The Indian rupee, IT stocks and the quandary of sell-side research

The rupee has depreciated by 7.5% in the past three months. If anyone has questions on what impact this will have on the profits of IT services companies, the last place they should look is a research report by sell-side research firms. Analysts at these firms are always in a quandary when the rupee is in free fall. For one, regardless of what they say, investors invariably turn bullish on stocks of exporters when the local currency depreciates.

The assumption is that rupee proceeds from projects billed in dollars will be far greater than earlier anticipated. Besides, the fact that a large chunk of these companies’ expenses are in the local currency means that margins can get a sizeable boost. The trouble is that things don’t work out as neatly, past experience has shown.

When IT projects come up for renewal, clients typically consider the fall in the rupee and then renegotiate billing rates with Indian IT service providers. This is one of the reasons gains from the rupee haven’t stayed on the profit and loss statements of the Indian IT industry for long. Despite a weaker rupee, margins have been declining for Indian IT in the past few years.

There may be near-term gains, but unless there is a continued slide in the rupee, gains won’t last beyond a year. Then there are losses on forex hedges to reckon with, which limit the extent of benefit in the near term as well for some companies.

Based on all this, it’s likely that IT earnings will get some boost in the current fiscal year, while in FY20 there may well be a drop in earnings, unless the rupee slides another 8-10% in that period as well. That’s because by that time, gains from the rupee would have been largely handed over to clients during deal renegotiations.

When some zealous analysts try and point this out to investors, the response they typically get is, “We’ll consider that when we come to that bridge.” In this generally upbeat environment, hardly any analyst wants to stick their necks out and state in a research report that the excitement about the rupee depreciation is overdone as far as IT stocks are concerned. Why, they may even lose their jobs, since such a call will lead to massive underperformance.

So expect analysts to shoot estimates of how much an IT company’s profit margins will expand for every one percentage point depreciation in the rupee. On an average, this works out to about a 20-25 basis points boost to margins, they’ll say. As such, the 7.5% fall in the rupee since early June could boost margins by nearly 200 basis points.

And their call has proven right yet again—IT stocks are on fire. The Nifty IT index has risen 20% since early June, and has outperformed the Nifty 500 index by 12.5%. Valuations of popular IT stocks were already well over 20 times forward earnings; they have now surpassed historical averages by a wide margin.

Sure, this may not end very well; but we can all consider that when we come to that bridge.

source: livemint


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