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HCL Technologies Ltd
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Ladies and gentlemen, good day, and welcome to the HCL Technologies Limited Q2 FY '19 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. I now hand the conference over to Mr. C. VijayaKumar, President and CEO, HCL Technologies Limited. Thank you, and over to you, sir.
Good evening, and good morning to all of you, and welcome to our commentary on our second quarter performance of fiscal FY '19. Today, I'm joined by several members of our leadership team, including Anil Chanana and Prateek Aggarwal. Prateek has taken over as the CFO beginning this quarter, permanent. We continue to deliver strong and consistent revenue and margin performance. Our robust financial performance is a result of 2 key focus areas: one of pursuit to rapidly evolve into both an exhibition services firm as well as building a highly profitable product revenue stream in line with our Mode 1-2-3 strategy. This unique business model differentiates us distinctly in the marketplace, and the results are on the book. In the quarter, we witnessed a strong constant currency growth of 3% sequentially and a year-on-year growth of 10.5%. Our EBIT margin came within our expected range of 19.9%, which is a 20 basis point increase over the previous quarter. We continue to bring home a number of transformational deals this quarter. Again, following a very good quarter in Q1, we find about 17 transformational deals in Q2 consisting of a pretty heavy mix of our service lines, Mode 1-2-3 offerings, different verticals and geographies. Our bookings and funnel remains quite strong. While we don't follow a specific booking number, we are happy to report that our bookings in Q2 was about the average of the last 4 quarters. Our Mode 2 and 3 combined revenues now constitute 28% of our total revenues. And most significantly, our Mode 3 business achieved the milestone of 1 billion annual run rate this quarter. I'll provide a little more color on this a little later in my comments, but before that, let me quickly review a few messages from our geography and vertical performance. The U.S. continues to deliver consistently good performance for many quarters now. In Q2, we posted a 4.4% Q-o-Q growth in constant currency. In U.S., we also completed 30 years of our operations, with a celebration of the 30 years of our presence and the contribution to the overall ecosystem. And I'm really proud that 65% of our workforce in the geography today are locals. Europe, on the other hand, was a little bit impacted by weakness in 2 customer engagements in Financial Services this quarter. However, our overall outlook in Europe continues to remain strong, and I hope to see better growth in the coming 2 quarters. Rest of the world witnessed again a strong quarter-on-quarter growth in constant currency terms. That is in spite of a small decline in our India business -- our India SI business. From a vertical perspective, 4 out of our 7 verticals have shown a pretty strong momentum led by technology and services verticals, Life Sciences and Healthcare, retail CPG and our public services vertical. All of them had some handsome growth in the last quarter. We continue to see an overall acceleration in the Financial Services segment. We see good momentum, not just in Mode 1 and even in Mode 2 services, a lot of discretionary spend. We see a good momentum. The demand is pretty good in Financial Services, except for weakness in a couple of clients, which we had pointed out earlier as well. In terms of our Mode 1 services, the global inflow business grew 3.2% quarter-on-quarter. We expect the momentum to continue in H2. This is primarily driven by our next-gen IT Infrastructure Services like digital workplace, software-defined data centers, all the business finding good traction. Almost all the deals that we've signed in the last 2 quarters had digital workplace as a key component. All of them have a private cloud as well as some amount of public cloud into the overall solution that we are executing for our clients. Our digital workplace service is particularly finding a lot of interest among the Fortune 500 enterprises, as we transform from the traditional device and enablement-centric approach of their device and enable-centric organization into our employee experience-centric workplaces of the future. So that's one good macro trend, which is driving adoption of digital workplace. This is evolving around cognitive service that entire building, collaboration and social framework environments within the enterprise. All of that is driving the success and availability and demand for digital workplace services. Our Engineering Services, the services business witnessed one of the best quarters. We grew 6.3% quarter-on-quarter. This was, of course, helped by Actian revenues which closed during the last quarter. There was also a seasonality in the IT business, which was a little bit offset by revenues from the new IT partnership that we signed in June. Overall, the headline message is our engineering business, our Services business witnessed one of the best quarters, and a lot of business fueled by technology investments, which is around productizing or stratification of some of the traditional products where we have a big role to play. A lot of platform engineering kind of opportunities where our Engineering Services team continues to have a market-leading proposition, and that is driving the growth there. Internet of Things is another area which has driven a little bit of growth in the Engineering Services in the past quarter. In Mode 2, we continue to do well. As you can see, we grew 5.3% quarter-on-quarter in constant currency terms. Our Digital and Analytics business primarily was driven by Financial Services, retail CPG and Life Sciences and Healthcare verticals. They contributed to the growth in the digital and analytics service. We're seeing increasing demand for digital transformation at scale, what we call a scale design lead where customers are seen to drive an operating model change within the enterprise. This operating model change, as we have mentioned earlier, it's not just a technology change, but it was also a significant change in culture and mindset and behaviors of the technology and the business teams collaborating to drive faster and have quicker outcomes for our clients. There is significant traction for digital at scale in U.S. as well as Europe. We see several strategic deals in the digital and analytics expected this quarter, including one with the largest telecom service providers in the U.S. with consolidated modernized middleware platform that supports B2B products. In our Cloud Native business, we are witnessing good modeling of Cloud Native solutions in most of the large infrastructure and application deals. We continue to strengthen our capabilities in Cloud Native Services in areas like cloud native platforms like Pivotal Cloud Foundry, Kubernetes and Public Cloud. In fact, for this quarter, we invested in building an extension of our innovation lab in London to accommodate a cloud foundry pivotal development team. We also won 2 partner awards at Pivotal SpringOne platform this year. One of them was the Systems Integrator Rising Star, and the second one was ANZ Global SI of the year. These awards are a validation of our excellence in the full spectrum of Pivotal Cloud Foundry services that we offer to our customers. We are also seeing significant demand in Cloud Native SaaS space especially around Commerce Cloud and CPQ. Both Internet of Things, IoT WoRKS and cybersecurity businesses, they continue to find good traction in the market, chipping in not just stand-alone deals but also creating a differentiator for us in some of the largest strategic engagements. Underlying all the Mode 2 opportunities and deals is our strong AI capability. As you would know, it still has been advocating the autonomics for smarter for the last many years, which is integral to our Mode 1-2-3 strategy. We believe in human plus machine augmentation model and have embedded this model deeply in our core delivery framework. In Mode 3, our revenues grew 10.4% Q-o-Q in constant currency. Our Mode 3 business is at a real inflection point. As I said earlier, it's now on $1 billion run rate and as well we start the acceleration of an offering in our industry segments. Our products and platform offerings are helping us win new accounts across geographies and verticals. Specifically, I want to call out -- we had a recent win with one of the largest U.S. banks, which was really a contributor by a capability of which we have now modernized as iControl, which is a part of our Alpha Insight acquisition, which we did a few quarters back. We also won a deal with a leading U.S.-based equipment manufacturer for a product lifecycle management solution on the strength of the PLM product offerings that we acquired with Geometric. Essentially, in summary, our Mode 3 IPs are aligning well with our Mode 1 and 2 offerings, and we are trying to work to create synergies that will kind of enhance and win some of these opportunities. We recently launched a third beta product release as a part of our IP partnership program. These releases are significant milestones as these new features improve stickiness with the existing client base, but it also helps us with retention. Some of these are catch-up features while many others are raising the bar for the entire market, which is what is helping some of these products to be improving their ratings in most analyst commentaries from what they had announced last year. We talked about some of those in our last quarter call in detail. We see similar trends continuing across the entire portfolio. The deal is strong validation of our partnership approach to IP that we took a couple of years back, a clear indication of confidence of our partners and customers as we deliver on the promise we made to them when we started on this whole IP partnership journey. Our organic IPs are continuing to move in the right direction. We continue to include these ideas across technology and vertical domains. We are now investing in a go-to-market strategy -- I mean, we started investing in a go-to-market strategy a couple of years back. We are continuing to accelerate that to help leverage our existing relationship but with a separate sales program to support the whole product sales lifecycle, which is quite different from these other Infrastructure Services sales life cycle. So overall, we've had very satisfying performance. We feel very confident of the momentum in the subsequent quarters. As we progress forward in the fiscal, we expect to deliver revenues around the midpoint of our annual guidance. With this broad commentary, I will request Prateek to provide you a minimal detail on the financials for this quarter. Over to Prateek.
Thank you, CVK. So just to recap, quickly, all the various numbers. So starting with revenue. Good constant currency growth, 3.0% quarter-on-quarter, 10.5% year-on-year. Especially gratifying to note that the Mode 3 business is now at a run rate of $1 billion annually. In terms of EBIT, we delivered again within the guided range of 19.5% to 20.5%, practically in the midpoint of that range at 19.9%. What makes me happiest is the net profit that we delivered this quarter, which is in rupee terms, INR 2,540, which takes us to a milestone of INR 10,000 crores annualized run rate net profit. It is in rupee terms, 5.7% growth quarter-on-quarter and 16.1% growth year-on-year. This quarter or rather at the beginning of this month, we also completed the buyback of INR 4,000 crores and happy to also report the return on equity is at 25.8%. Our revenue per employee stands at a very healthy number of USD 66,000 per annum. On the guidance, we continue to reaffirm our guidance of revenue. We expect to be around the midpoint of the guided range, 9.5 to 11.5. And as far as EBIT guidance is concerned, we are, again, reaffirming that we expect to be within the guided range of 19.5% to 20.5%. Just to provide you a quick walk of that EBIT movement on a quarter-on-quarter basis, we were at 19.7% last quarter, and we are at 19.9%. We had a benefit of tailwind of 90 basis points from the ForEx benefit, which is largely, in the U.S. the INR exchange rate. In this quarter, as we had announced previously, we had a rate implement impact of about 70 basis points across direct and unit cost. And SG&A increased over and above that by another 50 basis points, so that is plus 90, minus 70 and minus 50. We had a productivity coming in, you would have noticed that our utilization has significantly increased and also the benefits from the automation and orchestration that we see driving from DryICE and other IPs. So productivity delivered additional 80 basis points, and there were some other balancing factors of 30 basis points negative, which includes a little bit of PNP seasonality, et cetera. So that is how the 19.7% moved to 19.9% this quarter. A quick update on the ForEx hedging status. So we had a gain from ForEx in this quarter of 9.2 million. We continued to follow our layered hedging policy, which allows us to hedge a maximum of up to 40% for year 1 and lower thereafter. At September end, we had 1,764,000,000 of outstanding ForEx hedges. Most of it were options, about 2/3, 68% to be precise. And the balance, 32%, being forward largely in the cost currency areas where options are not so readily available. On the other income, we had a good increase on a quarter-on-quarter basis. We reported $25.8 million, which is $3.2 million higher compared to the previous quarter, driven by higher volume, more investments basically and a little bit of gain from the interest rates improvement as well. Our effective tax rate for the quarter is at about 21%, and we expect to be in the guided range again of about 22% to 23% as we have previously talked about. So that's the quick update from a financial perspective. Back to you, CVK.
So now we are ready to take any questions that you may have.
[Operator Instructions]The first question is from the line of Surendra Goyal of Citigroup.
I have a couple of questions. Firstly, what's your experience with INS contract renegotiations been so far? What is the kind of pressure that you have seen on your deal values or TCBs? And then, has it been better, worse or in line with what you expected going into this year?
Yes. Thank you, Surendra. In terms of INS, all the renewals that we had this year so far is on track. I would say, it's in line with what we had expected. I wouldn't say it was any worse or any better, largely in line. It's very difficult to quantify it because of the different dynamics, but generally in line with what we had expected.
Just following up. Are you seeing more customers move more workloads to you and that is kind of offsetting the unit pressure that would have been expected? Is that something which has been playing out?
Yes. Obviously, when we are confronted with a renewal and there is expectation that we should reduce and yield more productivity benefits, we also see how much we can pitch in for slightly broader set of services, not just infrastructure -- but I mean even in infrastructure, more workloads, more geographies and much more polar service offerings that we can offer. And that's been another strategy, which is also helping us a little bit offset some of the loss in revenue that comes up during the renewals.
Sure. And my second question was on Europe, and I think you said on TV that you expect growth to -- could end up first half going forward. What I wanted to understand here is if this client-specific issue will continue to be a headwind and, hence, Europe will still be growing well below company average like we saw this quarter?
Yes. I think that the company-specific headwinds, I mean, we expect it to continue for some more time. However, if you look at the overall book of business, the booking momentum in Europe, including the booking momentum in Financial Services looks pretty good. So I expect Europe growth to pick up. It may still be a little below our company average, but definitely much better than what we are seeing now.
The next question is from the line of Pankaj Kapoor from JM Financial.
The first question is on the Application Services business, which has been sluggish for quite a while now. So any thoughts in terms of how we should look at it going forward? And any kind of pivot step that we will be taking in that area?
The Application Services business has been -- of course, there is pressure on some of the traditional areas where we are focused on, including some of the business around FPP and things like that. However, our business channel practice is generating a lot of enthusiasm across the board. So we are very happy about how will this position in new opportunities in the digital space as well as the renewal of some other of our application engagements, are getting more simple to scale the drive engagements, and we have been able to protect all of our clients in this renewal process and migrated them into a scale whether our customer also had an interest to move into this model. So in terms of our proposition and capability, we are pretty confident, and that is what we're seeing is the momentum. However, you will see a softness in Financial Services largely because of the 2 client-specific issues. If you see what happened in the last year, we had one of the highest growths in Financial Services. So probably, there is some softness after a good growth phase. A similar trend is expected in the Application Services business.
Okay. And my second question is on the ER&D services where you highlighted we had good growth of the organic business also. Is it possible to give some color and more granular details there? Because I understand that that's an area where we have done several acquisitions and a lot of IP is also up -- under there. So is it possible to get a sense outside of Geometric and the other acquisitions that you've done and IPs, how the organic ER&D services of HCL has been doing?
Yes, I will request GH to...
This is GH Rao heading the Engineering and R&D services. Let me take the baseline of our Engineering and R&D services and especially per customer growth, in terms of our organic growth the $150 reduced trend because the acquisition is more than 2 years forward so. We have a broad-based growth in core Engineering Services today. It's not necessarily driven by the acquisitions but the growth has been predominantly in terms of for several reengineering opportunities of products that are coming up, driven by several technologies what we call cardinalization, a software addition, cloud applications, these are the 3 technologies which are growing. We have won several projects in the area of engineering. So the growth this quarter has not been driven by acquisitions, but the organic growth are, by and large, this is not economic growth driven, but around the engineering opportunities.
And the next question is from the line of Srinivas Rao from Deutsche Bank.
Two questions. Here, I mean, as someone had asked, have you -- are you seeing any change in the trajectory for BSSI? Your peers continue to reflect a slightly different picture than yours. So is that a client-specific issue? Or it's more the kind of mix of clients you have right now? That's the first question. Second, on your margins on the various mode segments, which you highlight, do you expect the margins for Mode 3 to improve further still? Or that's what we should expect going forward? I'll come back for more questions.
Yes. Rahul, do you want to take the question on Financial Services?
Yes. Thanks, CVK. So as CVK mentioned, we had a little bit of a headwind on 2 of our clients, but this was the back of -- we grew by almost between 10% and 11% all of last year, and most of our growth -- in fact all of our growth was organic growth, right? So there was very high growth we had last year and offset by a couple of client situations this time. Now if you spoke about whether it had anything to do with our mix of business, which has not rolled through, we have a very strong banking business in Financial Services, and we've seen some very high digital growth -- Digital and Analytics services growth in our banking businesses across Europe, U.S. and rest of the world. Most of our customers are -- especially the banking customers and insurance customers, are effectively adopting digital in a big way and our proposition around digital at scale is doing pretty good in these client bases. We are also seeing new customers. In fact, all of last year, we had acquired at least 3 or 4 large customers, which we are now ramping up this year. And lastly, we continue to see good traction in terms of both renewals and new customers being acquired even this year, right? So I think the base of the Financial Services business continues to grow. Of course, it is being offset, as we mentioned earlier by 2 client situations, which should even out over the next couple of quarters, and it should be okay after that. Yes. CVK, back to you.
Yes. Thank you. On the Mode 3 EBIT percentage, I think while we don't want to give specific guidance for any individual mode, but you're seeing 25% last quarter, this quarter is about 24.5%, I would expect that to remain in that kind of a range broadly. Of course, the product business has its own seasonality, and October to December tends to be the best. And Q4, which is January to March and July to September tend to be a little weaker. But that's the seasonality there. But otherwise, on an annualized basis, I would expect it to be in that range of around 24%, 25%.
Understood. If I may just ask one more question, I think on a previous question asked. On the Infrastructure Services, we have been hearing kind of mixed views in terms of how much of them flows then onto the large hyperscale cloud and how much are still in kind of transitioning to players like you. What's your sense when enterprises are looking at migrating their workloads to cloud? Obviously, a significant factor is the proportion of those deals, are you seeing kind of a relocation to cloud in terms of workload migration? And that's in relation to hyperscale cloud.
In the market segment that we operate, I think, the most prevalent solution is the hybrid cloud solution. There is, obviously, some percentage of our cloud services solution to move into some of the public cloud providers, but a very large part of the workload in large enterprises are either private cloud or software-defined data centers. And some of the new workloads, which are either getting built as a part of digital applications, some of that is slightly more a shift towards using public cloud in some of the areas. But there is also significant adoption of cloud foundry platforms. Pivotal CloudFoundry platform has a pretty strong adoption in some of the large enterprises. That's really helping customers to build applications which are cloud-agnostic, and that's where we see a lot of workloads are moving up.
The next question is from the line of Sandeep Shah from CGS CIMB.
Just a question in terms of looking at your guidance in a reported dollar terms at the midpoint. It shows that you may have to do 3.3% compounded Q-on-Q growth for the next 2 quarters. And my sense is I think a lot of deals have been announced in the last 3 to 4 quarters in terms of number of deals, including some mega deals. So is it fair to say that the coming December quarter could be one of the best in this year as well as the Q4 growth would also be better because of the deal ramp up if we even strip out some of the acquisitions, which will play out in the coming quarters.
Q3 has a couple of dynamics. Of course, it's a good quarter, it's one of the good quarters from a product seasonality perspective. But in all or some of our traditional businesses, there is a little bit of headwind around the partners and timeouts and things like that. And a lot of new deals also will transition into steady-state and projects. So I expect Q3 to be a solid quarter, and that's what is giving us confidence to let's say that we will be at a midpoint. Also, one of our acquisitions, which is a company in Germany that is small revenue in the previous quarter, we will have a full quarter impact of that in Q3. So overall, we are looking at a pretty strong quarter in Q3, and that's what is giving us a little more confidence for H2 and giving you a midpoint kind of a guidance for the full year.
Okay, okay. And just on the IMS, CVK, just wanted to understand, maybe in the fourth or fifth year of renewal cycle where some cloud element has been asked by the client and we might have provided by cannibalizing the revenue. Is it fair to say that after 1 year or maybe by the middle of next year, which is FY 2020, the impact of renewal through cloud cannibalization will reduce on a Y-o-Y, which may give you confidence to say that the organic growth prospects in the IMS next year would be better?
I mean, just leaving cloud apart, I mean our general outlook regarding the infrastructure growth will continue to get better. Some of the headwinds that we saw were all planned and factored into what we gave as a guidance this year. So I think just purely looking at the global infrastructure service, I think it will get better as we move forward.
Okay. Okay. And just last 2 bookkeeping questions. The cash flow generation at OCF level for the first quarter was weak. Even second quarter was weak. And wanted to understand in the cash flow statement, there is an 85 million payout for other asset. What is this exactly? And how are we looking at cash flow generation in the second half? And second is the Mode 2 margin, which is a pure digital service has further declined to almost like a 10% at the EBIT level. So what is causing this? Because most of the other peers are saying that Mode 2 services are high-margin businesses.
Prateek, why don't you answer the cash flow?
Yes. So Sandeep, the Q2, thanks to the -- and if you look at even the Q2 of last year, the cash flow from operating activities as a percentage of net income was at 78%. It happens to be exactly at that same 78% this year also. That is basically due to some seasonality factors in terms of annual flows. First of all, the annual bonuses get paid out during the third quarter. And secondly, we do have, in most geographies, a higher tax outflow going out in this quarter. And there have been some smaller things like annual insurance premiums and things like that. So that's just the seasonality, I would say. On an annual basis, I think we continue to be generating good cash, as always, and one would expect it to be in the same annual ranges that we have been in before.
And specifically talking about the Mode 2 profitability, even in the last quarter, when we, for the first time, provided visibility of EBIT level on Mode 1-2-3, we just pointed out that there is a caution, especially in Mode 2 and Mode 3, since the scale is low compared to the overall business. There will be some level of fluctuations. And at this point, we continue to do well in Mode 2. Our gross margins are definitely better than Mode 1 gross margins. Our investment in SG&A continues to be a focus area because we believe at this point we are really not focused on optimizing the margins in Mode 2 business. We are focused on how can we continue to build capabilities and make them across the geographies and markets that we operate in and their verticals. So you will continue to see some kind of fluctuations in Mode 2 margins. But as the business scales up, you will see kind of increasing margins here.
Okay. And just last question, what is the organic growth of this quarter? Apart from Actian, you also call out CVK, there was some revenue coming from the acquired IP business. So if we can just get out to a total inorganic portion for this quarter.
I would say largely organic barring Actian. Actian probably contributed about 1%. And there's also significant seasonality in the product business. This was one of the softer quarters in the product business. But a little bit of that was offset by some revenues from the new IP. So I think a little less than 2% would be the organic growth. And a lot of that is visible in our engineering services and infrastructure business and a little bit in the BPO business as well.
[Operator Instructions] We move to the next question from the line of Ankur Rudra from CLSA.
Just a question on the makeup of where organic versus inorganic is trending for the year. I think during the half year mark, you, at the beginning of the year, guided a certain figure. How has it trended so far for the first half? And do you think the mix between organic-inorganic will be different for the second half? I'm looking at Y-o-Y basis.
Yes. I think we started with half organic and half inorganic. As we stand now, it looks like we will do a little bit more organic and a little bit less inorganic for the full year.
Okay. So your organic business has done a bit better than you expected, is that what you're trying to say?
Yes.
Okay. A quick follow-up on the margin side. You had a margin tailwind this quarter. You broke out the margin take-up. I think even on the start level, there's a margin tailwind in 3Q. I noticed that you haven't revised your margin guidance for the full year, which was, I think, previously settled at probably lower average currency level. So what's the thought process behind that? Where are the puts and takes on the margin side for the rest of the year?
So Ankur, the margin guidance, we continue to sort of retain at 19.5 to 20.5. In the first half of the year, if you take the average of Q1 and Q2, we are at about 19.8. You are absolutely right. There is a tailwind going into Q3, but at the same time, we do intend to and plan to invest back in the business, both on the Mode 3 and Mode 2 side on an organic basis, which is what we have done partly this quarter. There are plans to do more of that, which is the reason we are sort of sticking to the guidance. We expect the second half to be incrementally better but within the range.
Can you elaborate a bit more on the area you're investing in?
Yes. So I think we had planned certain investments, aware of the investment pipeline of co-innovation labs. As a strategy, co-innovation labs has been a big anchor for a lot of our wins, so we are accelerating some of those investments, like we announced a lab for IoT recently in Seattle. We also expanded our -- very recently, we expanded our co-innovation lab in London to build the capability around rapid development using CloudFoundry Pivotal platform. And we continue to look at investments, organic investments, to build stronger capabilities across the globe, around UI, UX. We had good momentum in the U.S. Now we're continuing to hire and build a little more presence across the world. It's largely in line with some of the key things that we are doing, but maybe we are just accelerating, and we are a little more flexible to invest so that it will help us to kind of gain some more momentum as we move forward.
And just on that same front, was there any pressure on -- I know you have a lot bigger proportion of local employees in the U.S. Has there been any pressure on the supply front there that you may have to step up your investments, which may be another pressure point for the second half?
Yes, to some extent. I mean, there is a lot of demand, so there is definitely good competition for talent so that will increase some of our costs. But at this point, at least in the Q2 numbers, I didn't see that. But I generally see a little bit of pressure and more subcontractor usage. That's what we are seeing.
The next question is from the line of Rishi Jhunjhunwala from IIFL.
A couple of quick questions. So one, your gross local licensed IPR has declined by 66 million in this quarter versus last. Why would that actually decline, it's a growth market?
I think that's just the exchange rate because all of the IP that we have taken, I mean, through these partnerships, when we buy it it's in dollars, but when we record it in the books, it's in rupees. And when such volatility plays out, it's basically the exchange rate.
Okay. Because I was referring to your dollar GAAP accounts itself, so I thought rupee should not have mattered there.
The dollar number is converted into rupees and then getting converted back into dollar at a different rate. Rishi, we can connect offline if you have further questions on that, but that's really the reason. We can help you understand that better.
That's fine. The other thing is just on IMS, apart from some of the trends that you've already talked about, are you seeing pressure from either vendor consolidation or anything of that sort? Because one of your large European peers basically cut their guidance today in the morning, on the back of pressure on the IMS, especially in the U.S. and the Germany area. So just wanted to understand, is this something which is more prevalent across the sector? Or could it just be specific to one vendor?
I think there is definitely a little bit more focus around consolidation in IMS space, and we are definitely at the forefront of capitalizing on that opportunity. So I think we have a pretty strong advantage, even some of the clients, especially in the U.S., where they're consolidating some of their infrastructure landscape.
Okay. And lastly, on margins, do you have -- at what currency rates your margin guidance is pegged at?
I think last time, we don't believe the appreciation in dollar is all going to flow into margins because we have given a guided range, and we were open to invest, and we see a lot of opportunities to invest and grow some of the areas, especially in Mode 2, where the number of capabilities are 10 different areas across different offerings in Mode 2. So we're continuing with that. Irrespective of the currency movement, we believe we will deliver within our guided range. However, if the current state of currency continues, of course, it will create a little bit tailwind in the overall margins compared to what we saw in the H1.
The next question is from the line of Viju George from JPMorgan.
I think most of my questions have been answered, but if I may just press this point in acquisition. It seems to me that the last couple of years, CVK, you've been running at almost half-half organic-inorganic growth. Assuming that good a target is available, good IP is available for you to acquire at the right price point, do you think that having a 50-50 or a near 50-50 contribution of inorganic to organic, is a sustainable growth model? That's part 1. Second is that what could be the cash flow and margin implications of that kind of a strategy?
Yes. Viju, thank you for your question. First, we have 2 different themes, the mode services and Mode 2 and Mode 1 organization, and the leadership and management is dedicated to Mode 1 and Mode 2 services. And Mode 3 is a separate theme. So each one has an opportunity to look at what are the growth opportunities that are available. We do see significant opportunities on the Mode 3 front, especially -- I think a lot of products are needing significant transformation to be relevant in the new world, and not every company is focused on making those investments to make that shift. So I think that's where we're seeing opportunities. So as long as right opportunities at the right price point and the ability to make a difference to the product and create some synergies in our Mode 1 and 2, we will invest. I don't think investment will be a constraint because we think it's a strategic choice that we have made to not only deliver growth into next-generation services firm, but we also want to build a strong product business. And the whole -- the product business is a 100 billion-plus kind of an opportunity, and we have hardly scratched the surface of this. And this will mean some kind of -- I mean, our cash flows and some of that will have to be planned to help us do this. And I mean, as we have indicated, we would be open to borrow as well to try this because it's a very important element of our strategy, and it's working very well. It's creating the right synergy benefits. Our IRR is significantly better than what we had planned. So with all these, I think it's only logical that we pursue this strategy even more.
Okay. So essentially, you're comfortable with the current growth model, where a significant portion, may be close to 50%, comes from inorganic activity. So you're saying that's a sustainable growth model.
I think the 50-50 was a little bit incidental when we kind of gave the guidance for FY '19. I think it's going to be driven around opportunities, but we will continue to focus and grow our business organically, which is primarily in Mode 1 and 2 and, to some extent, in Mode 3. I think there is 0 dilution and focus on trying to drive that, so we will -- we continue to be very competitive. Our bookings look good. Our core business around infrastructure, engineering, our digital offering, all of that continues to drive good momentum in organic. So we will leave no stone unturned to continue to drive our organic business. So whatever growth rate it delivers, that's what it is. But inorganic, maybe there are bigger opportunities, so the ratio may skew as well. But be sure that there is adequate focus and adequate interest to drive greater and greater organic growth.
Sure. And the last question was on margins, CVK. If you assume a fairly reasonable component of inorganic growth in your growth model for years to come, do you think that eventually, longer term, it takes margins downwards or upwards? Because on the one hand, you can argue that IP revenue had better margins. But on the other hand, one can also argue that the organic growth rate may not be as good as it was in the past so the margins may tend to drop down. So what would have happened, the implications on margins, you think, at an overall level, maybe a year or 2 out in terms of direction?
Yes. At a macro level, I think this strategy has good -- the strategy will be a tailwind to the overall margin strategy in the mid- to long term because as and when our product mix increases and becomes significant, it will definitely change the mix of our margins between the different businesses. And as Mode 2 business scales up as well, that will deliver a little bit better margins. So I don't want to call out what will happen a couple of years from now. But generally, as a strategy, it was designed to deliver a higher margin. That's fundamental to the underlying Mode 1-2-3 strategy.
Sure. And my last question on the renewal cycle. I think you mentioned that you're probably close to the end of the renewal cycle in terms of deals getting negotiated downward in pricing due to cloud, new technologies, et cetera. Where do think -- you think, therefore, we could start to see this bottom out very quickly, and therefore, the new wins will translate substantially into revenue growth soon enough in IMS? Is that what you indicated?
Yes. I think when I talked to the board at the beginning of the year, I said FY '19 was probably the largest renewals that we were facing. Our FY '20 will be slightly lower. I think after that, I mean, while renewals may continue, a lot of deals would have been reconfigured with a new set of solutions, including a certain amount of public cloud adoption and things like that. So I think it's probably one more year is where you will see some deals which were in the traditional solution set to a new solution set so that will drive some kind of a reduction in revenue. But I think, I'd say that FY '20 will be a little lesser than FY '19, I would say.
The next question is from the line of Nitin Padmanabhan from Investec.
Last quarter, you spoke about how the deal pipeline was pretty solid and the last quarter was possibly the highest wins that you had. In that context, if you look at it this quarter, how would that compare versus last quarter in terms of the value of deals? Is it comparable? And two, how do you see the pipeline of this? And the final question is we have a lot of deals that are ramping up in Q3, a lot of those which we won in Q2. In that context, if you look at utilization, it's all-time high. And then we look at a lot of peers who suggest that the supply is very tight, and they'll need to create a utilization buffer. Just wanted your thoughts about how we'll go about executing in that context and whether you perceive any execution-related issues from a supply perspective.
Okay. There are multiple questions, Nitin. Let me take one by one. First, around booking. See, I don't want to call out a specific number, but if you recall, last year Q3, we said it was the highest booking. Then we also followed up in this year saying Q1 booking was even higher. So the Q2 booking is higher than the last 4-quarter average. So fairly good bookings. May not be the highest, but more than the average of the last 4 quarters, which is a -- which I consider is a very good sign. The pipeline from end of last quarter to end of this quarter, the qualified pipeline has increased over 10%, which is, again, a good indication. Now in terms of headcount growth, even this quarter, we hired close to 4,000 people. Net addition was about 4,000. Some of that may not -- I mean, when you see utilization, there are a lot of people who are doing transitions, so that would be considered as utilized, but that will translate into revenues in the subsequent quarters. At this point, while I do acknowledge that there is a little bit demand from a fulfillment perspective, I don't see it impacting our execution in Q3 and most likely in Q4 as well. And we put a lot of measures to strengthen our fulfillment agents across the globe in line with the increased demand that we are seeing. We started doing that at the beginning of the first quarter. I think we are in good shape there.
The next question is from the line of Ravi Menon from Elara Securities.
CVK, just to expand a question that previously asked about medium-term margins for Mode 3. What do you think we should expect here? Because as this scale's up, any new products that you acquire, that should be a fairly small portion because it's already a $1 billion run rate business. And this includes the organic IP as well. So shouldn't we see margins expand for this business over time or you think you need to make a lot more investments in creating a separate sales channel? So why -- so if you could just walk us through that.
Yes. I mean, as Prateek mentioned, I think margins will remain in this range in the near future, barring a little bit of seasonality, which is pretty common in the product business. In terms of investments, of course, we are not looking at IP investments to drive margins. But I think there is -- we're continuing to build that sales channel. We continue to invest in modernizing and kind of including -- we're also incubating a lot of ideas and a lot of product IPs in automation and some vertical segments. So at this point, we're comfortable to kind of see the business as a 25% EBIT level in the near future. Do you want to add anything, Prateek?
No. I was just conscious of the time. It's already 7:30. Can we take 2 more and the rest later?
Sure. So the next question is from the line of Dipesh Mehta from SBICAP Securities.
Two questions. Can you help us understand about...
Excuse me. This is the operator. Mr. Mehta, can you speak closer to the phone, please?
Yes. Is it better now?
Better.
Yes. Just want to -- can you provide some colors on manufacturing and communication outlook? Because it seems to be sluggish for some time now. So if you can help us what is leading to this weakness in the performance and how do you expect it to clear. And second question is if one looks at top 6 to 20 client performance, it seems to be weak for some time now. So if you can help us understand, except these 2 clients which you referred in BFSI, whether the weakness is broad-based in 6 to 20? Or it is because of these 2 accounts, it is leading to this kind of number.
So in terms of verticals, I mean, communications have definitely picked up. I see the second half to be having good momentum. Manufacturing as well, there will be an improvement over what we are seeing so far in the next quarter. I do not understand your question on the clients. Can you repeat that please?
Yes. So if one look at top 6 to 20 because we report top 5, 10 and 20. So if one do arithmetic on top 6 to 20, performance seems to be muted for, I think, a couple of quarters now. So is it because of the 2 clients which you are report in BFSI which is leading to this reported number or there are weakness in other clients as well?
No. I think the BFSI clients are the larger category, significantly larger category, not in the 5 to 20 category. That would be even -- some of these are like from 40 million -- 49 million something, can go to 51 million and -- or will reverse. So some minor changes. I don't see any specific issue there. In fact, our $20 million clients have gone up by 3 from a quarter-on-quarter perspective and a year-on-year perspective, 6. And $50 million clients have reduced by 1 quarter-on-quarter, but that's some marginal changes, that's it. I think some of this is also some currency impact as well.
The next question is from the line of Mukul Garg from Haitong Securities.
CVK, earlier in the call you mentioned about continued investment in IP acquisitions. So can you shed a bit more light on this? In the medium term, where do you see Mode 1, Mode 2, Mode 3 as share in total revenues? Is it possible that Mode 3 can move from current levels to somewhere in mid-20s a couple of years down the line? And similarly, do you have any sort of target in terms of how much cash you are willing spend annually? Is it something which will be a target-led meaningful amount which you'll be spending on attractive IP acquisitions?
Yes. In terms of, I mean, acquisitions, as we had called out, I mean, our payout ratio is 50-50, so we have the remaining cash flow potentially that will be used for acquisitions. So I think, I mean, our acquisitions will be somewhat similar to what you have seen in the last couple of years. However, it's also going to depend a lot on the specific opportunities. We may hit on a big opportunity, and there may be a slightly higher outflow, or we may not get the right opportunity, and you may see a little bit lower. So broadly, I mean -- directionally, I mean, the intention is to -- the plan is to see a similar amount of investments from an acquisition perspective.
Understood. So does that mean that we should expect Mode 3 to be a much larger portion of your overall revenues in a few years?
Yes, of course, I think there's a lot of focus on Mode 3. So definitely, you should see a much higher percentage of our revenues. But I don't have a number. All that we were stating was I think we want to drive to a 40% mix of Mode 2 and 3. But the way strategy plays out, you may see a -- maybe a higher proportion of Mode 3 business. But I mean, all of that will be visible to you as we grow our Mode 3 business. Like for this quarter, there have been -- there's a significant organic traction as well in the product business because a lot of IP that we acquired, we found good opportunities in our existing customers. So it's going to be -- Mode 3 is also going to be driven by both organic and inorganic, and we are continuing to build a strong sales channel to drive our products and platform revenue streams. So we will keep you updated as we invest more or as we find more opportunities.
Understood. And just one final point in this, given that your aspirations on Mode 3 are quite big, do you think you will, sometime in future, require a significant product-focused sales team, similar to what large -- many software companies have in place? Is there something that you foresee down the line?
Yes. We're already building a sales channel, as we said, even 2 years back. We already have 100-plus people focused on product sales and solutions and services around these. So it will continually evolve, and that will mean that we will build a strong product sales organization as well.
Ladies and gentlemen, this was the last question for today. I now hand the conference over to Mr. C. VijayaKumar for his closing comments. Over to you, sir.
Yes. Thank you, everyone, for joining us on this second quarter performance and the commentary. Overall, it's been a pretty satisfying performance. We continue to show incremental traction in our overall growth and the overall demand environment and the opportunity that is there and the strong differentiation and the distinct strategy that we adopted, we feel very confident about continuing to deliver industry-leading growth. And look forward to interacting with you in subsequent interactions, and thank you for joining us today.
Thank you very much, sir. Ladies and gentlemen, on behalf of HCL Technologies Limited, that concludes this conference call. Thank you for joining us, and you may now disconnect your lines.