New acquisition strengthens HCL Technologies in APAC but lacks zing

“Be bold, be right”. The famous parting advice of Steve Ballmer to the current chief executive officer of Microsoft Corp Satya Nadella works to an extent for HCL Technologies Ltd now.

HCL Technologies Ltd’s acquisition of Australia-based IT services company DWS Ltd ticks the “be right” box. The consideration of 158 million Australian dollars is similar to DWS’s FY20 revenue. The acquisition expands HCL’s reach in the Asia-Pacific (APAC) region and brings in the marquee ANZ clientele, points out BOB Capital Markets Ltd.

However, the acquisition falls short on the “bold” aspect. Similar to earlier acquisitions, DWS provides HCL linear growth opportunities such as geographical, client reach and cross selling venues. But the acquisition lacks the excitement that new age technology companies offer–rapid growth scope. In fact revenues of DWS fell in two of the last five fiscal years and operating profitability softened.

“The underlying theme across acquisitions is the valuations paid—nearly all acquisitions are at 1X or lower in price/sales multiple. None of the acquisitions are in the ‘exciting’ next-gen areas with the possible exception of Strong-Bridge Envision. The acquisitions seem safe from immediate earnings protection standpoint but lack the excitement of creating multiplier impact. We would like to see a higher allocation of capital for augmenting next-gen capabilities,” analysts at Kotak Institutional Equities said in a note.

Of course the acquisition strategy underscores the HCL’s conservative approach and focus on value. Higher offshoring and HCL’s execution capabilities can help it improve DWS’s profitability and extract better value from the acquisition.

Nevertheless DWS’s annual revenue constituted a little over 1% of HCL’s sales last fiscal and the immediate impact on the company’s finances can be marginal. “Based on the deal closure, DWS should contribute ~$30-40 million to revenue in FY21 (mainly in 4QFY21), which implies an additional ~30-40 basis points revenue growth in FY21,” Motilal Oswal Financial Services Ltd said in a note. One basis point equals one percentage point.

Investors meanwhile are enthused by faster recovery at the company. In a recent update HCL said it expects revenues to grow by over 3.5% in the current quarter, higher than the 1.5-2.5% growth it had projected in July. Operating profit margins are now estimated to be about 100 basis points higher than its earlier target.

The growth upgrade reflects strong execution. The company is seeing good booking momentum and deal pipeline. The healthy management commentary is helping the stock narrow the valuation gap with industry peers.

“Higher Q2FY2021 revenue and margin guidance has surprised us positively. We incorporate the revised growth and margin outlook in our FY2021/FY2022/FY2023 guidance, leading to an EPS upgrade of 3.8%/3.4%/4%, respectively. Strong order bookings, healthy deal pipeline, consolidation opportunities in both IMS and application modernization spend of clients are expected to drive the company’s growth going forward,” Sharekhan Ltd said in a note. EPS is earnings per share and IMS infrastructure management services.

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