HCL’s margins set to receive a boost from IBM deal

New products to provide synergies and scale

A decade after it purchased UK-based Axon, HCL Technologies (HCL) has bought seven products from global technology major IBM. However, concerns of high deal valuation and the need to take on debt have knocked the stock down by around 5 per cent in Friday’s trade.

The company will pay about $1.8 billion for the seven products, of which HCL has an ongoing IP partnership for five. About 48 per cent of the total cash consideration is payable by mid-2019 and the balance about a year later.

Valuation and debt concerns:

According to reports, HCL expects an annual revenue run-rate of $650 million from the products deal, though the amount is likely to be slightly lower in the first year due to transition issues. Thus, the company is paying more than 2.7 times expected annual revenue from these products as consideration, which may not be inexpensive. But margins are likely to increase after this deal.

HCL has indicated that it would fund the deal by taking $300 million in debt, mainly because some its funds are locked up in FDs and long-term bonds that it has chosen not to liquidate. The fresh debt should not be a major financial burden for the company, as it has almost $1.6 billion in funds (as cash, FDs, available-for-sale securities etc.) as of September 2018 and borrowings of $424 million.

On the whole, even after the full payment is made over the next 12-18 months, HCL would have a comfortable net cash position.

Margin accretive

The products deal is expected to augment HCL’s mode-3 (products and platforms) offerings, which accounted for 11.9 per cent of revenues (September 2018) and enjoy an EBIT margin of 24.4 per cent, much higher than the overall firm’s 19.5-20 per cent levels. These products from IBM reportedly enjoy better margins than HCL’s other service lines. Over the next couple of years, it is likely that HCL’s EBIT margins should receive a boost from these products.

Given that the company managed to integrate Axon well and drive growth, these new products too are most likely to provide synergies and scale for HCL.

The markets may have overreacted because of the perception that HCL is overpaying for IBM’s products.

But given the growth trajectory of the company – it is likely to record double-digit dollar revenue growth for FY19 – and very high valuation comfort with reference to its stock, the negativity is likely to fade out quickly.

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