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Edited Transcript of HCLTECH.NSE earnings conference call or presentation 7-Aug-19 1:00pm GMT

Q1 2020 HCL Technologies Ltd Earnings Call

Noida Aug 17, 2019 (Thomson StreetEvents) -- Edited Transcript of HCL Technologies Ltd earnings conference call or presentation Wednesday, August 7, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* B. Kalyan Kumar

HCL Technologies Limited - Corporate VP & CTO of IT services

* C. VijayaKumar

HCL Technologies Limited - President & CEO

* Gade Hanumantha Rao

HCL Technologies Limited - President of Engineering and R&D Services

* Prateek Aggarwal

HCL Technologies Limited - CFO

* Sanjay Kumar Mendiratta

HCL Technologies Limited - VP & Head of IR

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Conference Call Participants

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* Ankur Rudra

CLSA Limited, Research Division - Research Analyst

* Ashish Chopra

Motilal Oswal Securities Limited, Research Division - Research Analyst

* Ashwin Mehta

Nomura Securities Co. Ltd., Research Division - Former Regional Head of Software & Services Research

* Nitin Padmanabhan

Investec Bank plc, Research Division - Analyst

* Parag Gupta

Morgan Stanley, Research Division - Executive Director

* Ravi Menon

Elara Securities (India) Private Limited, Research Division - VP of IT Services & Internet and Analyst

* Sandeep Shah

CIMB Research - VP

* Sandip Kumar Agarwal

Edelweiss Securities Ltd., Research Division - VP

* Viju K. George

JP Morgan Chase & Co, Research Division - Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, good day, and welcome to the HCL Technologies Limited Q1 FY '20 Earnings Conference Call. (Operator Instructions) Please note that this conference is being recorded. I now hand the conference over to Sanjay Mendiratta, Head of Investor Relations, HCL Technologies Limited. Thank you, and over to you, sir.

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Sanjay Kumar Mendiratta, HCL Technologies Limited - VP & Head of IR [2]

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Good evening, and good morning, everyone. A very warm welcome to the Q1 FY '20 earnings call discussion of HCL Technologies. We have today with us Mr. C. VijayaKumar, President and Chief Executive Officer; Mr. Prateek Aggarwal, Chief Financial Officer; Mr. Apparao, the Global HR Head and the other business leaders.

I now hand over the conference call to Mr. C. VijayaKumar to give the opening comments.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [3]

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Good evening, and good morning to all of you. First of all, apologies for the delayed start. So we have a small presentation that we will walk you through. Followed by that, we will take questions and answers.

So to start with, I want to give you a very quick performance summary for the quarter. We've had a fantastic start to the year. We delivered $2.36 billion in revenue, which is a 15% Y-o-Y growth in reported currency and 3.8% quarter-on-quarter growth. On constant currency, this is 4.2% growth and 17% Y-o-Y growth. This is -- 17% Y-o-Y growth is the highest growth in the last 7.5 years, so it's really been a stellar performance. And I'll talk about what contributed to this in one of the subsequent slides.

Our EBIT margins was flat on a Y-o-Y basis. On a quarter-on-quarter, it dropped by about 6.3%, it's about 180 basis point drop. The margins are largely in line with what we had expected for various reasons in this quarter. The year-on-year drop is a little more steeper, 260 basis points. We will explain some of this in the subsequent slides. We had a very good momentum in our Mode 2 and Mode 3, a 20 basis point increase in the mix, it's now 29.7%, which is again 300 basis points growth from the previous quarter last year.

Our revenue momentum continues, and we've been talking about very strong deals, very large deals, which is what we talked about in 3 of the 4 quarters in the previous year. And all of this has been contributing nicely to our growth momentum. Last 6 quarters, we've had continuing acceleration in growth. A big part of this is organic growth. If you look at the last 2, 3 quarters, every quarter, we have a reasonable run rate, which is coming from all our businesses, but the big uptick is really contributed by the large deals, starting with Nokia in the middle of last year, followed by the Broadcom professional services agreement and the Xerox deal that we announced, which was one the largest deals that we've signed in our history which happened in March of last year. And that's also contributed significantly to the growth.

So each of these quarters, one of the large deals is really contributing to the x-factor in terms of growth. And what is very notable is, of the 17%, which pretty much contributes to -- the 4.2% contributes about $95 million of incremental revenue. Of that, only $11 million of revenue is from inorganic growth, which is through the integration of Strong-Bridge Envision, the digital transformation consultancy company that we acquired last quarter and has clearly kicked in from 1st of April.

A significant part of this is from one of the large deals that we won in the last quarter, which transitioned a little faster than what we expected. There was revaluing opportunity to drive some acceleration in how the execution needed to happen. So HCLites all over the world have been very, very busy executing some of the wins that we've achieved in the last few quarters, but more sharply the wins that we had in the previous quarter.

So overall, it's a very strong momentum in terms of overall growth, in terms of organic growth, which gives us tremendous confidence to get to a industry-leading organic growth in the third fiscal.

Moving on. If you look at our revenue by geography and vertical, Americas grew 21% year-on-year. Europe grew 11.3%. And rest of the world was more or less flat. If you look at the U.S., the large deal that we won was the key contributor to the big uptick, though there is growth across a few other segments, which has also contributed to the growth in the U.S.

Europe was soft, degrew 8% quarter-on-quarter. But if you look at the year-on-year growth, 11.3%. Obviously, when we have the large deals, there was a lot of implementation and transformation. Some of that ramps down when the deal gets into steady state, and that's what is reflected in these numbers. ROW has some contribution from India. But overall, ROW's performance has been soft, but we expect it to pick up in the coming quarters.

Across verticals, you can see that Manufacturing contributed by the large deal and tech -- Telecom & Media are 2 of the segments, which have grown over 28% year-on-year. Most of the verticals have grown good double-digit. Retail & CPG grew 22%; Life Sciences, 16%; Energy & Utility about 18%.

Financial Services, while the growth is broad-based, which is getting offset by one of the client situations, which is continuing to evolve and it has a downward impact on the Financial Services. We traditionally talked about -- in the last 2, 3 quarters, we talked about 2 clients in Financial Services. I'm happy to note that one of the clients have stabilized, and we are going to see some growth there. And the overall win momentum in Financial Services is also strong. So I do believe in the second half or in the last quarter of this year, we should see some good growth coming in Financial Services.

One of the big highlights of this quarter is we launched HCL Software. This is the new business unit for software products, which is really stacking up of all the IBM IP partnerships and the acquisition which is getting -- which got consummated on 1st of July. This is really to provide modernized software products to businesses. And our value proposition and vision for this business is to become the most client-centric software product business in the world. This is the philosophy which has guided us, the innovation, client centricity and empowerment and really focusing on adoption of the product is a very important theme. And our teams have -- in the last 2, 3 years, have built a lot of conviction on how product adoption can help create stickiness and long-term benefit for a software product business. And that's what we are -- we've got started and the deal got consummated and we will see the revenue momentum picking up from July.

We won about 12 transformational deals. As I said earlier, Financial Services was a good contributor here. Of course, Manufacturing and Retail are the segments which were the top 3 in terms of contribution to these transformational deals.

We continue to have a strong local presence and participation in different geographies. We celebrated 20 years in Australia and New Zealand. We have a 1,600-plus strong workforce across 8 locations, and we continue to increase our focus in this geography where our presence is significantly smaller compared to what the market opportunity is, and we are investing in this geography to create the growth that we need.

We're also very proud to announce that we've been chosen as a digital transformation partner for Cricket Australia. Again, this is about fan engagement, something that we've done fabulously well in Manchester United. This is a theme that we want to repeat in Cricket Australia. We also increased our focus and footprint on the cybersecurity business by launching a Cybersecurity Fusion Center in Frisco, which is already off to some -- a very good start with clients, including a government client in the state of Texas.

To give a little more dimension to these deal wins. We won a very large deal with a European oil major, which is largely an infrastructure deal and application management is a combined scope as a part of this deal. We won a fairly large deal with a multinational based in Europe for digital workplace services, replacing one of the traditional providers. Here, again, it's not a traditional workplace services deal, it's a digital workplace where DRYiCE Lucy is the cognitive agent and there is significant amount of user interactions, which are enabled through the cognitive virtual assistant. We also had a couple of wins, as I said, a large American investment company and a leading financial services group in Europe who we expanded the relationship. It's largely a digital engagement, which is continuing to scale very, very impressively, really becoming a flagship client for us for our digital transformation business line.

We've also now -- as we discussed in the last call, we have now created new business segments in line with how we see the business progress. So the infrastructure, BPO and the applications business, which was earlier classified under the Software Services, it's now classified as IT and Business Services, which has infrastructure, application and digital process operations as 3 significant components. A lot of deals which are integrated, a lot of cloud migration deals and a lot of digital transformation deals have all these 3 components, so that's why it makes sense to kind of combine this under one vertical segment. And we've also reorganized the sales channel, which happened last year, to have a vertical go-to-market strategy looking at selling IT and business services. We have one integrated sales channel, and we have dedicated delivery organizations driving this. Our Engineering R&D services, which has been a flagship service for us, we used to report the revenue contribution, but we now have a separate segment, which is around Engineering and R&D services and the focus and the target audience and the dynamics of this business are really different from the overall IT and business services. And that's why we segregated this as one segment.

And the last is Products and Platform. Earlier, it was classified under our software services. Now Products and Platform will have all the stand-alone product businesses that HCL has. To specifically call out, HCL Software will be a part of Products and Platform. The Actian acquisition that we did, that will also roll up under Products and Platform segment. And then IP partnership that we did with DXC, which is also rolling up into the Products and Platform. These are 3 stand-alone product businesses where we have made significant investments, and we wanted to provide you visibility on how this team is performing, and that's why we've called it out. There are some product businesses within the IT and Business Services as well as Engineering Services, which have largely embedded within those business services. Even though they are a dedicated group, but it is, overall, under an integrated leadership, so they continue to be classified under IT and Business Services or Engineering Services as well.

They're organic IP products which we have built, and that's what we will continue to incubate within these business clients.

So overall, Mode 3 will consist of Products and Platform, plus the organic products in IT and Business Services and Engineering and R&D Services will together contribute the Products and Platform mostly revenues.

Just a little more double-click into the HCL Software. The deal closed, as all of you would know, end of June, it's $1.8 billion, 7 software products in some specific areas like security, marketing, commerce and digital solutions, this is the group of products around Unica -- around Domino's and Connections. So that's what is a part for digital solutions. So there's tremendous amount of work that has happened in the last 3, 4 months. In fact, the last 6 months. We signed the deal in December, we've been setting up this entire business unit, which includes onboarding a lot of partners, getting all the approvals from the government, while continuing to focus on creating product road maps and product releases. The key differentiator that we envision for this business unit is in the software products business, I think there is a unique need for a very, very customer-centric product company. And this strategy worked extremely well in some of our core services where the services that we offered were very similar to what other providers had, but we came in with a very refreshing approach of really providing a very friendly contractual construct and a very customer-centric approach where we are not just focused on selling the products, but we have evangelists, product evangelists or customer evangelists, who are focused on adoption of the product and the value realization as a very important success metric, which we believe will be the right long-term success criteria, that our long-term success will be driven by some of these attributes.

With that commentary, I will hand it over to Prateek to provide you some more details.

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Prateek Aggarwal, HCL Technologies Limited - CFO [4]

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Yes. Hi, everybody. Good morning, good evening, whichever part of the world you are. I will start off my commentary with the biggest news that we have in this quarter is the stupendous growth, huge beat on revenue in Q1, 17% year-on-year in constant currency. And what I'm also very pleased to share is that comprises about 14% is organic in nature. I also want to point out that we are keeping the guidance the same, exactly what we communicated 3 months back, both on the top line as well as on the bottom line.

In terms of numbers, they're on the screen, mostly been commented upon. The EBIT, as you can see, is lower on a quarter-on-quarter basis by about 180 basis points. That's partly contributed by 4 real factors. Some of the factors common to the industry are a ForEx headwind of about 15 basis points, typical visa costs that come in this quarter of about 15 to 20 basis points. And as we had pointed out in the last call, there is a 50 basis points impact in the SG&A which is largely investment that we had already made in the previous quarter in anticipation and in readiness for the HCL Software revenues to start flowing and taking charge of the front end of the market in that business.

There is additional 110-odd basis points in the ERS business. Part of that was -- about 1/3 of that -- or actually more than 1/3 of that was driven by some one-timers in the previous quarter in that particular business. And the balance part of that was driven by some investments made in the business, in the ERS business as well as some on-site centric growth that we experienced this quarter and also some costs where we need to take some action going forward. So that's the EBIT walk by and large for the quarter.

I also want to talk about the ETR, the effective tax rate, which you would have noticed has gone up this fiscal to a number of 24%, which is largely driven by the consummation of the 7 software products acquired from IBM and its related accounting. While I'll go into the accounting in the next few slides, just on the ETR, the impact is largely coming from the goodwill that is recorded in the financial books, which is tax deductible at an accelerated rate of 25% written-down value under the Income Tax Act. However, in the financial books, as you know, goodwill is not amortized, and this leads to a permanent difference between the profit as per the financial books and the profit as per the Income Tax Act. So the impact of this is about 2.2% of profit before tax, PBT. So were it not for this one factor, our ETR would have been something like 21.8% or thereabouts. This is a GAAP-dictated noncash charge, which basically on the other side results in a deferred tax liability being created. It's a liability which is not payable to anybody at any point in time and is, therefore, completely noncash, like I said. So that's the factor that is pushing up the ETR, and I just wanted to explain that to you in some detail.

Moving on to the next page. These are the graphs, which basically show a longer-term 3-year CAGR picture in every which way, close to 12% revenue growth over a 3-year period resulting in close to $9 billion in the last 12 months, July to June. Both EBIT and EBITDA have also shown good traction, 9% -- 9.3% on EBIT and EBITDA, which is more representative in a business that is investing heavily into the business. EBITDA, which is the cash metric, tracks cash very closely, is growing at 13.1%, ahead of the 11.9% in revenue terms. Net income is at 7.1%. But that is, as I said earlier, impacted by the noncash factors like the amortization as well as the effective tax rate in this quarter that I already spoke about. And therefore, at the bottom right-hand corner, you see the 2 key metrics from an earnings per share perspective. And the cash EPS is the number that we like to track. Because it is cash, it excludes the factors like amortization and the ETR factor on -- that we spoke about, and that is at a healthy INR 86.2 per share, and that cash EPS has been growing at a 14.6% CAGR.

Giving you some color on both the segmental margins as well as the Mode 1-2-3 margins and the revenue mix. So if we look at the top half of the page, the growth of 4.2% quarter-on-quarter in constant currency was driven largely by Products & Platforms this time, 7%. Also ERS, Engineering and R&D Services, grew 5.6%; and IT and Business Services on that large base also grew at 3.6%, which is pretty much -- in dollar terms, is the biggest contributor to the close to $100 million growth during the quarter. In terms of Mode 1-2-3, again, all the 3 contributed significantly in very meaningful numbers across, as you can see on the right-hand bottom side.

With that, I'll move on to the next page and give you some more details about how the IBM deal closure, which closed on 30th of June, has been accounted in the books. To be very clear upfront, there is not a cent of revenue or EBITDA in the June quarter from this deal because the deal was closed at the very end of the quarter. The number on revenue and EBITDA starts flowing from the next quarter, which is July 1. However, in the balance sheet is where you see the biggest impact of the deal having been closed. And also on the ETR, which we spoke earlier.

Moving to Slide 18 (sic) [Slide 19]. So out of the total value which we had announced, $1,775 million or $1.8 billion to round it off, the consideration which is kind of fixed consideration is $1.625 billion, and half of that has already been paid out on -- actually a couple of days before June 30, the Friday was 28. And the balance $812 million out of that fixed consideration will be paid on the 30th of June next year. The second component there is the $150 million, which is earnouts which are payable in 3 installments. And each one of these 3 has been present valued. Of course, the first one is at the same value. And the present value of the second payment of $812 million is $794 million. And the estimated payout and present value of the balance $150 million is at $129 million, which completes the total of $1,736 million as you see on the bottom of that page. The right-hand side just shows -- reminds you of the 7 products that we are talking about. 5 out of 7 were already existing products under the IP partnership. That includes BigFix, AppScan, Digital Experience, Domino + Notes and Unica/Marketing Software. The new products that we have got for the first time are Connections and Commerce.

Moving to the next page. The story doesn't finish on the $1,736 million which I called out on the previous slide. Because of the 5 products which we already have as IP partnerships, there is an unamortized present value of the licensed IPRs, which is of the order of $427 million. And once you add the $1,736 million and the $427 million, this is what the purchase consideration which has been allocated across the various assets, which we'll get to in a second. So the total value is $2,163 million or to just round it off, $2.2 billion, which is broken into 4 primary parts. The largest asset that has been quantified is the customer relationship, which is $903 million. That is going to be amortized over 10 years in the proportion of the estimated revenues. So we have forecasts across the period of 10 years based on which this will be charged to the P&L. The second largest asset quantified is the technology or the IP, intellectual property, which is of the order of $352 million, and the basis of amortization of that is over a period of 7 to 10 years. It differs for each of the 7 products, some of them are at 7 years, some of them are at 10 years. On a weighted average basis, it is about 7.5 to 8 years kind of a number. And this will be amortized over that period of time for each of those products based on the simple straight line method.

There is a third net liability, which is nothing but the deferred revenue, and deferred revenue is a significant part of any software business, and so it is here. The gross deferred revenue is of the order of about $402 million. That's the liability that we are carrying in our books, which we'll service over a period of time. And against that, as per our negotiations with IBM, we have close to $400 million sort of as a receivable from IBM, again, over a period of time, which on a present value basis is quantified at $391 million. So you can see it's basically kind of offsetting each other, the net value is the net deferred revenue of about $11 million, which will flow into the P&L over a period of more than 1 year actually.

The balance then is the goodwill, which is amount of $919 million. This, as we discussed earlier in the context -- in another context, is not going to be amortized, and that is what is going to be in the books, and it will be tested for impairment, if and when there is a trigger that requires us to do that.

Moving to the next page. This is the chart which gives the amortization based on the principles I enumerated on the previous page over the next 5 years and the balance thereafter. So for the balance 3 quarters of this fiscal year, FY '20, the amount is $196 million. And then for the balance 4 years after that, is given in the table on Page 20 (sic) [Page 21]. And in total, this is $2,023 million, which is what -- by the way, I must clarify, this includes not only the 7 products that we are talking about but also all the previous non-products acquisitions that we had in the services business as well as the IP partnership, where -- leaving aside these 5 products which have become old now.

So with that, just to reemphasize, we are sticking with the guidance of 14% to 16% in constant currency at a total level. As you know and as we discussed last quarter, this in our estimate had included about 7% inorganic, and organic was supposed to be 7% to 9%. But of course, given the 1-month delay in the deal that we talked about, that 7% has gone pretty much near the 6% mark. And the difference of whatever that 0.7% or whatever it is, is kind of being made up in the organic part.

That's it from my side. Yes. I mean, margin continues to be at 18.5% to 19.5%. And given that we are at 17.1% in the first quarter, it is a number that we are retaining and we expect to achieve based on all the cost factors, actions that are already taking place as well as the IBM deal that we talked about, which will contribute handsomely to the margins starting July 1.

With that, operator, we can go to Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from the line of Ankur Rudra from CLSA.

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Ankur Rudra, CLSA Limited, Research Division - Research Analyst [2]

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Congratulations on the good execution on the revenue side. Could you elaborate, last quarter, you had said that organic growth would probably be weaker in the first half and pick up in the second half. Given that it's been so strong, I think you said 14%, has that view changed? And what drove that?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [3]

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Ankur, thank you for the question. When we started the year and when we did the planning, there were certain dynamics which were there. And to kind of break that into a little bit more detail, we had headwinds from 3 clients, 2 in Financial Services and 1 in Manufacturing, where based on the situation at that point of planning, they were to ramp down significantly. That was one. Of course, we had the large deal ramp-up, which was there, the large deal that we signed in March and announced in March where there was some uncertainty about how the rebadging will go and how much time it will take, all of that. I think some of that went absolutely flawless, and we could maximize the revenue from the new deal that we signed. And the headwinds that we expected, one of the financial services clients, actually, things turned around. We could gain some market share in one of the accounts. And the second account did not ramp down as much as we anticipated, and same was true for the manufacturing client as well. So collectively, things panned out much better than what we anticipated. And of course that's what shows up in the revenue.

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Ankur Rudra, CLSA Limited, Research Division - Research Analyst [4]

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And going forward, do you think this will be -- the first quarter was significantly stronger than the trend, and we see organic growth actually now fade out a bit or you think the momentum will sustain?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [5]

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I would -- I mean, I think the headwinds in some client-specific situations, at least 1 in Financial Services and 1 in Manufacturing, the challenge is there, and we see some softness based on those 2 large clients in this quarter and maybe even in the next couple of quarters. But we are also constantly booking new deals. And overall, I would hesitate to make a comment on how Q2, Q3, Q4 will go, but overall, we remain within the guided range. And as Prateek already highlighted, our organic growth has already contributed some 60 million more which will offset the 1-month delay in IBM. So our overall organic growth will be better than what we had anticipated earlier.

So there may be higher contribution from organic and lower contribution from inorganic. But given the momentum and the consistency with which we are able to win, the strength of our overall proposition, the integrated offerings, our ability to combine services and also understand the client situation in a very, very pragmatic manner and create win-win solutions, I think that gives us a lot of optimism on a large deal pipeline. They may not be driven by RFPs, but we are able to create some strong propositions and kind of convert large transactions. So that gives me confidence. Though it may not happen every quarter, but there is enough optimism on the booking and what it will translate. The only reason we have not increased the guidance is, given the macros that are playing out and the trade situation, I mean, obviously, there can be always some surprises, and this will be not the right time to kind of increase the guidance.

So we remain cautiously optimistic, but overall momentum is good, and we are positive about what we can deliver. And I'm pretty confident that we will deliver an industry-leading organic growth in fiscal '20.

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Operator [6]

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The next question is from the line of Sandip Agarwal from Edelweiss.

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Sandip Kumar Agarwal, Edelweiss Securities Ltd., Research Division - VP [7]

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Congratulations on a very good set of numbers on the revenue side. So I have 2 questions. One, on the demand side, while you amply clarified that you don't want to risk your guidance with uncertain macros. But I just wanted to dig a little deeper. Are you seeing any kind of signs, which makes you make this conservative assumption, one? Are you seeing some anecdotal signs of stress in some of the segments like high-tech or in the product engineering side or even on the financial side? That is question number one.

Question number two is more about bookkeeping with -- from Prateek. And Prateek has very well explained the whole amortization thing. Just one question which I wanted to understand in short, was that, is it right to assume that out of this total IP deal consideration which we are paying, we will be broadly writing it off around $200 million every year for the next 10 years on an average, and balance $1 billion or $900 million will be goodwill, which will not be written off unless there is a impairment assumption. So is it my understanding is correct?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [8]

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Yes. So maybe let me answer the first question, and then Prateek will respond on the second one. So Sandip, overall, the demand environment, if I look at it, first is to look at it clearly quantitatively. The pipeline that we had at the end of last quarter and the pipeline that we have at the end of this quarter, it's more or less the same.

Now in terms of verticals, I think there are some verticals where there is some slowness in some decision-making. But they're more projects type of work, where there could be some kind of delays that we have seen. However, I think the traditional Mode 1 business, there is enough opportunities which will continue to be happening in the market. And I think on that front, we also feel extremely confident of our differentiated positioning. Especially on the infrastructure business, the number of good quality players who have viability, whom the customers consider as a viable provider, that's going down quite a bit. We are in a pretty unique situation to really capitalize on the deals, renewals and rebid market. So I think that's very strong. And I do believe some of the macro things may only accelerate some of those things.

In terms of some verticals, there is delay in decision-making, though I wouldn't really attribute it to macros. It could be based on the deal dynamics. So I would say it's a mixed trend, that's why we are a little bit cautious. And this whole trade and some of these challenges, it hits our customers' bottom line significantly, especially for the clients who have a significant exposure to some of the markets which are kind of impacted due to this trade tensions. So there, when they come under cost pressure, of course, they will have a little more expectations from some of the providers.

So all these things are just playing in our mind. So we are being cautiously optimistic, Sandip. And over to...

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Prateek Aggarwal, HCL Technologies Limited - CFO [9]

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Sandip, to answer your question on amortization. I mean, you ask me a specific number, which I don't think is the right way to answer. It is -- in the first year, it is a number close to that number, but you can just do the math. I mean, we publish this information on a year-on-year basis every quarter. So you just have to take the March quarter disclosures and see this quarter, and you can see the difference. The other deal that we closed was Strong-Bridge Envision, which is much smaller in size, as you know, so there will be a bit of that. But really, it's -- just compare the 2 quarter-on-quarter amortization schedules published.

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Operator [10]

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The next question is from the line of Sandeep Shah from CGS-CIMB.

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Sandeep Shah, CIMB Research - VP [11]

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Congrats on good execution on revenue. Just a question in terms of the guidance. So if I look at the second quarter, you will have an incremental revenue contribution of almost $140 million, $150 million, which may be coming through IBM deal. That itself may give you a 6% Q-on-Q growth. So at the midpoint of the guidance, which is close to around 14.4, we are actually guiding almost a flat growth in the next 3 quarters on a Q-on-Q. So is it more a conservatism? Or is it some other client-specific issue which you may be foreseeing going forward because of macro?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [12]

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Sandeep, I know your maths are -- I absolutely agree. Though the contribution from IBM deal may not be $140 million, that it will ramp up. But overall, on a 12-month basis, we feel confident about the $625 million that we talked about when we announced the deal. So it may be a little smaller to start with, and then it will pick up. Some of the transitions, which are ongoing, especially rebadging kind of deals, the revenue could come down when you go into the next 2 quarters, but some of that could get filled as well through other pipelines.

And the client-specific situations I've already called out, 1 Financial Services client and 1 Manufacturing client, there are some specific challenges. So there is some uncertainty, and that's why we kind of kept the guidance the way it is. And we will look at it next quarter and depending on how we feel -- and also the whole IBM deal also may have, while annual revenue looks intact, but the ramp-up could be a little bit slower in the July, August, September quarter. And it may peak in OND and a little bit moderate in JFM.

So there are many, many variables. And overall, 14% to 16% was a healthy guidance, and we wanted to remain within that. And we will update you in case we feel there is an uptick possible.

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Sandeep Shah, CIMB Research - VP [13]

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Fair enough. Just a follow-up, sir. In terms of margins, just -- because we called out that first quarter we would be lower than the lower end of the guidance, largely because of the product side ramp up, so that should be Mode 3. When I look into the margin Q-on-Q, the Mode 3, Mode 2 margins have actually slightly improved, while the Mode 1 margins have gone down. So there is some amount of confusion versus what we foresee and what has come. If you can help us in terms of reconciling?

And Prateek, what should we model for the tax rate for FY '20 and going forward basis beyond FY '20?

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Prateek Aggarwal, HCL Technologies Limited - CFO [14]

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So Sandeep, let me answer your first question first, which is, see, P&P is a product business and that applies to any product business anywhere in the world. You should not see it on a Q-o-Q basis because that's great to see for a services business, but product companies, you have to see Y-o-Y. And that's because the seasonality that is there in terms of license sales which is, in turn, determined by when do those clients come up for renewals and things like that, so if you see -- and that data is given in the Ind-AS accounts where you will see the Q-on-Q, I mean, the margins in the previous year quarter was about 30, 31 percentage points. So compared to that, 24% is lower because it was 31.4%, and that is down to 24%, which is a 7.4% drop. So that is the drop which is really the investment which we made in anticipation and readiness for the deal to start from 1st of June. And that didn't happen, and that was -- we had kind of baked that into the guidance we gave 3 months back, but then the deal closure got delayed by another month. So that is the difference that is really the investment that has gone in.

On your -- yes, second question was on the tax rate. Sorry.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [15]

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If you just look at the AMJ '18 through AMJ '19 for the Products and Platforms segment, you will see a substantial increase in costs. So that should give you some indication of this.

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Prateek Aggarwal, HCL Technologies Limited - CFO [16]

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Yes. Going to your second question on the tax rate for FY '20, it was determined at 24%, like I explained earlier. And while it's kind of difficult to guide you for the next year, FY '21, at this point of time, it would tend to be slightly higher. Maybe 24% to 26% is a good range to work with, but these things are determined on a fiscal-to-fiscal basis. So this 24% is for this entire fiscal.

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Sandeep Shah, CIMB Research - VP [17]

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Okay. Okay. Just last question, if I can fit in, is in terms of the product growth on Q-on-Q, it is (inaudible). What we understand is, seasonally, this is a slightly softer quarter where there could be a Q-on-Q decline. So what has led like good growth versus a seasonality, which was expected in the Products and Platform business?

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Prateek Aggarwal, HCL Technologies Limited - CFO [18]

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I wouldn't agree that this AMJ June quarter is seasonally weak. I mean, typically, the strongest quarter, of course, is the December quarter. But June quarter is actually second out of the 4 quarters. The weaker quarters are actually the March quarter and September quarter.

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Operator [19]

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The next question is from the line of Viju George from JPMorgan.

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Viju K. George, JP Morgan Chase & Co, Research Division - Research Analyst [20]

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Good quarter. Just had a question on Mode 2 margins. I think it's low teens. And I guess your Mode 2 is probably more comparable with what peers call digital in terms of the kind of offerings, maybe not as a percentage of revenues. And generally peers call this out as normally a higher-margin business. So I'm curious to see whether margins of this are quite much lower than what we would have expected it to be considering peer commentary.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [21]

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Viju, I think it's the same as we've discussed this before, and our gross margins are definitely higher in this business. But obviously, the practice overheads of what we have invested into all these 4 areas, it kind of dilutes the gross margin. That's why EBIT is lower. And -- I mean, as the business scales up, I think this should improve.

However, if you look at the overall opportunity, there are a lot of areas where we need to do proof-of-concepts, and especially some platform-led deals, there is some groundwork that we need to do to kind of help showcase the right outcomes. So I think we are -- we continue to look at that as the right investments that we need to make in the long-term to kind of scale this business.

And the way the whole practice investment has helped us is, today, it's a very, very strongly differentiated service, and we are able to win against some of the strong established players, and the conviction of our own, I mean, sales teams to really go after large-scale digital deals has tremendously increased. And I really attribute it to these strong practice investments that we've made. And we will continue that for some time. I think still that business is in very early stages, and we can really do some significant scale up in the coming years. So that's why the margins are low. Quarter-on-quarter, there may be some marginal improvements, but fundamentally, the margins are going to be low in the foreseeable few quarters.

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Viju K. George, JP Morgan Chase & Co, Research Division - Research Analyst [22]

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But CVK, you assume on the gross margin side, they are tracking quite well, above company average?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [23]

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Yes. There are 2 elements there, Viju. One is, of course, there are large clients where you have a certain rate card, and sometimes we end up not necessarily differentiating this because there are large relationships where the whole change in rate card and things like that, it is taking some time. So -- but in any new deal, if we were to bid and win, we are very, very conscious of the rates and the level of gross margin that we need so that in the long term, it is kind of driving the right profitability profile here.

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Viju K. George, JP Morgan Chase & Co, Research Division - Research Analyst [24]

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Sure. The other observation was that on the return on invested capital. When I look at it over a 5-year basis, and sometimes margins don't just capture this declining trend. Your ROIC has declined by 15 percentage points as per our math from where that stood at 2013-'14. And part of it may be due to the acquisition-led strategy as well. How do you see this going forward because, I mean, there is also not just about the balance -- income statement but also the balance sheet and the acquisitions. So how do you manage for this going forward? And what might be a desirable level for you? You've stayed on the margin side, but anything on the ROIC side as well.

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Prateek Aggarwal, HCL Technologies Limited - CFO [25]

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So Viju, I think I referred to that in the commentary at the beginning. First of all, there are -- we need to look at -- as investors, we need to look at cash metrics more than accounting metrics because IRR is really the metric that we should be tracking, as internally, when we make our business cases for all these investments, that's how we measure it. And that's how I continue to sort of look at the overall metric.

The second thing I also want to point out is, you are looking at return on invested capital as a percentage. While percentages are great, we also need to look at who's investing how much. You can take an investment of $1 billion and return, let's say, whatever, 100% on that. That's a return of $1 billion. But if you take investment of $5 billion on the other hand, and even if you return 20% on that, that's still $1 billion in hard cash. I think, as investors, I tend to look at the actual $1 billion that is coming in, and what is it expected to deliver year after year after year, put it in a DCF calculation, and that gives me what it means to me in net present value terms. That's the way I look at it. Obviously, you have to make up your mind. We did exchange a few mails on this as well.

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Viju K. George, JP Morgan Chase & Co, Research Division - Research Analyst [26]

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Sure. And last question from my side. I think CVK you did mention this, the better-than-expected organic growth. Is that coming because of the upfronting of revenues in an accelerated manner or better revenue traction from other clients as well? So what I'm trying to say is, does this sort of mean that because of upfronting, you would expect it to sort of tail off a little bit towards the end of the second half of the year?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [27]

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So very little bit of -- I mean, I wouldn't say that too much has been upfronted. At least for 2 of the deals, 2 of the large deals that we won, I think it's already the -- it has reached a stable state as it is reflected in the numbers in this quarter. For one of the deals, of course, there is going to be some reduction. That reduction, I don't see it significant in the next 2 quarters. There will be some reduction, but nothing that should substantially change the dynamics. Of course, when you go to the next year, there could be some more pressure on this. But I think that's where we -- we are now looking at our business as there is a run rate business of momentum that we have. And then on top of it, we need to look at proactively constructing large mega transactions quarter after quarter, and that success is what will really drive a truly differentiated industry-leading organic growth in a consistent manner. I think that's the mix and formula that we believe we are getting it right consistently in the last few quarters. And we want to see how to perfect that art and ensure you have at least one mega deal every quarter, so that it really gives you the differentiated growth organically that we wanted to achieve.

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Operator [28]

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The next question is from the line of Ashish Chopra from Motilal Oswal.

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Ashish Chopra, Motilal Oswal Securities Limited, Research Division - Research Analyst [29]

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I had a question on the overall margins. So while you start the year at 17%, and Prateek, you articulated the headwinds that pulled it down. But how should we expect the trajectory from here on for you to be delivering upon the full year guided band? So do we expect you to get back in the range immediately with the integration of the IBM IT purchases? Or should it be more gradual and spaced out over quarters for you to see the improvement from here on?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [30]

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Yes, so obviously, the math works out to meet the guidance. We will have to be in the guided range from next quarter onwards. However, I see a slight peaking in OND and a little moderation in JFM and an uptick from AMJ to JAS. Exactly where it will land, I don't know. But our expectation is, we have enough levers to make the right metric. So overall year, it's where we will be, between 18.5% to 19.5%.

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Ashish Chopra, Motilal Oswal Securities Limited, Research Division - Research Analyst [31]

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Got it. And Prateek, you had also mentioned about the on-site heavy nature of the deal that ramped up in the quarter. So were you referring to just the one deal that did contribute a fair share of this quarter's growth? Or that would be probably the nature and dynamic of some of the other deals as well that you've been winning substantially large sizes?

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Prateek Aggarwal, HCL Technologies Limited - CFO [32]

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Yes, Ashish, I don't want to get very deal-specific, but yes, there was that one large deal, which we announced at the end of March, which really ramped up and contributed significantly to this quarter.

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Operator [33]

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The next question is from the line of Parag Gupta from Morgan Stanley.

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Parag Gupta, Morgan Stanley, Research Division - Executive Director [34]

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Just had 2 questions. So CVK, I guess, you have stopped giving any sense on infrastructure management in your metrics. But could you give us just a qualitative sense of what is happening in that area? What kind of deals are you seeing? And what's the outlook out there on the infrastructure management side? And the second question was, on transformation deals, I think, while you continue to win several of these deals, there has been a little bit of a downtick in this quarter versus, let's say, what you've been doing on an average for the last couple of quarters. So is there anything that we should read into what is happening in the macro environment? Or is it just a slight downtick, which doesn't really mean much from a dollar perspective?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [35]

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Yes. Parag, let me start with the infrastructure management. Of course, we're not going to call out the specific numbers, but I'm very, very happy to provide a qualitative commentary on IMS.

This quarter, again, we had some good wins. Couple of them I called out. The rebid market is -- continues to be very strong. A couple of large players are continuing to weaken, and the customers are concerned. So there are lots of opportunities in infrastructure business, but we are still being selective because we obviously need to maintain a certain margin profile compared to some of the other players who are seeking -- who have an operating model which allows them to operate at almost half the margins versus what we anticipate.

So actually, there is enough opportunities. We are picking and choosing the right opportunities so that it helps us to scale the infrastructure business in a profitable manner. That's as far as the new deals are concerned.

If you look at the existing deals, obviously, there is some year-on-year reductions, which are structured as a part of the deals. Obviously, we take over, we optimize, we bring in significant amount of automation, DryICE, all of that. So that would mean that subsequent annual reductions will happen.

And the third element is -- I mean, even if -- either during renewals or even midway in a deal in a large client relationship, sometimes customers do ask for some reductions. So we try and make it a win-win proposition on how we can gain other businesses and support the customer ask. So these are the 3 dynamics which are playing in. And the whole cloud adoption journey, I think I said this 3.5 years back, that 30% will go to public cloud. There are many analysts who've written it could go to 50%, 40%, 70%, but everybody seems to be trending to come back to the 30% that I quoted about 4 years back.

So I think our conviction on how much will move to public cloud is very high, the percentage is very high. Some of the traditional enterprise workloads, hybrid cloud is the right operating model. A lot of new workloads around some of the new things like advanced analytics and IoT, autonomous driving, some of those workloads could be in public cloud, so the core enterprise IT landscapes will continue to adopt hybrid cloud, and our capability there is going to continue to differentiate us to win these transformation programs.

On the deal momentum, see, out of 3 -- I mean, in the last year, of the 4 quarters, 3 quarters, we had increasing peaks. And this quarter, of course, it's moderated, we didn't have a megadeal like what we would have had in the other 3 quarters. But if I look at the pipeline, may not -- I mean, there are opportunities, which are large, but I don't know when they will convert. But we are constantly looking at how to create these large opportunities. So it's a matter of 1 or 2 quarters, we should get another peak in the booking.

So nothing to get concerned. I don't think the lower bookings this quarter was anything to do with the macros, but it could also -- I mean, some of it could be due to us being a little bit more selective in some of the opportunities, but nothing on the macro, which kind of eroded some deal bookings this year -- this quarter.

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Parag Gupta, Morgan Stanley, Research Division - Executive Director [36]

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Got it. And CVK, just to clarify on that. When you say you're being more selective, is that largely from a margin perspective or are there other considerations as well?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [37]

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Certainly margins is, of course, that's the consideration. I mean, of course, we obviously look at the -- we have a client profiling and all of that, but in a great customer, if we're not able to see the right margins with all the levers that we have, then obviously we are being selective there.

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Operator [38]

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The next question is from the line of Ashwin Mehta from IDFC.

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Ashwin Mehta, Nomura Securities Co. Ltd., Research Division - Former Regional Head of Software & Services Research [39]

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Congrats on good growth. I had 2 questions. One was on margins. So Prateek, just wanted to check what was the nature of the one-off in ERS costs in this quarter. And secondly, you had indicated earlier, there will be a $30 million investment on the IP deals this year. So is it -- has it significantly come through in this quarter? Or there will be a flow-through in the subsequent quarters?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [40]

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Yes, we will -- we have GH Rao, who's President of our Engineering business. I think he can provide a little more details on the dynamics in the ERS business.

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Gade Hanumantha Rao, HCL Technologies Limited - President of Engineering and R&D Services [41]

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So yes, we had 2 aspects of margin in the quarter, one is a one-off as you pointed out. That is -- this was a large revenue write-off in this quarter. Second is, we had one -- several programs. To start with, they are more on-site centric. And over a period of time, we expect them to transit to offshore. Some of the programs start with on-site and move offshore, but if you take some of the high technology areas, you may have to service the customers and operate continuous period of time in on-site. And also, we have our own portfolio of products within the ERS and the yield has been lower in this quarter compared to the earlier quarters. So that also has contributed to lesser margins. And we are also investing for future growth in areas like 5G or Industry 4.0, which have also contributed towards lower margins.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [42]

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Maybe Prateek, you want to...

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Prateek Aggarwal, HCL Technologies Limited - CFO [43]

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The second question you had, Ashwin, was on the hedging cost, which I had mentioned in the previous call. That is already flowing in as we speak. This quarter was about $6 million to $7 million odd, I'm just speaking from memory. And that will play out like I had -- we can't give you an exact sort of guidance on it quarter-on-quarter for the simple reason it depends on how the exchange rates play out.

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Ashwin Mehta, Nomura Securities Co. Ltd., Research Division - Former Regional Head of Software & Services Research [44]

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And my second question was in terms of the IBM IP deal, now that we've signed it and we have more clarity, what's the kind of EBIT margins that we would make on that deal? We had earlier indicated that it will be a little lower in the first year and then improve in the second year. But now that we have more clarity in terms of how monetization will work, what is the kind of EBIT margins we will make on that thing?

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Prateek Aggarwal, HCL Technologies Limited - CFO [45]

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So Ashwin, like I mentioned earlier, the EBITDA is going to be 50%-plus, and the amortization is of the order of about 20%, it changes on a year-on-year basis. So in net terms, EBIT terms, it would be something which is around 30% on the incremental revenue that we are talking.

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Operator [46]

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The next question is from the line of Nitin Padmanabhan from Investec.

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Nitin Padmanabhan, Investec Bank plc, Research Division - Analyst [47]

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Just wanted your thoughts on the Actian product, primarily because I think in the Hadoop ecosystem, we have been seeing a lot of markdowns and write-downs across the ecosystem. So just wanted your thoughts on how that's doing at this point.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [48]

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KK, are you on the call? Can you just take that question?

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B. Kalyan Kumar, HCL Technologies Limited - Corporate VP & CTO of IT services [49]

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Yes, Vijay. So I think -- see, Actian typically does not operate on the Hadoop ecosystem. They are a high-speed in-line analytics, and -- they basically have 3 products. They have a super fast, really fast in line analytics engine, which can handle like vector processing. So they use Hadoop as a file system feeder, so they -- whether they could run on-prem Hadoop, they could run their own file system or they could run off any cloud-based object file storage. That's what their Avalanche product does. And they have a data integration platform which works in the hybrid landscape, both cloud and on-prem. And then third, they have Edge-embedded analytics and embedded databases object as well as NoSQL. So they are pretty much immune from the Hadoop ecosystem perspective. So it doesn't have any material impact on what they are currently trying to do.

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Nitin Padmanabhan, Investec Bank plc, Research Division - Analyst [50]

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Sure. And just one last one was, with respect to the ERS sort of margin drop that you saw this quarter, how much of that do you think can be recouped in a quarter or so? Or do you think that will be spread over the remainder of the year?

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Gade Hanumantha Rao, HCL Technologies Limited - President of Engineering and R&D Services [51]

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Yes. I think we will start seeing some weakness in next quarter itself. However, I think it should take a while for us to recoup most of it. But nevertheless, there are some permanent past headwinds, which are there, which probably will have more non-perm impact -- or more permanent impact, which we are trying to find alternative means to rebook. So in a nutshell, you'd see improvement in next quarter itself.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [52]

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Yes. Just to kind of add a little bit more. I think the cost aspect that GH talked about pertains to getting some higher end skills onshore, which is very unique skills from our engineering portfolio, especially around 5G and some of the new ones that we are doing. And there are some cost increases, and we have a structured plan on how to address it. But it's not an immediate solution. It is going to take some time. So there would be some improvement in margins in the next quarter and subsequent quarters, but it would not come back to this whatever average margins from the business for a few quarters. So there is some real heavy lifting to be done to get it to the historic margin levels here.

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Operator [53]

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The next question is from the line of Ravi Menon from Elara Securities.

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Ravi Menon, Elara Securities (India) Private Limited, Research Division - VP of IT Services & Internet and Analyst [54]

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CVK, the Mode 1 EBIT margins have been surprisingly low at 17.8%. So the cost of those IBM products, obviously, that should have come under Mode-3. So what's really impacted the margins in Mode-1. I know there is a large deal for managed services -- or the shared services program that was signed in March, but that alone should not have really dragged this down so much, right? So what else has been the headwind?

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C. VijayaKumar, HCL Technologies Limited - President & CEO [55]

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I think a lot of ERS businesses also gets classified under Mode 1. And as GH just highlighted, the drop in margins in ERS would also reflect in Mode 1. And of course, we had a large deal, but I don't think it has, I mean, diluted in any meaningful manner, the large deal, maybe marginally. But definitely, for a size of the deal, we -- I think it was like -- it didn't really create a big impact on Mode 1. It's largely around ERS. I think if you do the math, -- anyway, you have ERS segmental profitability and the other business segment profitability. You should be able to see how Mode 1 has come down.

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Operator [56]

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Thank you. Ladies and gentlemen, this was the last question for today. I now hand the conference over to Mr. C. VijayaKumar, President and CEO of HCL Technologies Limited, for closing comments. Over to you, sir.

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C. VijayaKumar, HCL Technologies Limited - President & CEO [57]

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Thank you, everyone, for joining this call. We -- in closing, I mean, we remain very positive about what we can accomplish. I want to close this call with 2 forward-looking comments. One is, we are very committed to deliver an industry-leading organic growth. And as we said in the last quarter, we're all excited in chasing a $10 billion target, and Team HCL is really going after the aspiration of hitting $10 billion and deliver a margin within the guided range.

So thank you for joining us, and look forward to meeting you either during meetings in between or during the next quarterly results. Thank you, and have a good day, and good evening.

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Operator [58]

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Thank you very much, members of the management. 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.