HCL Tech's Q3 earnings disappoint; stock tanks 8%

HCL Tech's Q3 earnings disappoint; stock tanks 8%
  • HCL's Q3 results missed expectations.
  • Stock price fell sharply after report.
  • Valuation leaves little room for error.

HCL Technologies Ltd. experienced a significant downturn following the release of its December quarter (Q3FY25) earnings, which fell short of market expectations. The company's stock, which had reached a 52-week high of ₹2,012 just the day before, plummeted approximately 8% on Tuesday. This sharp decline highlights the elevated expectations of the market and the potential impact of overall muted equity market sentiment. The primary reason for the underperformance was weaker-than-anticipated revenue growth in the software business, attributed to delays in deal closures and renewals. While the services business showed better growth, it was still impacted by factors such as furloughs and typical seasonality. This underperformance underscores the challenges HCL faces in navigating the current IT landscape.

The sequential constant-currency (CC) revenue growth of 3.8% lagged behind the consensus estimate of 4.2%, adding to the disappointment. Management cited a planned ramp-down of the Verizon deal and the completion of several projects as contributing factors to this shortfall. These factors are expected to impact the retail, consumer packaged goods (CPG), and telecom verticals of the services business in Q4FY25. Furthermore, the slower-than-expected ramp-up of discretionary deals represents a concern, particularly given the increasing momentum of short-cycle deals. The total contract value (TCV) of new deals in Q3 stood at approximately $2.1 billion, slightly lower than the $2.2 billion achieved in Q2 and below the targeted $2.3-2.5 billion. This softness in new deal TCV raises questions about HCL's ability to maintain its growth trajectory. While shorter deal durations could potentially support near-term growth by improving the annual contract value, the speed at which these shorter deals are implemented will be crucial for future performance.

Despite the disappointing Q3 results, HCL revised its FY25 revenue growth guidance upwards, raising the lower end from 3.5% to 4.5%. The new guidance, ranging from 4.5% to 5%, includes the impact of HP's CTG acquisition (approximately 50 basis points). However, this leaves organic growth guidance essentially unchanged. This revised guidance, coupled with a projected soft Q4 exit rate, has nevertheless triggered concerns about HCL's year-on-year revenue growth in FY25. Several brokerages have already lowered their FY25 earnings-per-share estimates, reflecting a more cautious outlook. The management's projected ask rate for Q4FY25, ranging from -1.3% to +0.6% sequentially in constant currency terms, further fueled these concerns. Analysts, such as those at Prabhudas Lilladher, have incorporated these anticipated delays and the planned ramp-down, resulting in a revised FY25 revenue growth forecast of 4.8% YoY CC (previously 5.3%).

On a positive note, HCL's earnings before interest and tax (Ebit) margin expanded by 90 basis points sequentially to 19.5%, driven by operating efficiency measures and favorable foreign exchange rates. However, this improvement is expected to be short-lived, with margins potentially declining in Q4 due to planned salary increases for junior staff and the weaker-than-expected performance of the high-margin software business. HCL maintained its FY25 Ebit margin guidance at 18-19%. The company's relatively low exposure to the struggling banking, financial services, and insurance (BFSI) sector has positioned it favorably compared to its peers. Despite the recent setbacks, HCL's stock has performed relatively well, showing a 17% increase in the past six months, outperforming the Nifty IT index's 11% return. However, the company's valuation, trading at a FY26 price-to-earnings multiple of 26x, is a significant factor impacting investor sentiment.

HCL's valuation, almost on par with Infosys, which is widely viewed as a major beneficiary of the anticipated revival in discretionary demand, raises questions about its future prospects. Analysts at Kotak Institutional Equities highlighted HCL's significant exposure to verticals facing demand headwinds, including manufacturing and telecom, and others where discretionary spending recovery is lagging, such as healthcare and public services. These verticals contribute to 56% of HCL's revenue and could significantly slow down the overall recovery pace. This exposure to potentially weaker sectors, combined with the already evident near-term challenges, makes the current valuation particularly vulnerable. The market's reaction to the Q3 results underscores the lack of margin for error in HCL's current valuation. Investors will be closely watching the company's performance in the coming quarters to gauge its ability to overcome the current headwinds and justify its premium valuation relative to its peers.

In conclusion, while HCL Technologies has demonstrated some strengths, particularly its relatively low exposure to the struggling BFSI sector and its recent upward revision of revenue guidance, the Q3 results have exposed significant vulnerabilities. The weaker-than-expected performance in the software business, coupled with concerns about the pace of discretionary deal ramp-up and a projected soft Q4 exit rate, have cast a shadow over the company's prospects. Furthermore, its current valuation, almost comparable to industry leader Infosys, leaves little room for error. Investors are likely to remain cautious until HCL demonstrates a more convincing path toward sustainable growth and improved performance in the coming quarters. The market's sharp reaction to the Q3 results underlines the heightened scrutiny on HCL and the crucial importance of exceeding expectations in future reporting periods.

Source: HCL serves up a heady cocktail, but valuation leaves no room for error

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