of deals in BFSI over last 3 quarters). This is an opportunity for the company to get into blue chip clients, which it was shut out from due to limited participation in the Y2K boom and strong deal ramp-ups in the 2003-05 period.

Reasons for churn and key success factors
The company sees vendor churn because of: 1) dissatisfaction with existing vendors on rigidity in cost structures and limited flexibility, 2) availability of more innovative cost structures, 3) the need to delink technology and services, and 4) greater stability of technology over time reducing input costs and change in importance of systems as business requirements change. The key success factors according to the company are: 1) an ability to showcase a business case with savings of at least 10-15% being imperative for a client to look for churn, 2) zero defect transitions (as extensions are costly and there is a set timeline to
shift from one vendor to another), 3) reference-ability and 4) the availability of alternatives like HCLT to take up large total outsourcing deals, which wasn’t available previously when these deals were signed.

Discretionary demand soft; growth through shift from RTB to CTB
The company sees discretionary demand to be soft and growth largely being driven by need to cut costs (e.g ERP consolidation), shorter-term ROI projects and mandatory spending (e.g risk & compliance). Investments to discretionary projects are largely through reallocation of cost saves in RTB to CTB (e.g in Europe a trend seen of EAS projects being bundled with ITO deals).

Segmental outlook: Positive on Europe, Telecom remains sluggish
The company remains confident on the growth outlook in Europe (increased cost push at clients) and expects broad-based growth across verticals with strength in manufacturing, retail, energy & utilities and healthcare (except telecom – 8% of revenue). Telecom continues to be sluggish and the company has not seen any material trends to suggest a reversal. Within Europe, the company sees Nordics to be an area of

Confident on EBIT margin stability at FY12 levels of ~16%
The company was not defensive on their lower margin profile versus tier 1 IT peers and believes that this is conscious choice, which has been made given the profile of business (total outsourcing deals) that the company chases. It remains confident on holding EBIT margins at FY12 levels of ~16% if USD-INR rates are sustained closer to 55 levels. The company ended 4QFY12 at 19% EBIT, it would face pressures on wage hikes (8% offshore and 2% onsite) and possible increases in sales expenses as big deal flow comes up for decision making by 2Q/3Q. The company sees pricing to be stable. Within BPO, the company sees it
operating closer to breakeven for a year.

Cash usage, dividends and visas
The company indicated that it has converted ~100% or higher of its net income to operating cash flow over the last 3 years and has distributed ~60% of the FCF generated to dividends. The company does not have any acquisitions or abnormal capex in the pipeline over the near term. The company does not see visas to be a material issue and remains committed to creating 10,000 incremental local jobs in US/Europe by FY15.