India’s software services industry has suffered a major blow ever since the rupee appreciated sharply against the dollar in recent months. In financial year 2006-07, the average dollar rate on business booked by Infosys stood at Rs45.06. Currently, the rupee is 10% lower, at Rs40.5. Each percentage drop in the rupee is known to hit operating margins of software companies by 35 basis points. If this relationship holds, and the rupee continues at current levels, margins on current business could be as much as 350 basis points lower compared with the previous year. Not surprisingly, IT stocks have underperformed the market (see chart).
The big question now is whether the stocks of IT services companies have corrected sufficiently to reflect the gain in the rupee. The IT analysts’ community is largely of the view that the high degree of underperformance is not justifiable since the impact of the rupee can be offset by cost-cutting measures. To be sure, the Infosys management had mentioned in their earnings call that the impact of the rupee and rising wage costs could be offset by increasing employee utilization, and better management of SG&A (selling, general and administration) expenses as well as the costs incurred in subsidiaries, some of which are expected to break even this year. But when they said this, the rupee rate assumed was 4.4% lower than last year’s average. Since then, the rupee has fallen by another 6%.
But while IT stocks have underperformed the broad market, it’s interesting to note that in absolute terms, they’ve hardly fallen. NSE’s CNX IT index has remained steady at the 5,230-levels since end-March, when the rupee began its sharp rally. Some stocks such as Infosys and Wipro have fallen, but only by about 5-6%. TCS has dropped by less than 3%, and Satyam has risen by more than 6%. (Satyam’s guidance assumes a dollar rate of Rs42.3 versus Infy’s Rs43.1.)
Based on this data, it actually looks as if the markets are rather optimistic about software companies’ ability to protect their margins. The last time the rupee’s appreciation was a big issue was in 2003-04, when it went up by 7.4% against the dollar. That year, Infosys’ earnings per share rose 29.5%. But this time the rupee’s appreciation has been sharper, the base is much bigger and new concerns such as attrition and wage hikes have also made their appearance.
Still, what could work in the industry’s favour is that volume growth is very strong. Morgan Stanley noted in a recent report that volume growth of the four largest software companies stood at 35% last fiscal. High volume growth abets higher pricing, which would help cut margin losses. Besides, analysts are also optimistic about opportunities for cost savings. Then, of course, there would be gains to be made on derivatives contracts used for hedging forex risk. But it’s important to note here that this should be seen only as temporary comfort. Once the derivatives contracts come up for renewal, they would be booked at prevailing rates. In fact, if the rupee remains at current levels in the medium t- long term, the industry would be operating at lower levels of profitability. That concern is hardly factored into IT stock prices currently.
The acid test, nevertheless, would be a little over a month from now when IT companies report June quarter results. By then, it would be clear if volume growth and cost-cutting triumphs over the industry’s old foes— rupee appreciation and wage inflation.
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