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Strong rupee adds to IT firms' woes

Gaurav Dua

After growing relentlessly for quite some years, it's been a tough last few quarters for domestic software services companies.

It all began with the marked slowdown in the global economy which not only led to a big squeeze in demand for software services but the near-recession like situation also resulted in pricing pressure.

Customers turned more conscious about maximising the value from their investments in building the ifotech infrastructure.

This apart, the massive price undercutting by mid-sized players to stay afloat by building on volumes have considerably impacted margins of software firms.

If this wasn't enough, the recent trend of US dollar depreciating against every major currency, even the rupee, has come as an unexpected blow to the services companies. And understandably so, as bulk of their revenues is in US dollars.

Ironically, the software services companies are one of the important reasons for the strong rupee today.

India, after a gap of 25 years, has shown a current account surplus last fiscal, that is, the economy has earned more dollars than it spends, and a big chunk of it is contributed by dollar income of software companies.

That's not all. Economists warn that if the software sector actually grows in line with the Nasscom's projection of $80 billion of software and IT-enabled services exports by 2008, the rupee will simply zoom up due to the huge current account surplus.

The Reserve Bank of India is already doing its level best to prevent the rise of the rupee. It has been buying dollars and consequently further bolstering its foreign exchange reserves.

But economist believe their is a limit to this, since holding large forex reserves imposes costs on the economy. So eventually RBI will have no option but to let rupee appreciate against the dollar.

Sound logic, indeed. But such a possibility, even if it does happen at all, is quite a few years down the line. But let us look at the immediate impact of the 0.9 per cent appreciation of rupee in the last quarter alone.

The negative impact is clearly visible in the quarterly results already been announced by tech companies.

For instance, Infosys' management admitted that the dollar depreciation resulted in a gross negative impact of Rs 3.64 crore (Rs 36.4 million) against the handsome forex gains of Rs 6.5 crore (Rs 65 million)reported in the first quarter of this fiscal.

Gauging the impact: The foreign exchange variations impact both the operating revenues as well as non-operating 'other income'. In case of operating revenues, there are three main factors that influence the extent of impact at the gross level.

First, the percentage of total revenues denominated in US dollar. On an average, the top ten domestic software companies have 85-90 per cent of their contracts in US dollars.

So logically company's with higher dollar income will have greater impact.

Second, the impact will depend upon the onsite-offshore business mix of the company. That's because companies with higher proportion of onsite business has much larger proportion of cost in dollar.

Thus, the rupee appreciation actually has a positive impact in terms of lower cost base for the company.

Among the leading domestic players, Digital GlobalSoft stands to benefit as its onsite business contributes to around 67 per cent of the total turnover as compared to an average of about 50 percent for the other companies.

This apart, a leading foreign brokerage house made an interesting observation that the impact is lower if the EBITDA (earnings before interest, tax, depreciation and amortisation) margins are higher.

As per the sensitivity analysis carried out by the brokerage house, a one per cent appreciation of rupee could depress the EBITDA margins by as much as 1.3-1.8 per cent depending upon the existing margins.

The case in point is the Wipro's recently announced second quarter results. The management claims that the 140 basis points drop in the operating margins was largely due to the rupee appreciation against the US dollar.

But the good news is that the companies can hedge themselves against the volatility in forex markets by entering forward contracts.

Although this does mitigate the negative impact to quite an extent but it is difficult to ascertain it exactly.

So analysts believe that the companies could mitigate around 30-35 per cent on the negative impact by hedging mechanism.

Non-operating income: Given the bloated cash reserves of most of the leading software companies, the exchange rate volatility can have a significant bearing on the non-operating income.

Especially since many companies has excess cash parked in the US dollar deposits. These deposits need to be re-valued using end-of-period exchange rates and could lead to large fluctuations in other income bookings.

This is booked as translation gains or losses within other income.

Among the top-rung companies, the risk to Satyam's earnings is the highest because over 90 per cent of its cash is parked in US dollar deposits.

Even Infosys with only about 20.3 per cent of cash in foreign currency deposits, it had to make translation adjustment of about Rs 1 crore (Rs 10 million) in the last quarter.

So what's the way out for the domestic software companies? Economists believe the most strongest defence against the strong rupee is globalisation of production, development centres in case of software companies.

Having build the critical mass, the biggies of the domestic software sector could opt to set up development centres in countries in other emerging markets which have cheap labour and much weaker currencies.

That's exactly what the Japanese manufacturing companies did in the 1980s to counter the negative impact of yen appreciating against the dollar.

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