22 March 2021 Company Update | Sector: Technology HCL Technologies BSE SENSEX S&P CNX 49,771 14,736 CMP: INR978 TP: INR1,300 (+33%) Buy Valuations continue to discount Product opportunity Stock Info HCLT remains one the most attractive stocks in our coverage, trading at 15x FY23E P/E Bloomberg HCLT IN (38%/26% discount to TCS/Infosys), despite delivering 20% earnings growth in FY21 YTD. Equity Shares (m) 2,714 We expect this discount to narrow as it benefits from increasing Cloud spend, given its M.Cap.(INRb)/(USDb) 2652.9 / 36.7 large exposure to IT infrastructure. It can potentially re-rate if it continues to deliver 52-Week Range (INR) 1074 / 400 growth in the Software Product business, which remains a key overhang on the stock price, despite outperforming expectations over the last two quarters. 1, 6, 12 Rel. Per (%) 6/-13/53 12M Avg Val (INR M) 5919 Cloud remains a large opportunity We view Cloud deployment and application migration to be among the biggest Financials Snapshot (INR b) areas of corporate spend in the medium term, growing at 15-18% CAGR Y/E Mar FY21E FY22E FY23E between CY20-25E (Exhibit 3). Sales 761 875 990 EBIT Margin (%) 21.6 21.8 22.1 With its high exposure to Infrastructure Management Services (over 30% of PAT 130 153 176 total revenue), HCLT would be one of the key beneficiaries to the Cloud shift. EPS (INR) 48.0 56.5 65.0 It continues to be rated among the top vendors by industry analyst in the EPS Gr. (%) 18.0 17.5 15.1 Cloud migration space. BV/Sh. (INR) 217 241 260 We expect HCLT’s Mode 2 business to grow at 26% CAGR over FY20-23E to Ratios reach 28% of total revenue in FY23E. RoE (%) 23.6 24.6 25.9 P&P performing better than expected RoCE (%) 20.8 21.7 22.9 Payout (%) 37.5 50.0 60.0 HCLT has delivered double-digit growth (over 13.4% YoY growth in six months Valuations ending Dec’20) in its IBM software-led Product and Platform (P&P) business. P/E (x) 20.3 17.3 15.0 This should help address investor concerns since the acquisition of these IP in P/BV (x) 4.5 4.1 3.8 Dec’18, mainly on account of legacy software like Domino/Lotus Notes. EV/EBITDA (x) 12.8 10.9 9.6 We expect this business to continue to grow well and deliver 13% revenue Div Yield (%) 1.8 2.9 4.0 CAGR over FY21-23E. Despite the investment impact, we expect EBIT margin Shareholding pattern (%) to stay meaningfully above IT Services profitability. As On Dec-20 Sep-20 Dec-19 With the upcoming launch of Domino V12 (third major update in 2.5 years Promoter 60.3 60.3 60.0 after the last update under IBM in CY13) and a large user base (partially DII 10.3 10.7 8.5 dormant), we see upside risk for P&P growth led by client upgrades. FII 24.9 24.9 27.7 We expect the drag from a large investment on HCLT’s RoIC to bottom out in Others 4.5 4.1 3.9 FY21E (Exhibit 10 and 11). FII Includes depository receipts Valuation and view Higher exposure to IMS (over 30% of revenue), aided by strong demand for Stock Performance (1-year) HCL Technologies Cloud services, should help deliver over 14% revenue growth in FY22E. Sensex - Rebased Broad-based sequential growth, coupled with healthy deal wins and a robust 1,150 pipeline, indicates a good demand outlook. We expect strong performance in 950 the Products business, driven by HCLT’s capabilities to rightly align and sell 750 these products. 550 Given its deep capabilities in the IMS space and strategic partnerships, 350 investments in Cloud, and Digital capabilities, we expect HCLT to emerge stronger on the back of an expected increase in enterprise demand for these Jul-20 Nov-20 Mar-20 Mar-21 services. The stock is currently trading at a modest ~15x FY23E earnings, which offers a margin of safety. Our TP is based on 20x FY23E EPS (a 20% discount to TCS). Maintain Buy. Mukul Garg– Research analyst ([email protected]) Anmol Garg - Research analyst ([email protected]) / Heenal Gada - Research analyst ([email protected]) Investors are advised to refer through important disclosures made at the last page of the Research Report. Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital. HCL Technologies Exhibit 1: HCLT trades at a huge discount to TCS… Jan-14 Aug-14 Feb-15 Sep-15 Mar-16 Oct-16 May-17 Nov-17 Jun-18 Dec-18 Jul-19 Jan-20 Aug-20 Mar-21 0% -15% -30% -45% -60% Source: Bloomberg, MOFSL Exhibit 2: …and to Infosys Jan-14 Aug-14 Feb-15 Sep-15 Mar-16 Oct-16 May-17 Nov-17 Jun-18 Dec-18 Jul-19 Jan-20 Aug-20 Mar-21 15% 0% -15% -30% -45% Source: Bloomberg, MOFSL Higher exposure to IMS to be a key growth driver While Cloud has been a focus area for large corporates for the last few years, we have seen significant acceleration in Cloud adoption and migration work post lifting of COVID-led lockdown restrictions. As per industry experts, Cloud will be among the biggest areas of spends from corporates in the medium term. With the adoption of multi-Cloud environments, Cloud migration and maintenance should continue to drive significant growth for IT Services companies. HCLT’s high exposure to Infra Outsourcing and Management Services (over 30% of total revenue), comprising a larger share of non-discretionary spends, should enable it to capture increased demand for Cloud services. It has been consistently rated as a leader by industry analysts (IDC/Gartner) in hybrid managed infrastructure, data center outsourcing, and managed Cloud services. We expect the company to see improved growth in its IT Services vertical in FY22 (+14% YoY). 22 March 2021 2 HCL Technologies Exhibit 3: Cloud to be the key growth driver for the IT industry 2020 2025 500-550 500-540 350-380 300-350 320-350 200-250 180-220 150-170 145-160 110-135 Cloud consumption Cloud services Digital services Traditional services BPM services Source: Nasscom, MOFSL According to Gartner, as organizations increase their reliance on Cloud technologies, IT teams rush to embrace Cloud-built applications and relocate existing Digital assets. “Building, implementing, and maturing Cloud strategies will continue to be a top priority for years to come.” Exhibit 4: 35% growth CAGR in IaaS is mainly led by Cloud… Exhibit 5: …compared to 1% CAGR in Managed Services IaaS 17.8 Managed Services 20.8 14.8 20.5 12.0 19.4 7.7 19 5.3 18.4 9MCY16 9MCY17 9MCY18 9MCY19 9MCY20 9MCY16 9MCY17 9MCY18 9MCY19 9MCY20 Source: ISG, MOFSL Source: ISG, MOFSL Our past analysis suggests that the deal pipeline for the next few years is strong with many large Infra deals coming up for renewal. Exhibit 6: Multiple large Infra deals coming up for renewal over the next few years Client Renewal Description DNB Bank CY21 Managing IT infrastructure and core applications Pepsico CY21 Infrastructure management services Roll out PC as a Service for 30,000 users worldwide and will enable local end-user Alstom CY21 support services across 360 locations in 62 countries Prepare Volvo's infrastructure for Cloud, Automation and Big Data, and look after Volvo CY21 3,500 applications, 20 data centers, 12PB of storage, and 15,000 network devices End-to-end integrated infrastructure and applications covering data center services, Husqvarna AB CY21 network services, security services, application operations, and support services Managed services construct spans IT infrastructure, end-user computing, data center, Singapore Exchange CY22 Cloud services, workplace transformation, managed networks, and enterprise security Reducing JLT's data center footprint by over 50%, leverage HCL's DryIce to lay the Jardine Lloyd Thompson CY22 foundation for a global hybrid Cloud platform Nokia CY23 Transforming and modernizing Nokia's IT infrastructure and application landscape Adoption of Cloud; reducing Anglo American’s global data center footprint, provide Anglo American CY23 regional and local service desk support, and end-user computing services Source: Company, MOFSL 22 March 2021 3 HCL Technologies IBM products have not dragged down performance HCLT acquired select IBM software products for USD1.8b in mid-CY19. The software product in scope represented a total addressable market of over USD50b. This business (part of the P&P vertical) has delivered good performance over the last few quarters, growing above 10% YoY despite the COVID-led slowdown. This was contrary to investor apprehensions of a decline in these businesses, which would have been a drag on overall performance. Exhibit 7: HCL Software Products’ roadmap principles Source: Company, MOFSL Part of this performance was on account of the management’s focus on improving the life of the legacy portion of its portfolio (led by the 30-year-old Domino platform). From its legacy version (last updated in CY13), it rolled out two large updates for Domino to its large installed base and is in the process of launching V12 in 1HCY21, with a higher emphasis on mobility and a refreshed user interface. If HCLT is able to convince additional clients to upgrade and stick to Domino, this can potentially be a very lucrative, high margin business. Exhibit 8: Domino has gone through multiple upgrades under HCLT Source: Company, MOFSL 22 March 2021 4 HCL Technologies The company managed a net new license TCV of USD91m in 3QFY21 in its P&P business, up 3.5x YoY.