HCL Technologies: Street is concerned about scaling up of inorganic biz

The announcement of HCL Technologies that it was acquiring select products from IBM for $1.8 billion did not go down well with the Street. Despite the management’s assertion of $625-650 million incremental revenues over the next couple of years, with margins of 50 per cent, the stock shed about 5 per cent.

The Street is concerned about execution and management bandwidth to drive the product business, incremental investments required to expand the business, and the sales potential. 

Key concerns, according to analysts at ICICI Securities, are about the ability of the company to maintain margins at 50 per cent, revenue growth potential not fructifying, lower focus on organic growth and near term pressure on cash flows. The company has indicated that it will raise debt of $300 million while the rest of funding for the acquisition will come from internal accruals. About 48 per cent of the deal value is expected to be paid at the end of the deal closure (mid-2019), while the balance is to be paid a year after. The company had cash and cash equivalents just under $1.6 billion at the end of the September quarter. 

While the deal is cash earnings per share basis there is uncertainty at the net profit level about the benefits once depreciation and amortisation charges are applied. While the company has purchased seven products from IBM, it had an existing relationship with the company for five of these. Including the earlier intellectual property related partnerships, the total investments in the products is $2.6 billion. Analysts believe the additional debt and upfront investments could strain cash flows in the near term. 

In addition to the large client base that the company will get for the products and existing cash flows, the product business will also help it bundle its services and digital businesses to the acquired clients. Further it also gives it access to new markets and clients and an addressable market size of $50 billion. While these are positives analysts believe that the tilt towards inorganic segment for driving growth could put pressure both on revenues and margins. 

Given the concerns about the ability of the company to scale up the acquired business, brokerages are cautious.