HCL Tech Ratings | Buy — Rising capex has been a drag on return ratios

HCL’s estimate of useful life for amortisation of IPRs (over 5-15 years) was higher than peers TCS (2-5 years) and IBM (over 1-5/7 years).

HCL’s FY19 annual report highlighted a continued focus on inorganic growth to expand the product portfolio. This resulted in higher capital intensity and thus a reduction in the return ratios (RoCE down 750bp to 24.8% over FY15-19). Around 54% of operating cash flow (Rs 356.6 bn) over

FY15-19 was utilised for capex (Rs 118.7 bn; mainly for acquisitions of IPRs) and business takeovers (Rs 72.5 bn), leading to high intangibles (Rs 85.3 bn, 20.6% of NW) and goodwill (Rs 90.6 bn, 21.9% of NW).

HCL’s estimate of useful life for amortisation of IPRs (over 5-15 years) was higher than peers TCS (2-5 years) and IBM (over 1-5/7 years). While Ebitda was up 23.8% to Rs 139.3 bn in FY19, its conversion to cash flows declined to 83% (FY18: 95%) as the cash conversion cycle elongated from 64 days in FY18 to 68 days in FY19. This was primarily due to a decline in advance from customers to 1 day (FY18: 5 days). A comparison of HCL with peers suggests that it has generated a higher RoE (26.0%) than Infosys (23.7%) and Wipro (17.2%) but lower than TCS (36.0%).

Rising capital intensity drags return ratios: Over FY15-19, HCL utilised 54% of OCF (Rs 356.6 bn) for capex and business takeovers. Of the cumulative capex over FY15-19, ~Rs 87.5 bn was used for the acquisition of licensed IPRs from IBM. Note that the CAGR in capital employed (17.3%) was higher than that in earnings (Ebit and other income; ~9.2%). As a result, RoCE declined 750bp to 24.8% (post tax) over FY15-19.

Significant intangibles with higher estimated useful life than peers: Licensed IPRs formed significant part of intangibles at ~86% (Rs 73.5 bn) in FY19. HCL’s amortisation period for licensed IPRs (over 5-15 years) is higher than that of peer companies, and thus amortisation of IPRs in line with peers could materially impact profitability (~3.9% to 63.3% of PBT in FY19), in our view. Goodwill arising from business acquisitions is not amortised but tested for impairment at the end of each year.

Operating performance improves: Ebitda increased by ~23.8% in FY19, supported by revenue growth of ~19.5% and Ebitda margin expansion of ~80bp to 23.0%. This is mainly due to higher contribution from the Ebitda margin-accretive licensed IP business, which led to lower personnel cost (-45bp to Rs 292.8 bn) and outsourcing cost (-85bp to Rs 97.6 bn). Depreciation & amortisation increased from Rs 13.8 bn (2.7% of revenue) in FY18 to
Rs 20.7 bn (3.4% of revenue) in FY19.