HCL Technologies Q4: FY19 guidance weak; digital, IP biz key growth drivers

HCL Technologies (HCLT) posted a modest performance in the final quarter of FY18. The management’s subdued guidance, especially for organic revenue growth, in FY19 indicates that pressure on its legacy business is yet to be countered by traction in digital and intellectual property (IP) led businesses. We expect FY19 to be a work in progress year. While valuation at 15.2 times FY19e earnings is at a discount to its largecap peers, the wait for bright sunshine at the end of the tunnel may be a long one.

For the quarter-ended March 2018, HCLT reported a revenue of $2,038 million, a sequential (quarter-on-quarter) growth of 2.5 percent in reported currency and 1.2 percent in constant currency. Growth was led by financial services, manufacturing, life sciences and healthcare and retail and consumer products. Operating margin was stable.

For the full year, constant currency revenue grew 10.5 percent on year, with strong growth accruing from Americas and engineering and R&D services. Application and infrastructure services which still constitute close to 73 percent of total revenue grew at a slower pace. The infrastructure management services business is likely to see lower than company average growth considering cannibalisation of the existing business through automation and transitions to the cloud. Going forward, the key matrix to track would be progress on what the management terms as Mode 2 (which essentially is its digital offerings) and Mode 3 services (software IP-led business).

The share of Mode 2 and Mode 3 in total revenue has increased from 18.6 percent in FY17 to 23.4 percent in FY18, with Mode 2 and Mode 3 growing by 29 percent and 68 percent YoY, respectively. Progress in these two areas is going to be critical and the company has already embarked upon an aggressive inorganic route to bolster its presence in its next generation services.

The management has demonstrated its risk-taking appetite through nine IP deals and 11 acquisitions in the past three years. The company has spent close to $2.1 billion on these acquisitions/inorganic initiatives, of which over $1.6 billion has been on IP and product company acquisitions.

In keeping with its stated merger and acquisition (M&A) strategy, HCLT announced two acquisitions in the first-half of April. The first was Actian Corporation (Palo Alto-based software product company) in partnership with Sumeru Equity Partners (SEP). The all-cash deal, valued at $330 million, has come at a valuation of around three times CY17 sales. The rationale behind the stated acquisition is strengthening of its Mode 3 offerings in data management products and platforms and combining the acquired IP (Mode 3) with its Mode 2 service offerings to offer complete solutions (product and associated services) to clients.

The second acquisition was of C3i Solutions that would enhance HCLT’s capabilities in life sciences and consumer packaged goods (CPG), provide it market access and strengthen its relationship with Merck & Co. The management said revenue from this company has been on a declining trajectory and that its margin profile too is much inferior. It said it would be a three-year journey to restore it at par with the company’s margin level.

While inorganic moves had raised hopes of a stronger guidance, the management’s FY19 guidance was disappointing. For FY19, the company expects constant currency revenue growth to be 9.5-11.5 percent and operating margin in the range of 19.5-20.5 percent.

A deep dive into the guidance suggests that the management expects organic growth of 5.25 percent (4.25-6.25 percent range) and inorganic growth of four percent. This factors in the full impact of acquisitions done in FY18 as well as the latest acquisitions of C3I and Actian.

Actian  acquisition is expected to be consummated by August. These will be partially negated by the decline in India business. The company expects remaining growth of 1.25 percent from inorganic moves this year.

The management’s organic growth guidance is tepid to its peers. It admitted that it is witnessing compression in renewals in its legacy businesses and that deal sizes are getting smaller.

While a lot of management bandwidth is now getting devoted to Mode 2 and Mode 3 services and even inorganic moves are focused on beefing up these pieces, they are yet to fully compensate the decline in the legacy business like application and infrastructure services. However, overall optimism on these new services resonate with what the peers have expressed so far.

While the management has directional clarity, the turnaround in acquisitions and ramp up of its digital and product offerings remain critical. The stock is currently trading at 15.2 times FY19e earnings, a discount to its peers. This gap can narrow only if next generation services assume a critical mass.