Citigroup has recommended buy rating on HCL Technologies with target price of Rs 400 based on 18x FY09E EPS. We value HCL Tech relative to Satyam, which is similar to HCL Tech in terms of revenue. We expect a 28% CAGR in earnings for the next three years, and believe the stock should trade toward the higher end of its historical three-year trading range of 14-23x 12-month forward earnings.

Operationally in-line; 4th quarter of 9%+ qoq — HCL Tech's Q4FY07 results were in-line with expectations – higher than expected revenue growth (+9.2% qoq in USD-terms) but lower than expected margins (170bp qoq) resulted in EBITDA of USD 85 million (as against expectation of USD 86 million). Margins were lower on account of INR – net income was significantly higher due to forex gains.

Momentum in infrastructure services continues — Infrastructure services reported another strong quarter with revenues growing 18% qoq. However, margins in infrastructure services declined around 100bps qoq – due to INR.

IT Services reports another decent quarter — IT Services reported sequential growth of 7.6% qoq. Volume growth was 6.5% qoq while offshore realizations improved 180bp qoq.

BPO - headcount declines sharply — BPO reported revenues of USD 54 million – growth of 8.5% sequentially. Low hiring coupled with attrition in the quarter resulted in headcount declining by 1200. In our view, this could be due to management focus on improving utilization to counter the challenge of sharp appreciation in INR - gross margins in BPO improved 70bps qoq.

Guidance of 30% growth + margin expansion — HCL Tech management guided to 30% growth for FY08 and indicated that margin expansion should continue. HCL Tech now has Rs.33 per share of cash and dividend yield of 2.5%. The stock trades at 17x FY08E – maintain our Buy/Medium Risk rating on the stock.

Other key highlights

Software services revenues increased 37% yoy (USD terms) in FY07 while margins declined 40bp yoy to 23%.

Infrastructure services reported growth of 75% yoy (USD terms) in FY07 while margins expanded 200bp yoy to 17%.

BPO revenues increased 41% yoy with EBITDA margins remaining stable at 24.5%.

According to the company, EBIT growth was 15% qoq (adjusting for forex).

HCL Tech had USD 1.16 billion of outstanding hedges at the end of the quarter for the next six quarters. In Q4FY07, HCL Tech reported forex gains of USD 61 million out of which USD 10 million pertain to Q4FY07.

7 large deals announced in the quarter including Fonterra of New Zealand.

ESOP cost for the next year is expected to be USD 24 million.

USD 9 million of transition-related revenues and USD 3 million of profits not recognized in FY07 as per US GAAP.

Investment thesis

We rate HCL Tech as Buy/Medium (1M) Risk. Based on our analysis, offshore IT services demand will remain strong, with industry revenues forecast to grow 25- 30% pa over the next four years. HCL Tech has been at the forefront of pursuing large deals. It has won at least four multi-year USD 50 million-plus deals in the past fiscal year. Significant presence across IT services, BPO services and IMS has helped HCL Tech to qualify for multi-year outsourcing deals. Infrastructuremanagement services, R&D and BPO service offerings should enable it to post strong revenue growth. We forecast 28% revenue CAGR and 28% EPS CAGR for FY06-09. The stock has underperformed the Sensex for the past two quarters.

Valuation

Our 12-month target price is Rs 400 based on 18x FY09E EPS. We value HCL Tech relative to Satyam, which is similar to HCL Tech in terms of revenue. We expect a 28% CAGR in earnings for the next three years, and believe the stock should trade toward the higher end of its historical three-year trading range of 14-23x 12-month forward earnings. HCL Tech has traded on a par with Satyam in the past two years. Our P/E target is based on a 5% discount to our target multiple of 19x for Satyam primarily because of lower growth and return ratios than Satyam. We believe P/E remains the most appropriate valuation measure given HCL Tech's past profitability and future earnings visibility.