October 3, 2007 | Information technology

Initiating Coverage

HCL Technologies (HCLTEC)
Strategy at work …
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. However, with the twin challenges of an appreciating rupee and the phasing out of the STP tax holiday under sections 10A and 10B in FY10, earnings growth would decline. In the third phase of its transformation, the company 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.

Current price Rs 305 Potential upside 19%

Time frame 12 months Potential upsidemonths Time frame 12 13%

Target price Rs 365 Time Frame 12 months

PERFORMER

Nitin Padmanabhan nitin.padmanabhan@icicidirect.com Manoj Kabra manoj.kabra@icicidirect.com

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

Impact of appreciating rupee to be minimal

HCL 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 this is among the most well hedged companies in the IT space.

Stock metrics
Promoters holding Market Cap 52 Week H/L Sensex Average volume 67.55% 20,282 crore 365/254 17291 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 environment coupled with the impending impact of higher taxes in FY10, the room for outperforming is limited. The stock currently trades at 14.5x its FY09E EPS of Rs 21 and at an EV/EBIDTA of 9.5x FY09E. We have based our valuations on a DCF stress test that gave us a worst case price of Rs 284 per share. Hence downsides are limited from the current price. We have valued the stock 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 Net Profit Shares in issue (crore) EPS (Rs) % Growth P/E (x) Price/Book (x) EV/EBIDTA RoNW (%) RoCE (%) FY06 774.0 66.5 11.6 26.2 3.2 19.0 25.0 24.6 FY07 1356.0 66.5 20.4 75.2 15.0 5.0 13.5 33.8 26.3 FY08E 1268.7 67.9 18.7 (8.4) 16.3 4.4 11.2 27.2 26.2 FY09E 1452.1 69.0 21.0 12.6 14.5 3.9 9.4 27.0 26.2
450 375 300 225 150 75 0 Oct-01 Apr-02

Comparative return metrics
Stock return (%) 3M 6M 12M

HCL Technologies Wipro Satyam Infosys

-15 -14 -8 -5

-4 -25 -8 -12

2 -13 2 2

Absolute sell Target price

Absolute buy

Oct-02

Apr-03

Oct-03

Apr-04

Oct-04

Apr-05

Oct-05

Apr-06

Oct-06

Source: ICICIdirect Research ICICIdirect | Equity Research

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Apr-07

Company Background
HCL was founded in 1976 by Shiv Nadar after the government passed a law that discouraged multinational corporations from doing business in India. The company envisioned becoming a global leader in the manufacture of computer systems. 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 – 1) HCL Infosystems to focus on the domestic market and 2) HCL Technologies to focus on the global market. HCL focused heavily in the R&D and technology space and believed that the dot-com revolution would take it to the next level. In doing so the company missed the opportunities that came with Y2K and Application development. The dot-com bust in 2001 saw the company grappling for a new growth engine which led to a slew of transformation initiatives which includes a change in focus from single service to multi-service deals.

Share holding pattern
Shareholder Promoters Institutional investors Other investors General public Source: Insight, ICICIdirect Research Percentage holding (%) 67.55 23.58 4.12 4.75

Promoter & Institutional
80 70 60 50 40 30 20 10 0 69.15 69.02 67.55 67.55

(%)

25.06

23.78

21.87

23.58

Q1FY07

Q2FY07 Promoter holding (%)

Q3FY07

Q4FY07

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 dotcom 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. 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. 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. 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
Guaranteed IT spending as a percentage of revenue Product based royalty

Representative engagement
US based supplier of automated test 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 Source: Company, ICICIdirect Research

US based supplier electronic components

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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 multiyear 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 Autodesk Leading European bank DSG International Teradyne Skandia Fonterra
Source: Company, ICICIdirect Research

Deal size (US$ mn) 50 120 330 70 200 not disclosed

Vertical Independent software vendor Banking Retail Manufacturing Insurance FCMG

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 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
Differentiate USA United Kingdom Geography Dominate Continental Europe Asia Pacific Australia – NewZealand Japan
Source: Company, ICICIdirect Research

Differentiate Global 500

Company size Dominate Companies with revenues between $1 billion and $10 billion, a blue ocean.

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Exhibit 6 : Infrastructure management services (IMS) - Blue oceans
Wipro IMS business revenues ~$500 mn (post acquisition of Infocrossing) Targets Global 500 Owns data-centers (an important value- add for Global 500 customers.
Source: ICICIdirect research

HCL Technologies IMS business revenues $196mn Targets companies with revenues less than $10 billion Leases data-center space from third parties (not a big value add for customers HCL targets)

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 Banking, Financial Services & Insurance (BFSI) Micro verticals Capital markets, Insurance, Retail & corporate banking Independent Software vendors, Semiconductor, Consumer electronics, Storage & servers, other manufacturing, OEM's and Tier1 suppliers in Aerospace and Automotive industries Telecom Service providers, Telecom technology vendors Specialty retail, Apparel & Footwear, CPG, Food & Grocery, Retail Independent service vendors, e-tailing Publishing, Casinos, Lottery, Mobile gaming, Recorded music, Business information services, e-learning, broadcasting Pharmaceuticals, Medical devices, Healthcare providers State & Federal governments, Energy & Utilities covering Oil & Gas, Power, Water, Waste & recycle management Y-o-Y growth%* 54% Niche verticals, niche projects A case in point would be the aerospace micro vertical where the company has strong competencies. The company has been working on Boeing’s prestigious ‘Dreamliner’ project as a tier1 vendor. Billing rates in these engagements are higher than the company’s average as it entails high levels of domain expertise. Similarly, the company has bagged a contract from Alenia Aeronautica, an Italian aerospace giant to redesign the C27J Spartan aircraft.

Hi-tech Manufacturing

21%

Telecom

31%

Retail Media Publishing & Entertainment (MPE) Life Sciences Others

46%

31%

66% 24%

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 HCL Technologies Hedges $1.73 billion @ Rs43.15 Remarks Covers 90% of the net inflows for the next six quarters and partially for two quarters thereafter Covers 60%-70% of the net inflows for the next two quarters and partially for six months thereafter 100% cover for the next two quarters

Wipro

$750 million @ approximately Rs41

Infosys

$925 million

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 6|Page

• •

• •

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
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 HCL Technologies Wipro Satyam
Source: ICICIdirect Research

FY07 34% 30% 24%

FY08E 27% 26% 23%

FY09E 26% 28% 23%

25% 31% 27%

RoE’s would rise post the planned acquisition in the BPO space. The company currently has an estimated Rs2287 crore in cash and investments.

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
HCL Technologies Wipro Satyam
Source: ICICIdirect Research

FY06 22% 25% 31%

FY07 22% 25% 27%

FY08E 21% 19% 25%

FY09E 20% 19% 24%

Margins would rise if the company closes a higher number of large deals going forward. Large deals garner margins higher than the company’s average.

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

18891 284 We believe this would be the most likely scenario going forward

Average exchange rate Target price
Source: ICICIdirect Research

34 288

36 328

39 365

42 402

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 EV/EBIDTA HCL Technologies Infosys Wipro Satyam
Source: ICICIdirect Research

FY09E P/E 16.3 23.7 23.3 18.3 EV/EBIDTA 9.4 13.9 12.4 9.1 P/E 14.5 20.2 19.2 14.6

11.2 16.6 15.2 12.1

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Profit & Loss Account
(in Rs crore) Sales % Growth Total expenses EBIDTA % Growth Depreciation Other Income Profit Before Tax (PBT) % Growth Taxation Tax as % of PBT Extraordinary/Minority interest Net Profit % Growth Shares O/S EPS (Rs) % Growth
* Adjusted EPS

FY06 4388.20 3415.10 973.10 191.60 57.30 838.80 63.20 7.53 -1.60 774.00 66.50 *11.64

FY07 6033.66 37.50 4696.60 1337.06 37.40 253.10 426.00 1509.96 80.01 148.50 9.83 -5.50 1355.96 75.19 66.50 20.39 75.19

FY08E 7709.33 27.77 6115.75 1593.58 19.19 347.86 161.29 1407.00 -6.82 141.20 10.04 -2.04 1268.72 -6.43 67.90 18.69 -8.36

FY09E 9487.82 23.07 7622.06 1865.76 17.08 430.71 196.12 1631.17 15.93 179.97 11.03 -4.08 1452.07 14.45 69.00 21.04 12.63

Revenues to grow at a CAGR of 25%. Large deals could change trajectory.

Decline in profitability in FY08E on account of extraordinary forex gains in FY07.

Balance Sheet
(in Rs crore) Sources of funds Share capital Reserves & surplus Secured loans Unsecured loans Current liabilities & prov Total Application of funds Net Block Investments Cash Trade receivables Loans & advances Inventory Deferred tax asset Total FY06 64.69 3038.95 58.87 0.21 933.73 4096 951.38 1524.85 312.53 870.83 260.04 130.28 46.54 4096 FY07E 133.00 3900.00 76.00 0.21 1111.11 5220 1081.57 1500.00 786.67 1000.00 340.00 432.08 80.00 5220 FY08E 135.80 4534.36 76.00 0.21 1443.49 6190 1133.70 2000.00 917.45 1277.72 340.00 440.99 80.00 6190 FY09E 138.00 5260.39 76.00 0.21 1796.29 7271 1302.99 2500.00 1024.98 1572.48 340.00 450.44 80.00 7271

Cash and cash equivalents reduces downside risk to valuations

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Cash Flow Statement
Pre tax profit from operations Depreciation Expenses (deffered)/others Pre tax cash from operations Other income/prior period ad Net cash from operations Tax Cash profits Increase in current liabilities (Increase) in current assets (Increase) in fixed assets (Increase) in investments (Increase) in loans & advances Cash flow from financing activities Opening cash balance Closing cash balance FY06 781.5 191.6 (7.5) 965.6 55.7 1021.3 (63.2) 958.1 (8.6) (289.8) 193.4 279.7 (58.5) (1239.8) 231.4 312.5 FY07E 1084.0 253.1 (33.5) 1303.6 420.5 1724.1 (148.5) 1575.6 3.6 (431.0) (383.3) 24.8 (80.0) (409.5) 312.5 786.7 FY08E 1250.7 347.9 0.0 1598.5 159.2 1757.8 (141.2) 1616.6 2.2 (286.6) (400.0) (500.0) 0.0 (631.6) 786.7 917.5 FY09E 1440.0 430.7 0.0 1870.7 192.0 2062.8 (180.0) 1882.8 2.4 (304.2) (600.0) (500.0) 0.0 (723.8) 917.5 1025.0

Ratios
EPS Book value per share (Rs) Enterprise value (Rs crore) EV/EBIDTA Employee exp / Sales (%) Earnings per employee (Rs) Market cap/Sales Price/Book value Operating margin (%) Return on Net-worth (%) Return on capital employed (%) Debt/equity Fixed assets turnover ratio Debtors turnover ratio
* Adjusted EPS

FY06 *11.6 96.0 18504.2 19.0 63% 237234 4.6 3.2 22.2 25.0 24.6 0.0 4.6 5.0

FY07E 20.4 60.6 18072.0 13.5 62% 347095 3.4 5.0 22.2 33.8 26.3 0.0 5.6 6.0

FY08E 18.7 68.8 17868.3 11.2 64% 268442 2.7 4.4 20.7 27.2 26.2 0.0 6.8 6.0

FY09E 21.0 78.2 17596.2 9.4 66% 245695 2.2 3.9 19.7 27.0 26.2 0.0 7.3 6.0

Valuations attractive

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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 ICICIdirect Research Desk, ICICI Securities Limited, 2nd Floor, Stanrose House, Appasaheb Marathe Marg, Prabhadevi, Mumbai – 400 025 research@icicidirect.com harendra.kumar@icicidirect.com

Disclaimer
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