More than two years after it started booking revenue from its largest acquisition, and five years after it first made its foray into software products and platforms, HCL is struggling, to put it mildly, to reap the full benefits from its IBM acquisition.
Three straight quarters of sequential decline (in constant currency terms) in the P&P business has made at least three analysts wonder whether business from this division may have already peaked. To make matters worse, the profitability of the P&P business has nosedived over the last fifteen months from 33% at the end of March 2020 to 19.4% at the end of September 2021.
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Lastly, HCL’s approach of selling these legacy products of IBM has helped it get additional business and improve operating cash flow in the near term. But its approach of prioritizing revenue and cash in the short-term is in contrast with the strategy adopted by Infosys Ltd and Wipro Ltd, which are investing in cloud computing platforms and setting up design hubs as they look to make themselves future-ready.
Simply put, a business HCL painstakingly built after spending $3.5 billion over the last five years now runs the risk of not reporting any growth in the current fiscal. This development will surely have ramifications for HCL’s overall business.
Understandably, executives and analysts argue that the firm’s chief executive officer C. Vijayakumar has a difficult task in the months ahead. Vijayakumar was inducted into the board in July 2021 after HCL founder Shiv Nadar stepped down as chairman and took over the role of chairman emeritus.
“It’s a fair question to ask on the road ahead for this business (P&P business). But it is not that this business is facing an imminent threat and will overnight disappear or become zero,” said an executive who reports to the chief executive officer of HCL, while requesting anonymity. “On the question of the investments, the leadership will take a call as to how much money needs to put into it (after) looking at the business trajectory. (But) it will not be (an) easy decision.”
So, what went awry with a move that can only be described as one of the boldest and most contentious strategic decisions ever undertaken by billionaire Nadar at HCL? And what lessons does it hold for Indian IT majors in general?
Nadar, the former chairman and chief strategy officer, steered HCL’s initial foray into the P&P business. In July 2016, the firm first licensed intellectual properties (IPs) from IBM and DXC Technology Co. HCL’s business model was to build products around these software licenses. Beginning July 2016 and until December 2018, HCL spent $1.25 billion in stitching such commercial agreements with global IT giants, Vijaykumar had told Mint in an earlier interview.
On 7 December 2018, HCL announced that it had agreed to buy eight software products such as IBM Notes, Domino and Appscan. These acquisitions, HCL hoped, would help the firm bag over $625 million in incremental revenue every year. As part of the transaction, HCL was to pay 48% at the time of the acquisition and the remaining 52% at the end of the first year. Even though the demand for these IBM products was slowing, this did not deter the management from buying these legacy products.
“This is a big growing market, especially areas like security, marketing and commerce,” Vijayakumar had told analysts then. “It is not just services. The software product business is a $50 billion market opportunity in these product areas that we have acquired. Many of these areas are quite strategic to HCL because they all play into digital, marketing, operations, marketing automation, omni-channel, commerce and security.”
At the heart of HCL’s shift towards making software products and platforms by selling proprietary products and services was the company’s desire to get more revenue, according to two former executives of the firm. This came at a time when HCL’s rivals such as Tata Consultancy Services Ltd (TCS), Infosys and Wipro were witnessing slow revenue growth.
Sceptics argue that HCL is merely buying revenue in the near term by getting assured business tied to these products.
“The underlying point, and it is pretty much known to all senior company executives, is that no new company wants to get most of these IBM products—like Lotus Notes, (which was) bought by HCL,” said a former executive at HCL, who was earlier involved in one of the IP partnerships with DXC Technology. “HCL bought these products thinking they could introduce some of these legacy products from on-premises to cloud. But if merely refreshing these products were so simple, why would IBM even have sold this business? And if merely selling refreshed legacy products is your strategy, then the question to ask is: Is this the right business model for a company to make it future-ready?”
HCL is the country’s third-largest IT firm after it ended March 2021 with $10.17 billion in annual revenue and an operating margin of 21.4%. The P&P business accounted for 13.6% or $1.38 billion, but at a higher 28.3% profitability. The company does not split the business it gets from IBM products and its other products built through licensing IPs from other companies. Instead, HCL clubs all the software products business into P&P.
HCL’s P&P business reported an 18% growth in the year ended March 2021, and this steered the company as its full-year revenue grew 2.4%. Save for TCS and Infosys, most IT companies saw their full-year revenue shrink last year due to the covid-19 pandemic. In this context, a 2.4% dollar revenue growth at HCL was encouraging. But FY22 is a whole different ball game.
Beginning this year, as firms across industries have once again upped their spending on technology to make their business future-ready, home-grown IT giants are emerging as the biggest beneficiaries. Full-year revenue at Wipro, Infosys and TCS are expected to grow 25%, 17% and 14%, respectively, in the current financial year, according to Mint research.
However, as the P&P business runs the risk of not reporting any growth, HCL is estimated to grow slower than its peers. HCL does not give any definite full-year guidance, saying it expects to clock double-digit growth. In the quarter ended 30 September, HCL reported an 8.4% sequential decline in the P&P business. This was on the back of the P&P business reporting a 1% quarter-over-quarter dip and 4.9% sequential fall in revenue in the June and March quarters, in constant currency terms, respectively. Mint could not independently ascertain the reason behind this decline in the P&P business.
However, despite these headwinds, HCL remains optimistic. “The October-December is going to be a strong quarter for the products and platforms business. So, we expect a very strong performance of the product business in the quarter. We remain optimistic about the growth trajectory for the business going forward,” said a spokesperson for HCL.
Here, it is important to point out that the P&P business reported its best sequential growth of 8.3% in the December quarter of 2020. HCL, which received $680 million from the P&P business in the first half of the current financial year, will need to put up an even better show and generate at least $702 million in the October-March period if it expects to keep up with the $1.38 billion in business it brought in the year ended March 2021.
A bigger cause of concern for HCL is the falling profitability in the P&P business.
“As we have mentioned, during the current quarter, closure of certain P&P (products and platforms) transactions got deferred to (the) next quarter, which has adversely impacted its margins… as most of the revenue would have flown down into EBIT (earnings before interest and tax),” the spokesperson cited above said. “Without this impact, current quarter margins would have been similar to P&P’s last quarter margins,” the spokesperson added.
Even if the P&P segment manages to retain a profitability of 23.7% (the profitability at the end of June quarter as stated by the spokesperson), this will be 93 percentage points lower than the 33% operating margin at the end of March 2021.
“(A)s repeatedly emphasized over (the) last 5 quarters, (the) P&P division has significantly invested in sales and marketing in view of higher proportion of sales happening to end customers directly through HCL sales channel,” the spokesperson said. “P&P division has also invested in research and development, and product enhancement including making the products cloud-enabled (HCL SoFy and HCL Now). These two are planned investments and account for the balance reduction of margins.”
The way ahead
For now, HCL does not share how much money it has additionally spent in making these changes to the erstwhile IBM products.
However, a senior company executive had let slip the size of investments needed for the P&P business to report a profitability of 30%. “There are hundreds of millions of dollar investment budgeted and planned per annum, after which the expected EBITDA is 50% and expected EBIT after amortization is 30%,” HCL’s chief financial officer, Prateek Aggarwal, told investors and analysts in a call organized by IDFC on 20 September 2019.
However, some analysts remain unfazed. “From a service provider’s perspective, these deals convert balance sheet into P&L (profit and loss), contributing to revenue growth, margin accretion and possibly even EPS (earnings per share) accretion in the first year,” Kotak Institutional Equities analysts Kawaljeet Saluja and Jaykumar Doshi wrote in a note. “However, we believe these deals bring little in terms of strategic benefit for the service provider—either in terms of client access or building out new IP competency.”
Improving earnings per share was also one of the company’s stated goals when it agreed to buy IBM products in December 2018. “The most exciting part of this is on a cash EPS basis. It should be adding about 15% to our cash EPS,” Vijayakumar, the firm’s chief executive officer, had told analysts in December 2018.
To HCL’s credit, it has achieved this goal. The firm’s cash EPS or operating cash flow was $1.35 billion in the twelve months ended December 2018, which has jumped 51% to $2 billion in the twelve months ended September 2021.
For now, analysts and investors are content that HCL has decided to return to its shareholders 75% of its total new income over the next five years, as outlined in its new capital allocation policy announced last week.
“This is heartening because this limits the company from going out and making another large acquisition,” said a Mumbai-based analyst at a foreign brokerage on the condition of anonymity.
“Yes, the company can still find ways to fund large acquisitions. But we are of the view that under CEO Vijayakumar, HCL may again focus on reinvigorating its services business.”
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