Rising rupee may hit IT sector: Phaneesh

Phaneesh Murthy, chief executive officer, iGate Solutions believes that the real impact of the rising rupee is likely to be felt by Q3 FY08. Ashwin Mehta, IT Analyst of Ambit Capital states that the rupee impact could see billing rates go up by 4-5 per cent in the second half of the year.

Murthy does not see a dramatic decrease in OPM (operating profit margin) due to rupee appreciation. He added that a change in other variables would help in relaxing the effects of rupee appreciation.

According to Mehta, a 5-8 per cent correction in IT stocks is possible at current rupee exchange rates. They see a 150-220 bps correction in margins of IT companies.

Excerpts from CNBC-TV18's exclusive interview with Phaneesh Murthy and Ashwin Mehta: 
 
In view of the badgering of IT stocks, would you say that if the dollar were to hold at Rs 40 or Rs 40.50, most of the bad news will be discounted?

Mehta: In terms of the correction, most of these stocks or the top-run counters have corrected by almost 15-20 per cent. We see a possible correction of 5-8 per cent, if the rupee stays at the current levels.

Infosys increased their forex hedge to about $1 billion from about $470 million. The rupee has appreciated to about 8.5 per cent. What are you factoring in, in terms of margins, for the largecap companies like Infosys, Wipro and Satyam and for some of the midcap IT companies, like iGate?

Mehta: If the rupee stays at current levels, you will see a margin decline of almost 150-220 bps, depending upon the company. But what is very discerning is that in terms of the British pound and euro, which have on the closing rates depreciated by almost 5.7-6 per cent. So, all the stock of diversification of revenues would have a marginal impact on an average basis but on a closing price basis, the diversification would have only a marginal improvement.

How do you tackle this issue at iGate? Would it mean more hedges and are you covered for the first quarter? Do you think the real hit will start from the second quarter onwards where people are perhaps completely unhedged?

Murthy: Certainly, in our estimates, the real impact will start happening from third quarter or the second half of the financial year. This is because most of the companies would have hedged for the first six months and would have covered themselves for that period of time. So, the bigger impact will be on the second half of the year.

This is an evolving system and all other parts of the business do not stay exactly the same just because this has happened. So, presumably you will start figuring out how to get more efficient. Presumably, your customers will support us saying that they understand that the dollar and the rupee parity has changed. Therefore, there will be some negotiations back and forth and they will end up picking up some of the tap for this and so on. So,I think a lot of factors will start changing.

If you look at the history of the IT industry, you will find that this is exactly what has happened. When something happens, all other parts of the system change to accommodate that and when something else happens, the other parts of the industry accommodate it.       

Specifically, with regards to hedges and the way the rupee is moving, will it call for companies like yourself to actually increase the amount of hedging that you have in the second half of the year? Consequently, what sort of a margin impact and even a billing rate impact will the rise of the rupee have on your company, which has already gone up by about 7-8 per cent in this current quarter? 

Murthy: I think we have a hedging policy where we actually hedge more than 80 per cent of our net inflows. So, we are anyway more conservative and this was based on some advice that we had received. We have been doing this for the last year and a half.

It may go up from that number marginally but that is what we are currently using as our hedging policy. If there is no other change in the business, there will be a fairly dramatic margin impact on all IT companies. The fact is that most IT companies have 60 per cent plus exposure or 50 per cent plus exposure to the US dollar. So, to that extent there will be a fairly significant impact, both in the topline converted to rupees and a bottomline impact because of that.

The numbers suggest that for every one per cent change in the rupee, the margin impact is about 30 bps. Now we are looking at a 10 per cent appreciation of the rupee or thereabouts. You are saying that efficiencies will lead to that margin compression being reduced. If you just take this thumb rule of one per cent, then the margins could dip by as much as four per cent points. What is your best guess that efficiencies can reduce this to?

Murthy: There are two things - one is efficiency and the second is positive bill rates. It would be very surprising for me because from our own experience we find that customers do tend to support you at this time. If this is a long-term impact, they will look at it and then figure out how to extract productivity out of the system, but they will tend to support.

So, I think that overall between the customer support, the productivity increase based on other factors and the growth that everybody gets, there may not be any increase in margins in the IT companies. However, I do not see a dramatic reduction in margins of IT companies.

Could you tell us what are you currently hedged at and what does it translate in total amount of hedging in dollar million? What sort of an impact would it have on margins directly, if you could give it to us in terms of basis points for this particular quarter?

Murthy: I do not have the figures for this particular quarter. But we were able to do our March hedging at Rs 44; in April it was at Rs 42.1 and it looks like the May one will be probably at south of Rs 41.

Will this actually have an impact on the billing rates for the current quarter as well?
 
Murthy: Yes, the revenues will go down in rupees, but I do not think we will get any changes in the billing rates for this quarter. That will come progressively.

In terms of the kind of stocks you track, where do you see the most impact? Would you say that the big four or the big five would be slightly better placed to tackle this kind of an eventuality? Would that change the kind of recommendations you are making?

Mehta: I can talk about who will be hurt less. Everybody would get hurt but there are people who have higher percentage of hedging. Companies like HCL Tech would be hit lesser as they have almost 71% of their last year revenues hedged.

There are companies, which have done FCCBs and have used those funds. They would get the benefit of translation gains and there are companies, which have a higher onsite content, which would benefit more.

In terms of FCCBs, I think 3i-Infotech would possibly be less impacted. In terms of higher onsite content, it would be companies like Prithvi, as almost 90 pper cent of its revenues are onsite.

In light of what you have just heard from Mr Murthy, would it give you enough reason, on the margin compression basis to actually rework some of the stocks? Would the analysts' talk of the rupee going to 38-38.50 levels call for a significant re-rating of any of the stocks that you track?

Mehta: Our analysis shows that if the rupee goes to the current prices factor in the target multiples that people have given, up to 38 levels, you have a buffer zone. This is in terms of the fact that if rupee is above 38, you have an upside, though reduced on the larger stocks. 

You said that you are all hedged up to almost 80%. Would that be for the first half of the year?
 
Murthy: Yes, it is for the first half of the year. 
 
Do you think that you will be able to re-negotiate your billing rates for the second half itself?
 
Murthy: Yes, I think so. This is the time when people are seeing the projections that it may go down to 38, 39, 40 and we are finding that there is enough interest in the customers to negotiate it now and fix it for a year or two, rather than wait for some more dramatic changes before they are negotiating it.

How much would that billing rate re-negotiation be in percentage terms?
 
Murthy: This is not a billing rate re-negotiation for a change in margins. Effectively, what will happen is that if you look at cost versus dollar parity, you can get maybe 4-5 per cent change in the billing rates.

Going by what Mr Phaneesh Murthy has said that they will be able to manage cost efficiencies and in terms of billing as well, would you say that you would be re-looking or re-calculating any of your earnings forecast?

Mehta: In my view, because you have got the benefit of rupee depreciating in the first half, it would be slightly difficult to renegotiate based on the rupee appreciation right now. It would come with a lag of course.

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