Re appreciation to dent IT firms' Q1 results

The first quarter of the financial year 2007-08 for the Indian information technology (IT) sector will be a rather disappointing one but the long-term growth story remains intact.

All the software majors are expected to post a decline in margins during this quarter. Infosys Technologies had estimated a margin drop of up to 50-60 basis points, assuming the rupee was at Rs 43.1 to a dollar.

Satyam's guidance talked about flat margins based on Rs 42.3 to a dollar, while TCS indicated flat year-on-year margins, with the rupee at Rs 43.5 to a dollar.

The rupee appreciation, however, has exceeded the projections by around 4.2 per cent in case of Infosys, 5.05 per cent for TCS and 2.40 per cent for Satyam.

Every one-rupee appreciation, say analysts, knocks off 35-40 basis points (bps) from the operating margins and 1.6 per cent from the earnings of software majors. With the dollar currently quoting at Rs 41, CLSA has projected a decline of 150-230 bps in operating margins in the first quarter of FY08.

Citigroup analysts expect rupee appreciation, wage inflation and visa costs (for some companies) to result in a sharp decline in margins, by around 350-400 bps. The first quarter numbers are based on Rs 41 to the dollar assumption. The rupee has appreciated by 4-6 per cent after the FY08 guidance were issued by Infosys and Satyam.

The rupee appreciation of 5.4 per cent since the start of the fiscal year, according to Merrill Lynch analysts, would be negative for overall earnings (a 5 per cent appreciation in the rupee hits earnings by around 330 bps). Given that the exports are priced in foreign currency, the software exports (currently totalling $31.4 billion, according to Nasscom) stands to be a big loser, especially since around 60 per cent of their business still comes from the US.

Besides, while the rupee may weaken against the dollar over the next few months, the average rupee in FY08 is expected to be stronger than what most analysts have estimated, leading to pressure on the earnings of IT firms.

Moreover, IT firms face issues such as wage inflation (since both the onsite and offshore salaries have been hiked by 3-5 per cent and 10-15 per cent, respectively), growing competition from global IT systems integrators such as Accenture, IBM and EDS, which affects margins, and increasing visa costs (for some companies).

The positive signs are that IT firms, especially the larger ones, have increased their hedging. Tata Consultancy Services (TCS) has increased its forex cover across vendors by $1,500 million, Infosys Technologies upped it by $1,000 million, HCL Technologies to $900 million and Wipro and Satyam Computer by $600 million each. The increase in forex covers would help the companies to arrest the decline in margins in case the rupee appreciates further.

Going forward, analysts also expect strong volume growth to lead to steady earnings increase. The financial year 2006-07 was good for the information technology and business process outsourcing (IT, ITeS/BPO) sectors. Riding atop a booming economy and bullish IT outsourcing environment, the sector is well on its way to touch the $60 billion mark by 2010.

Moreover, companies (including mid and small-caps) have effected increases in their existing and old billings, shifted more work offshore, hired more freshers (thus reducing wage costs) and expanded to geographies other than the US (the UK, Canada, Latin American countries and China). Effectively, the global delivery model will help them stave off competition.

Citigroup analysts advise investors to look beyond the first quarter while making investment decisions.

"The risk-reward scene is favourable. With an approximately 15 per cent underperformance against the BSE Sensex, we believe that currency-related negatives are largely priced in. Business momentum continues to be strong with the pricing on an uptrend, and reasonable valuations provide a good entry point for long-term investors."