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IT: Forex is a big determinant

Feb 19, 2010

Indian IT industry has been a poster boy for Indian economic growth in the last decade. Our homegrown IT mega-vendors are servicing clients in every nook and corner of the world. The industry has witnessed stellar growth rates. In particular, the Big-3 of Indian IT industry i.e. TCS, Infosys and Wipro have grown at a cumulative rate of over 30% over the past 5 years. They even dealt with the financial crisis and global meltdown in style. However what continues to plague Indian IT is the vast fluctuation in currency rates. Let us show how.

The graph depicts the fluctuation in the operating margins of the top 3 IT companies in India during the last five years. What's more intriguing is the rollercoaster swing in the value of rupee against the US dollar in the aforementioned period.

The graph shows that other things remaining the same, the operating margins of software companies fluctuate significantly with the movement of US dollar. The reason is not hard to decipher. Indian IT companies mainly export their software services and products, mainly to the developed nations in the west. The US which is the major market accounts for over half of the revenues generated by the Indian IT industry. About 90% of the receivables of these companies are in US dollars, i.e. their clients pay them in dollars. However, most of the employees and other assets of the companies are based in India. So their expenses are majorly in Indian currency. Here the cross currency movement comes into play. To explain in simpler terms, let's consider an example of an IT company working on a project employing 1 person. Suppose the client is paying US$ 1 per person month for this project and the company is paying Rs 20 per month for this employee. Hypothetically there is no other expense. When the exchange rate is at Rs 50 for a US dollar, the company earns operating profit of Rs 30. When the rupee appreciates to say at Rs 40, the company's operating profits decline by 33% to Rs 20. A big slip to deal with, isn't it?

We accept that a minor fluctuation in the currency is a normal course of business for any exporter round the world. However, the period of FY07 and FY08 was one of financial reckoning for the Indian IT. The rupee inaugurated 2007 at around Rs 44 to a dollar and went uphill. Nearly no one ever expected it to jump 11% in a year to reach Rs 39 for a dollar as 2007 drew to a close. As a result the 'Big-3' of Indian IT industry wriggled in pain at operating and net profits level. They saw a significant dip in their operating margins. The year of early 2009 when the global recession began to show signs, the companies saw a decline in demand for their products. This made financial honchos of the big IT all the more worried.

As an attempt to de-risk their profits from such vast fluctuations in different currencies, the IT companies like other exporters hedge their cash-flows. In simpler terms they lock-in the exchange rate for their receivables in order to have a better visibility of revenues and profits. After seeing the wide fluctuation of 2007, the companies took huge forex covers for their long-term cash flows at a range of Rs 39 to Rs 41 for a dollar. To their utter dismay, it turned out that dollar appreciated to Rs 47-48 in a matter of few quarters. Companies again suffered. This time on account of their long and huge hedge positions. They reported huge foreign exchange losses on their books.

However, in this article we will not deal with the complex accounting of these forex hedges. Nevertheless, we would like to highlight that Indian IT has come a long way in dealing with the currency volatility. Other things like operating performance, employee utilization and other cost management remaining same, it appears that Infosys has better managed its hedges as compared to its peers in the near past. One reason can be its different hedging policy. While most of the IT players hedge their future cash flows for a year or so, Infosys restricts its hedges to two quarters. This allows it to manage currency fluctuations more dynamically.

To conclude, we reiterate that a volatile currency can play a big part in operating margins of IT companies. While in good times it can bring cheers, in others it can act a spoilsport. Also, one cannot bet on the best way to hedge. However, we suggest investors to always factor in this uncertainty about the rupee fluctuations while investing in IT companies. For that matter any export dependent company.


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