Rupee appreciation: Can Infosys do a Toyota? - Views on News from Equitymaster

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Rupee appreciation: Can Infosys do a Toyota?

Nov 23, 2007

Over the past 12 months, the appreciation of the Indian rupee against the US dollar has emerged as the biggest villain for the export driven technology sector. What was termed as an industry risk a few years back has now emerged as company specific risk for most of the IT services companies. But why this appreciation in rupee is such a big scare of the tech sector? What happens when rupee appreciates?
Indian IT companies prepare their financial statements in rupee terms as well as US dollar terms. When dollar earnings are converted into rupees, the currency comes into play. As the rupee begins to appreciate against the US dollar, while the dollar earnings will not be affected, the rupee earnings will be affected. How? IT companies earn their revenues in US dollars but most of their costs are in Indian rupees. So when they are converting their topline from dollar to rupees they are using a lower currency base for conversion. So the topline in rupee terms is the first thing to get affected.

Second thing to get affected is the operating margin. While revenues in rupee terms decline due to a lower conversion factor, the fact that there is no change in rupee costs leads to the compression in operating margins. Further, rising wage costs (12% to 15% per annum), are also putting pressure on these companies’ profitability.

While the companies are resorting to aggressive hedging policies, one thing that has to be kept in mind is – when a company is buying options or futures to hedge against currency appreciation, it will definitely protect it to some extent against the appreciation but the company will also have to bear the costs of hedging.

Lastly, due to decline in operating margins, the impact is also seen on the net profitability, which ultimately impacts the growth in earnings per share (EPS). Since the EPS growth is lower than before the, markets tend to de-rate the valuation bands of these companies as a lower growth shall entail a lower band. This can be seen in case of all IT companies. For example, where Infosys has guided for 34% to 35% YoY topline growth for FY08 in dollar terms, it has only guided for 20% to 22% growth in rupee terms. Since there are concerns about the pace of growth going forward as well, the stock, which was available at trailing 12 months band of 28 to 30 times, is now available at a band of 20 to 22 times.

Are there any lessons from the past?
An almost similar situation was faced by Japanese auto major Toyota in the late 1970s and 1980s when the Japanese Yen began its long appreciated - from 325 yen to a US dollar to 80 yen to a US dollar (by 1999). Even in such a scenario, Toyota, over the past 25 years has managed to not only to maintain its market share but also increase the same to become the world’s second largest carmaker.

How did Toyota achieve this?
The crude oil prices jumped four times in 1973, and this was followed by a subsequent price increases in 1979-80. As a result of this, the US consumers switched their demand away from the gas-based motorcars to more energy efficient imported cars, especially those made in Japan. Competition from overseas market led to a contraction of the US auto industry, and the workforce employed in vehicle assembly by the Big Three (General Motors, Ford and Chrysler) contracted. During this time, the Japanese yen also started appreciating. However, Japanese manufacturers (Toyota, Honda and Nissan) overcame the yen appreciation and the voluntary export restraints (VER) by setting up assembly plants known as ‘transplants’ within North America, and by designing bigger luxury cars.

In case of Toyota, what it did was that for product lines where they made the highest margins – ‘Lexus’ – they continued production in Japan. However, for lower-priced models where their profit margins were lower and would have been eroded further by the rising yen, they moved production to the US. They protected their margins on non-premium products by moving production and therefore shifting costs into dollar-denominated areas.

The factors that were attributed to this growth of the Japanese automobile industry were:

  • Small size cars,
  • Adoption of American mass production principle, and

  • Cheap labour utilised.

Against this general perception, American mass production principle is not what Toyota practiced to grow its business. Rather, the company grew because it focused more on:

  • More decentralised authority with greater cross communication across functional boundaries,

  • More multi-skilled workers and general purpose machines for flexible production, and

  • Keeping small buffer stock so that they can respond quickly to demand fluctuation.

So this is how Toyota and other Japanese auto majors countered the massive yen appreciation against the US dollar.

Can Infosys achieve this?
Now, the billion-dollar question is whether the Indian IT companies will be able to do a Toyota? Seems difficult but definitely possible. But one thing that should be borne in mind is that although both the industries (auto and IT services) in question are completely different in nature, the outcome can be quite similar. The major difference between the two is the presence of operating leverage in the auto industry and the absence of it in the IT services industry. And this could be perhaps the biggest problem for the latter to replicate what the Japanese automakers like Toyota achieved.

We firmly believe that Indian IT companies that have mainly focused on cost arbitrage for their success till date should take a similar approach in the current situation. All they need is to consider how to adapt their business models to the changing landscape. One major challenge will be to develop other sources of competitive advantage, such as building high-level capabilities, which cannot easily be replicated by competitors. Another thing, which they can do, is to change the mix of activities carried out in India versus other countries. Thirdly, they will need to analyse their costs and move delivery capabilities to more economic zone.

Reference: Oxford University research paper

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