Should investors worry about the lopsidedness of HCL Tech’s growth?

After a series of earnings disappointments, HCL Technologies Ltd has beaten the Street’s estimates by a wide margin. Analysts were expecting revenues to grow by around 2.5%, after adjusting for the contribution from acquisitions. HCL Technologies reported growth of as high as 4% sequentially in dollar terms.

What’s more, while margins were expected to decline by around 100 basis points, the company has managed to maintain margins. As a result, earnings before interest and tax beat the Street’s estimates by about 5.5%. A basis point is 0.01%.

But nearly all of the incremental revenues in the June quarter came from the infrastructure services business. Should investors worry?

Analysts at JP Morgan Research wrote in a note to clients: “To be a sustainable, longer-term pick, we continue to believe that HCL Tech needs to broad-base its business model.” They added that while the company has the strengths to grow engineering and R&D services at a healthy 14-15% on a sustainable basis, the tepid growth in the other segments will limit the company’s ability to mine its clients more effectively.

Even so, it must be noted that infrastructure management services (IMS) and engineering and research and development (R&D) services are the fastest growing segments for the entire industry. To some extent, then, HCL Technologies’ performance is a reflection of ground realities. And while the IMS contribution stands out in a sequential comparison, the performance of some other segments was not that bad on a year-on-year basis.

The company adds that the engineering and R&D services segment was impacted because work on a project was moved offshore; while this helped margins, revenues were impacted. Offshore billing rates are far lower vis-à-vis onsite rates.

The performance on the margin front, meanwhile, is commendable. The recently acquired Volvo external IT services business, which accounted for about 40% of incremental revenues, operates at far lower margins. Besides, the June quarter included a small headwind because of visa costs and did not have the benefit of an expense reversal like the March quarter. Despite all this, margins were maintained at the previous quarter’s levels.

The company’s strong performance in the June quarter has helped bridge the gap with other large-sized IT services companies. A month ago, HCL Technologies shares traded at 13 times estimated fiscal year 2016-17 earnings, far lower than the 18-19 times valuation for companies such as Infosys Ltd and Tata Consultancy Services Ltd. In other words, it traded at a valuation discount of around 30%.

Now, with the performance of some of its peers falling short of expectations, the discount has narrowed to around 15% vis-à-vis Infosys.

The company’s decision to start providing a revenue and profit margin guidance will certainly build confidence. Revenues are expected to grow between 9.4% and 11.4% after adjusting for acquisitions this year. This is more or less in line with the industry’s expected growth this year. And the margin guidance is fairly healthy too. Some investors may well be glad that HCL Technologies has a high proportion of its business coming from segments that are growing well lately.

But undue concentration is a risk which may rear its head in the future. Unless the company demonstrates that it can fire on all cylinders, there is little reason for investors to be too excited about its long-term prospects.


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