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Software companies: Sensitive to the currency!

Sep 28, 2006

The Indian software industry is an export-oriented sector, where a lion's share of the revenues comes from exports. In fact, for companies like Infosys, India accounts for just 1.5% of the total revenues. One factor common to all the 'Top-4' software companies is the fact that all of them earn most of their revenues from the US. Of course, the proportion varies from company to company, but overall, the importance of the US in these companies' future growth plans cannot be underestimated. Consequently, these companies earn a majority of their billings in US dollars, and as a result, are subject to the vagaries of exchange fluctuations of the Indian rupee. In this write-up, we briefly analyse the impact of the movement of the Indian rupee vis--vis the US dollar on the sales and EBITDA margins of Indian top-tier software majors.

The undeniable impact

Sales
It cannot be denied that the rupee movement against the dollar does have an impact on these companies' realisations in rupee terms and thus, on their sales growth. A simple example would be Infosys in FY06, the latest fiscal. The company recorded a 33.5% YoY growth in its topline in rupee terms. The rupee rate used for conversion was Rs 44.22 to the dollar, 1.3% lower than the figure used in FY05 (Rs 44.80). In FY06, billing rates were largely stagnant, with onsite rates falling by a marginal 0.1% and offshore rates increasing by 0.4%. Consequently, the growth in dollar terms was higher, at 35.3% YoY, and it was very clear that volumes were the only real reason for the 33%+ growth seen in Infosys' topline (onsite volumes grew at 38.8% YoY, while offshore volumes grew at 31.6% YoY).

Infosys in FY06: Core volumes enthuse!
(%, YoY) FY06
Onsite volume growth 38.8
Offshore volume growth 31.6
Onsite billing rates (0.1)
Offshore billing rates 0.4
Sales growth (US$) 35.3
Rupee (appreciation)/depreciation (1.3)
Sales growth (INR) 33.5

Now, we believe that if volume growth is the primary cause (or only) for revenue growth in any quarter or fiscal, it is a positive sign for the company, since this is the core growth that can be sustained in future. Currency fluctuations are regular, and one year, exchange rates may be favourable, while in other years, they may not be so favourable. Billing rates, on the other hand, are unlikely to witness a sustained up-tick, given the relatively higher bargaining power of the customers, who generally use multiple vendors (think GE, BT, Nortel) and competitive pressures. Thus, the topline growth of Infosys in FY06 is indeed commendable, when we consider the flat trend seen in billing rates, and the unfavourable currency movements seen in that fiscal.

EBITDA margins
As we have seen above, the impact of the rupee movements against the dollar does have an effect on the sales growth in rupee terms. We have taken an unfavourable year (FY06) in terms of currency movements to prove our point. If we take FY03 as an example, the sales growth rerecorded by Infosys was 39.8% YoY. The rupee rate was higher by 1.2% for the fiscal (Rs 48.35 to the dollar, against Rs 47.77 in FY02). Adjusted for this, the sales growth would have been 38.1% YoY.

This, therefore, also has an impact on the company's EBITDA margins. If we take FY06 again as an example, Infosys' operating margins stood at 32.5%. If the realised rupee rate was to be kept constant at FY05 levels (instead of the actual 1.3% appreciation witnessed), the EBITDA margins increase to 33.3%, an increase of 80 basis points. Therefore, it is clear that the impact of currency movements (either appreciation or depreciation) can be significant on the EBITDA margins. For Infosys, a 1% movement of the rupee either way against the dollar typically impacts EBITDA margins by around 25 to 30 basis points.

The 'HR factor'
It should be noted that the rupee movement is not the only factor that impacts EBITDA margins of a software company. In fact, the biggest cost item, in our view, which determines margins, is undoubtedly the employee cost. The software industry is a people-oriented business, where employees are the 'raw material' for any company. Thus, employee costs form the biggest chunk of the total operating expenditure for any software company, accounting for around 70% to 75% of total operating costs. Thus, any significant movement in this item is bound to impact margins as well, and in probably a more significant manner than currency movements. It must be noted that in the graph below, the primary reason for the fall in margins of companies like Infosys and TCS is the increasing proportion of employee costs to sales.

* As per US GAAP
** EBIT margins of the Global IT services business

Billing rates too!
Apart from the above factors, billing rates also play their role in shoring up the topline of the company. This is a factor of the business mix (a higher proportion of higher-end services like package implementation in sales increases average billing rates), bargaining power of customers (typically higher, due to the fact that they generally have multiple vendors) and competition. Thus, we believe that over the longer-term, billing rates are unlikely to trend significantly upwards with any sort of regularity. Competitive pressures and the relatively low bargaining power of suppliers (vendors) are likely to keep rates in check. These can be shored up by consistent initiatives on the part of the vendors to do a greater proportion of higher-end work for their clients, like consulting.

Conclusion
While the movement of the currencies is undoubtedly an important factor to keep an eye on for software companies, it must not be viewed in isolation. The demand environment, volume growth, billing rates and cost-side pressures are other major factors to watch out for in order to understand future trends in margins for the software sector. In any case, all the major software companies do adopt hedging mechanisms in order to mitigate any potential impact of adverse currency movements on their topline and margins. We remain positive on the sector from a long-term perspective.


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