How long will investors ignore currency gains for IT companies?

The rupee has depreciated 25% in the last ten months. All other factors remaining the same, every 1% fall in the rupee typically leads to a 40-50 basis points improvement in the operating margin of software companies. For a firm that operates on a 25% profit margin, this should result in a 40-50% jump in profit.

Even so, software stocks haven’t risen during this period. Instead, the CNX IT index has dropped 5.7% since last August, doing only slightly better than the Nifty, which fell 8.5%. Apart from Tata Consultancy Services Ltd, the shares of most large IT companies have either declined or remained flat during the period. The chart alongside shows that while the rupee continued to weaken from around 49/dollar in early February to 55/dollar currently, the CNX IT index also declined. What gives?

To start with, investors are increasingly wary about the demand prospects for Indian IT companies. Cognizant Technology Solutions Corp.’s announcement last month that it is revising its 2012 guidance downward by nearly $200 million reignited worries that demand is weakening at a faster pace compared to what most analysts had predicted.

Additionally, for various reasons, the gains from the rupee depreciation aren’t entirely expected to flow into companies’ bottomlines. Some companies are expected to use a large part of the gains to invest for future growth. Clearly, for such companies, the rupee depreciation is a blessing in disguise, thanks to which they can invest heavily even in a weak demand environment.

Lastly, some investors are reluctant to value Indian IT stocks based on the current dollar-rupee rate, citing that the weakness of the domestic currency may not persist. But most economists now agree that the weakness in the rupee will not disappear in a hurry. According to a recent report by Deutsche Bank, “We think that the currency can snap back as oil prices ease, but we also see the economy dealing with a substantially weaker exchange rate relative to the recent past. Our forecasts suggest that the currency will be, on average, 10% weaker in FY12/13 than the previous year.”

About a month from now, Infosys Ltd will revise its guidance for the year ended March 2012. While it may or may not change its revenue estimates, it is certain to upgrade its earnings estimate materially if the rupee stays where it is currently. This may force investors to rethink the case for Indian IT stocks, especially at a time when few other sectors and companies stand out from an earnings growth and valuation perspective. True, the outlook on demand is still uncertain, but the impact of the rupee depreciation on earnings as well as investment plans of companies can’t be ignored either.