October 3, 2007 | Information technology

Initiating Coverage
Current price Target price
HCL Technologies (HCLTEC) Rs 305
Potential upside
Rs 365
Time Frame
19% 12 months
Time frame
Potential 12 months
upside 13%
Strategy at work … Time frame
PERFORMER
12 months

HCL Technologies has transformed itself from a marginal IT player to a well

differentiated, full services player focused on large deals. This would sustain
dollar based revenue growth at a CAGR of 32% over the next few years. Nitin Padmanabhan
However, with the twin challenges of an appreciating rupee and the phasing nitin.padmanabhan@icicidirect.com
out of the STP tax holiday under sections 10A and 10B in FY10, earnings
Manoj Kabra
growth would decline. In the third phase of its transformation, the company manoj.kabra@icicidirect.com
plans to re-define its business model to reduce the linearity between
manpower expansion and revenue growth and this should dampen the decline
in EPS. We initiate coverage on the company with a Performer rating.

ƒ Aggressive strategy to de-link manpower expansion and revenue growth

Business models in the IT services industry have predominantly borne a Sales & EPS trend
direct correlation between manpower growth and revenue growth. HCL 10500 25
plans to reduce this correlation by using innovative pricing models (device- 9000 20
7500
based pricing, outcome-based pricing, pricing per user, etc). The company 6000 15
4500
already has a number of engagements based on these models. While peers 3000
10
5
also plan to de-link man power growth and revenue growth, we believe HCL 1500
0 0
with a smaller base and a well outlined strategy is at the forefront of this FY06 FY07E FY08E FY09E

change. Sales EPS (Rs)

ƒ Impact of appreciating rupee to be minimal Stock metrics

HCL has forward covers for the next eight quarters to the tune of $1.73 Promoters holding 67.55%
billion at an average rate of Rs 43.15 to a dollar. The hedges cover 90% of Market Cap 20,282 crore
the net forex inflows for around six quarters. We believe this is among the 52 Week H/L 365/254
most well hedged companies in the IT space. Sensex 17291
Average volume 1,24,958
Valuations
We believe HCL Technologies is likely to enjoy strong revenue growth.
However, with the increasing pressure on margins and a challenging currency Comparative return metrics
environment coupled with the impending impact of higher taxes in FY10, the Stock return (%) 3M 6M 12M
room for outperforming is limited. The stock currently trades at 14.5x its FY09E HCL Technologies -15 -4 2
EPS of Rs 21 and at an EV/EBIDTA of 9.5x FY09E. We have based our valuations Wipro -14 -25 -13
on a DCF stress test that gave us a worst case price of Rs 284 per share. Hence Satyam -8 -8 2
downsides are limited from the current price. We have valued the stock Infosys -5 -12 2
factoring an average dollar-rupee exchange rate of Rs 39 and this gives us a
price of Rs 365 discounting its FY09E EPS by 17.4x.

Exhibit1: Key financials

Year to June 30 FY06 FY07 FY08E FY09E
Absolute sell
Net Profit 774.0 1356.0 1268.7 1452.1 450
Shares in issue (crore) 66.5 66.5 67.9 69.0 375 Target price
EPS (Rs) 11.6 20.4 18.7 21.0 300
% Growth - 75.2 (8.4) 12.6 225
Absolute buy
P/E (x) 26.2 15.0 16.3 14.5 150
Price/Book (x) 3.2 5.0 4.4 3.9 75
EV/EBIDTA 19.0 13.5 11.2 9.4 0
Oct-01

Apr-02

Oct-02

Apr-03

Oct-03

Apr-04

Oct-04

Apr-05

Oct-05

Apr-06

Oct-06

Apr-07

RoNW (%) 25.0 33.8 27.2 27.0

RoCE (%) 24.6 26.3 26.2 26.2
Source: ICICIdirect Research

ICICIdirect | Equity Research

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Company Background Share holding pattern
Shareholder Percentage holding (%)
HCL was founded in 1976 by Shiv Nadar after the
Promoters 67.55
government passed a law that discouraged
Institutional investors 23.58
multinational corporations from doing business in
Other investors 4.12
India. The company envisioned becoming a global
General public 4.75
leader in the manufacture of computer systems. Source: Insight, ICICIdirect Research
However the company found it difficult to gain an
entry into global markets as an Indian player. Shiv
Nadar reorganized the company into two companies Promoter & Institutional
– 1) HCL Infosystems to focus on the domestic
market and 2) HCL Technologies to focus on the 80 69.15 69.02 67.55 67.55
global market. HCL focused heavily in the R&D and 70
technology space and believed that the dot-com 60
50
revolution would take it to the next level. In doing so

(%)
40
the company missed the opportunities that came 30 25.06 23.78 21.87 23.58
with Y2K and Application development. The dot-com 20
10
bust in 2001 saw the company grappling for a new 0
growth engine which led to a slew of transformation Q1FY07 Q2FY07 Q3FY07 Q4FY07
initiatives which includes a change in focus from
single service to multi-service deals. Promoter holding (%) Institutional holding (%)

Source: Insight, ICICIdirect Research

Exhibit 2: Revenue model

HCL Technologies

Core software Infrastructure management BPO

Revenue contribution: 73% Revenue contribution: 14% Revenue contribution: 13%

EBIDTA contribution: 74% EBIDTA contribution: 11% EBIDTA contribution: 15%

Source: Company, ICICIdirect Research

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INVESTMENT RATIONALE

The transformation – focus on value not volumes

HCL Technologies is unlike other IT companies in many ways. The company did
not cash in on the Y2K movement prior 2000 and earned almost 70% of its
revenues from businesses that were offshoots of the Internet boom. The dot-
com bust in 2001 saw the company struggling for a new growth engine. While
other players had already jumped in the application development bus HCL was
left behind. This came with other side effects like increasing attrition in both
employees and customers.

The company outlined a three phase strategy in 2005 — Focus, Lead and
Dominate.

ƒ Phase 1: Set the house in order - Focus

In the first phase, its sales and delivery engines were restructured to help the
company focus on winning large deals. Processes were put in place and a large
number of them were automated. The Blue Ocean strategy was outlined
whereby the company decided to clearly focus on uncontested markets spaces
across verticals and business lines. A multi-service delivery unit with 200 of the
company’s brightest engineers was established to win and deliver large deals.

ƒ Phase 2: Forge partnerships, create value & lead

The second phase involved building selective partnerships with other
companies to jointly offer value added services to customers. HCL built a one of
a kind partnership with Celestica Inc, an electronics manufacturing company to
offer customers end to end solutions from design to manufacture in 2006. We
believe this venture would yield revenues of $100 million over the next three to
five years. Prior to this in 2005, the company formed a JV with NEC Japan to
offer off-shored software engineering solutions to NEC, its subsidiaries and
clients around the world.

ƒ Phase 3: Change the business model - dominate

The company has initiated its third phase of transformation whereby it seeks to
radically change the business model to dominate in select market spaces by
offering more value to customers. HCL plans to do this by offering innovative
pricing mechanisms.

Exhibit 3: Innovative pricing models

Pricing model Representative engagement

Guaranteed IT spending as a percentage of revenue US based supplier of automated test

Product based royalty Leading US based aircraft manufacturer

Guaranteed percentage of savings on IT cost Europe based specialty retailer

Device based pricing US based supplier of pharmaceutical products

Upfront cost benefit from transformation US based supplier electronic components

Source: Company, ICICIdirect Research

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We believe the benefits of the transformation are clearly visible in the
company’s financials. Revenues have grown at a CAGR of 34% over the last
three years. We will now dissect the actions and benefits that have accrued
from the transformation. We will also bring out the company’s strategy of
differentiating in crowded market spaces and dominating in uncontested
spaces.

Transformation bearing positive results

The transformation has clearly geared the organization towards large
transformational deals. This is evident from the number of total outsourcing
deals that the company bagged over the past two years. It won its first multi-
year large deal worth $50 million from Autodesk in 2005. This was followed by a
number of large total outsourcing deals.

Exhibit 4: Large deals gaining traction

Large deals Deal size (US$ mn) Vertical
Autodesk 50 Independent software vendor
Leading European bank 120 Banking
DSG International 330 Retail
Teradyne 70 Manufacturing
Skandia 200 Insurance
Fonterra not disclosed FCMG
Source: Company, ICICIdirect Research

HCL believes that it has key strengths in the infrastructure management space
(IMS) and typically approaches large deals with 35%-40% IMS content. The
company showcases its key achievements which include a 99.999% uptime of
the IT infrastructure, which facilitates large volume of transactions for one of
the largest stock exchanges in the country

Apart from large deals, the company is also bagging a number of multi-service
deals which increases customer stickiness. About 50% of customers
contributing revenues in excess of $5 million and 72% contributing in excess of
$10 million are multi-service customers. These metrics are an outcome of the
company’s Blue Ocean strategy

ƒ The Blue Ocean strategy

The Blue Ocean strategy does not seek to out-perform the competition in
the existing industry, but to create new market spaces or blue oceans,
thereby making the competition irrelevant.

Exhibit 5: Dominate in uncontested market spaces & differentiate in crowded ones

Geography Company size
Differentiate Dominate Differentiate Dominate
USA Continental Europe Global 500 Companies with
United Kingdom Asia Pacific revenues between $1
billion and $10 billion,
Australia – NewZealand a blue ocean.
Japan
Source: Company, ICICIdirect Research

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 Exhibit 6 : Infrastructure management services (IMS) - Blue oceans

Wipro HCL Technologies

IMS business revenues ~$500 mn (post IMS business revenues $196mn
acquisition of Infocrossing)
Targets companies with revenues less than $10
Targets Global 500
billion
Owns data-centers (an important value- add for Leases data-center space from third parties (not a
Global 500 customers. big value add for customers HCL targets)
Source: ICICIdirect research

Similarly HCL has identified blue oceans across verticals and business lines in
which it would dominate (see exhibit 5). The company identified micro verticals
within verticals to develop strong domain expertise and offer niche services.
The success of the strategy is visible from the growth rates of the various
verticals. We are impressed by the success of the strategy, which is visible in
the overall q-o-q revenue growth rates of 10.3%, 10.2%, 9.5% & 9.2% for FY07.

Exhibit 7: Blue ocean strategy at work

Verticals Micro verticals Y-o-Y growth%*
Banking, Financial
Capital markets, Insurance, Retail &
Services & 54% Niche verticals, niche projects
corporate banking
Insurance (BFSI) A case in point would be the aerospace micro
vertical where the company has strong
Independent Software vendors, Semi-
conductor, Consumer electronics, Storage & competencies. The company has been working
Hi-tech -
servers, other manufacturing, OEM's and 21% on Boeing’s prestigious ‘Dreamliner’ project as a
Manufacturing
Tier1 suppliers in Aerospace and Automotive tier1 vendor. Billing rates in these engagements
industries are higher than the company’s average as it
Telecom Service providers, Telecom entails high levels of domain expertise.
Telecom 31%
technology vendors Similarly, the company has bagged a contract
from Alenia Aeronautica, an Italian aerospace
Specialty retail, Apparel & Footwear, CPG,
Retail Food & Grocery, Retail Independent service 46% giant to redesign the C27J Spartan aircraft.
vendors, e-tailing

Media Publishing & Publishing, Casinos, Lottery, Mobile gaming,

Entertainment Recorded music, Business information 31%
(MPE) services, e-learning, broadcasting

Pharmaceuticals, Medical devices,

Life Sciences 66%
Healthcare providers
State & Federal governments, Energy &
Others Utilities covering Oil & Gas, Power, Water, 24%
Waste & recycle management
Source: Company, ICICIdirect Research
*Y-o-Y growth for the last three quarters only, due to reclassification of reporting

We believe the micro-vertical strategy coupled with offerings that derive

outcome/device based pricing and SaaS (Software as a Service) which can
derive per user or per transaction type revenues augurs well for HCL.

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BPO business looks to transform inorganically
HCL plans to make an acquisition in the non-voice BPO space and we believe a
strategic one would significantly transform its business. The company currently
derives 13% of its revenues (Rs 798 crore in FY07) from its BPO business.
However the business is largely voice based (around 70%). Margins in this
business are currently high at around 25% against the industry average of
around 12%-15%. Customer concentration is also high with 4-5 customers
accounting for 80% of its business. We believe this poses considerable risk to
the business. The proposed acquisition should help take it higher up the value
chain while reducing risk to the business.

Execution of strategy impeccable, but systemic risks limit outperformance

HCL today faces two key systemic risks – 1) a hostile currency environment and
2) the end of the tax holiday for STPI units.

The rupee has appreciated by 11% since January 2007, and this has impacted
earnings of most players in the IT industry. We believe this is a long term trend
with capital inflows to India rising unabated. Inflows almost trebled from $5.5
billion in FY05 to $16 billion in FY06.

The company has forward covers for the next eight quarters to the tune of $1.73
billion at an average rate of Rs 43.15 to a dollar. The hedges cover 90% of the
net forex inflows for around six quarters. We believe HCL Technologies is
among the most well hedged companies in the IT space. Though this could help
for a few quarters long term concerns remain.

Exhibit 8: Amongst the most well hedged in the IT space

Company Hedges Remarks
HCL Technologies $1.73 billion @ Rs43.15 Covers 90% of the net inflows for
the next six quarters and
partially for two quarters
thereafter
Wipro $750 million @ approximately Rs41 Covers 60%-70% of the net
inflows for the next two quarters
and partially for six months
thereafter

Infosys $925 million 100% cover for the next two

quarters
Source: Company, ICICIdirect Research

Another systemic risk is the end of the tax holiday for STP units in FY10E. The
company plans to shift incremental headcount to SEZs and estimates the
effective tax rate to be around 20% by FY10 (9.8% currently). We believe this
would impact the company’s EPS by around 12% and return on equity could fall
by 526bps (100bps = 1%).

Risks to our call

• A significant increase/decrease in the rupee dollar rate from current levels

could change valuations

• Impact of large deals materializing going forward

• A deceleration in the off-shoring movement due to unforeseen economic

circumstances

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• Extension of the tax holiday for STP units would be a positive surprise

• Our estimates have not factored in the positives of the changing business
model

Financials

ƒ Return on equity (RoE) on a declining trend

We believe the company would show a declining trend in return on equity
going forward as it bears the brunt of an appreciating currency and
impending change in the tax structure. Although the ROEs in FY09 appear
to be at the levels of FY06, we believe the fall would be much steeper in
FY10 post the phase out of the STP tax holiday.

Exhibit9: RoEs on a decline

FY06 FY07 FY08E FY09E
RoE’s would rise post the planned
HCL Technologies 25% 34% 27% 26%
acquisition in the BPO space. The
Wipro 31% 30% 26% 28% company currently has an estimated
Satyam 27% 24% 23% 23% Rs2287 crore in cash and
Source: ICICIdirect Research
investments.

ƒ Margins trending downward

HCL is seeing its margins decline as like all other IT companies, with the
rupee appreciating at a rapid pace. The company should benefit from a
flattening employee pyramid as the infrastructure business grows,
employing more diploma holders, thereby reducing the pace of growth of
employee costs. Higher than expected increases in billing rates should also
help reduce the decline in margins. The company would also benefit as it
revamps its business model.

Exhibit 10: Margins trending downward

FY06 FY07 FY08E FY09E Margins would rise if the company
HCL Technologies 22% 22% 21% 20% closes a higher number of large
Wipro 25% 25% 19% 19% deals going forward. Large deals
Satyam 31% 27% 25% 24% garner margins higher than the
company’s average.
Source: ICICIdirect Research

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 Valuations
HCL is expected to see dollar revenues grow at a CAGR of 32% over the next
two years, while rupee growth is likely to be subdued at a CAGR of 25% to
Rs9,488 crore by FY09E. However with RoEs declining as like most IT
companies the stock is not likely to outperform the broader market. We did a
DCF stress test to see what could be the worst case scenario.

We have assumed a terminal growth rate of 2% with the Re/US$ rate reducing
over time to Rs 28 to a dollar. We ascertain a fair value of Rs 284 per share in
this scenario. It also takes into account the tax impact post FY10E. Hence, we
believe downside is limited from current price.

Exhibit 11: DCF stress test

FY08E FY09E FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E
Sales (US$ crore) 194 241 286 325 365 401 433 459 477 487 497
Exchange rate
39.68 39.30 38.55 35.00 34.00 33.00 32.00 31.00 30.00 29.00 28.00
(Rs/US$)
Sales (Rs, Crore) 7712 9479 11006 11391 12394 13232 13858 14230 14322 14122 13907
Operating cost 6116 7622 9060 9569 10411 11115 11779 12238 12460 12427 12517
Free cash flow 1157 1459 1416 1267 1385 1483 1415 1307 1162 988 671
Terminal value 5445
PV of TV 5366
NPV 18891
Fair value 284

Average exchange rate 34 36 39 42 We believe this would be

the most likely scenario
Target price 288 328 365 402 going forward

Source: ICICIdirect Research

We have arrived at our target price of Rs365 at an average exchange rate of Rs39
to a dollar. Our target price discounts FY09E EPS by 17.4x and EV/EBIDTA by
11.7x. We would wait for the change in the business model to bear fruit before
we revise our estimates.

Exhibit 12: Relatively cheap when compared to peers

FY08E FY09E
EV/EBIDTA P/E EV/EBIDTA P/E
HCL Technologies 11.2 16.3 9.4 14.5
Infosys 16.6 23.7 13.9 20.2
Wipro 15.2 23.3 12.4 19.2
Satyam 12.1 18.3 9.1 14.6
Source: ICICIdirect Research

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Profit & Loss Account
(in Rs crore) FY06 FY07 FY08E FY09E
Sales 4388.20 6033.66 7709.33 9487.82 Revenues to grow at a CAGR
% Growth 37.50 27.77 23.07 of 25%. Large deals could
Total expenses 3415.10 4696.60 6115.75 7622.06 change trajectory.
EBIDTA 973.10 1337.06 1593.58 1865.76
% Growth 37.40 19.19 17.08
Depreciation 191.60 253.10 347.86 430.71
Other Income 57.30 426.00 161.29 196.12
Profit Before Tax (PBT) 838.80 1509.96 1407.00 1631.17
% Growth 80.01 -6.82 15.93
Taxation 63.20 148.50 141.20 179.97
Tax as % of PBT 7.53 9.83 10.04 11.03
Extraordinary/Minority interest -1.60 -5.50 -2.04 -4.08
Net Profit 774.00 1355.96 1268.72 1452.07
Decline in profitability in
% Growth 75.19 -6.43 14.45
FY08E on account of
Shares O/S 66.50 66.50 67.90 69.00
extraordinary forex gains in
EPS (Rs) *11.64 20.39 18.69 21.04
FY07.
% Growth 75.19 -8.36 12.63
* Adjusted EPS

Balance Sheet

(in Rs crore) FY06 FY07E FY08E FY09E

Sources of funds
Share capital 64.69 133.00 135.80 138.00
Reserves & surplus 3038.95 3900.00 4534.36 5260.39
Secured loans 58.87 76.00 76.00 76.00
Unsecured loans 0.21 0.21 0.21 0.21
Current liabilities & prov 933.73 1111.11 1443.49 1796.29
Total 4096 5220 6190 7271
Application of funds
Net Block 951.38 1081.57 1133.70 1302.99
Investments 1524.85 1500.00 2000.00 2500.00
Cash 312.53 786.67 917.45 1024.98
Trade receivables 870.83 1000.00 1277.72 1572.48 Cash and cash equivalents
Loans & advances 260.04 340.00 340.00 340.00
reduces downside risk to
valuations
Inventory 130.28 432.08 440.99 450.44
Deferred tax asset 46.54 80.00 80.00 80.00
Total 4096 5220 6190 7271

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Cash Flow Statement
FY06 FY07E FY08E FY09E
Pre tax profit from operations 781.5 1084.0 1250.7 1440.0
Depreciation 191.6 253.1 347.9 430.7
Expenses (deffered)/others (7.5) (33.5) 0.0 0.0
Pre tax cash from operations 965.6 1303.6 1598.5 1870.7
Other income/prior period ad 55.7 420.5 159.2 192.0
Net cash from operations 1021.3 1724.1 1757.8 2062.8
Tax (63.2) (148.5) (141.2) (180.0)
Cash profits 958.1 1575.6 1616.6 1882.8

Increase in current liabilities (8.6) 3.6 2.2 2.4

(Increase) in current assets (289.8) (431.0) (286.6) (304.2)

(Increase) in fixed assets 193.4 (383.3) (400.0) (600.0)

(Increase) in investments 279.7 24.8 (500.0) (500.0)
(Increase) in loans & advances (58.5) (80.0) 0.0 0.0

Cash flow from financing activities (1239.8) (409.5) (631.6) (723.8)

Opening cash balance 231.4 312.5 786.7 917.5

Closing cash balance 312.5 786.7 917.5 1025.0

Ratios
FY06 FY07E FY08E FY09E
EPS *11.6 20.4 18.7 21.0
Book value per share (Rs) 96.0 60.6 68.8 78.2
Enterprise value (Rs crore) 18504.2 18072.0 17868.3 17596.2
EV/EBIDTA 19.0 13.5 11.2 9.4 Valuations attractive
Employee exp / Sales (%) 63% 62% 64% 66%
Earnings per employee (Rs) 237234 347095 268442 245695
Market cap/Sales 4.6 3.4 2.7 2.2
Price/Book value 3.2 5.0 4.4 3.9
Operating margin (%) 22.2 22.2 20.7 19.7
Return on Net-worth (%) 25.0 33.8 27.2 27.0
Return on capital employed (%) 24.6 26.3 26.2 26.2
Debt/equity 0.0 0.0 0.0 0.0
Fixed assets turnover ratio 4.6 5.6 6.8 7.3
Debtors turnover ratio 5.0 6.0 6.0 6.0
* Adjusted EPS

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 RATING RATIONALE

ICICIDirect endeavors to provide objective opinions and recommendations. ICICIdirect assigns ratings to its
stocks according to their notional target price vs current market price and then categorises them as
Outperformer, Performer, Hold, and Underperformer. The performance horizon is 2 years unless specified and
the notional target price is defined as the analysts' valuation for a stock.

Outperformer: 20% or more

Performer: Between 10% and 20%
Hold: +10% return
Underperformer: -10% or more

Harendra Kumar Head - Research & Advisory harendra.kumar@icicidirect.com

ICICIdirect Research Desk,

ICICI Securities Limited,
2nd Floor, Stanrose House,
Appasaheb Marathe Marg,
Prabhadevi, Mumbai – 400 025

research@icicidirect.com

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