The rupee vs dollar being the most visible parameter, the stock price movement of IT services companies seems to be correlated with this phenomenon.

K. Venkatasubramanian

Ever thought of making the connection between the rupee’s exchange rate against other currencies and the earnings of software and hardware companies?

How do companies protect themselves from erosion in earnings? The exchange rate of a dollar to the rupee is Rs 44.5 now, which has created a buzz around IT stocks.

Most Indian IT services (software) companies derive 50-60 per cent of their revenues from their clients in North America. The billing is done in US dollars.

Throughout 2007, the rupee gained in value vis-a-vis the dollar and from Rs 44 to a dollar fell to Rs 39 levels. This meant that these companies realised Rs 5 less for every dollar converted.

Infosys, for example, has indicated that it lost around Rs 2,000 crore in 2007-08 because of the rupee appreciation, and TCS lost Rs 1,850 crore. The scenario was not too different for other major and minor software companies.

But starting mid-January this year, the rupee has lost ground against the dollar due to greater dollar buying on the back of soaring oil prices. This meant that from a low of Rs 39.02 to the dollar, the exchange rate is now at Rs 44.5.

Of course, there are business reasons and operating parameters that determine the growth and earnings of these companies.

The rupee vs dollar being the most visible parameter, the stock price movement of IT services companies seems to be correlated with this phenomenon.

To protect themselves from exchange rate fluctuations, companies hedge their dollar revenues and peg it at specific levels. The large IT companies hedge about 30-40 per cent of their overall revenues. Plain hedging is understandable.

But at times, the treasury department of software companies and banks tend take exposure to complex derivative products and contracts. Multiple currencies become involved, as a result of which there is volatility. This means that the hedged dollar’s value also fluctuates.

The value of the underlying is, thus, subject to a marked-to-market loss/gain. Some of this may be to gain on currency movements rather than purely hedging purpose.

Once these contracts expire, the actual value of the hedged position becomes known. If there is heavy fluctuation in the underlying, there may be substantial marked-to-market component which can cause blips in quarterly numbers.

Apart from hedging, many IT services companies are also looking to diversify into Europe, West Asia and the Asia-Pacific, largely due to business opportunities that these geographies provide. Additionally, this also provides a currency-diversification strategy.

But mid-tier IT companies hedge a larger part of their revenues when compared to their large sized peers, in some cases to the extent of 70 per cent of their revenues.

This has two implications. If it is a plain hedge, a good part of the revenue is protected. But if complex derivative products are used, the danger of marked-to-market loss substantial enough to even erode profits during a quarter.

But there are select companies even in the software segment that are unaffected by the movement of the rupee against the dollar.

Companies such as Rolta India and 3i Infotech derive a substantial portion of their revenues from India and other countries in the Asia-Pacific region.

With a substantial Indian presence, the hedged portion tends to be very minimal. As a result, there may be lesser erosion or gain in margins due to currency. It may, of course, be due to business reasons.

So such stocks tend to be less volatile in the market and viewed differently from their North America-dependent peers.

But IT hardware players are affected differently by the rupee movement. Companies such as CMC and HCL Infosystems import a large part of hardware and software that they use for clients in India.

These include servers, computer systems, routers, operating system and security software and other network products.

So when the rupee depreciates, these companies can buy less goods per dollar. The converse happens when the rupee appreciates.

Despite being domestic demand driven, these companies are still affected on account of rupee movement vis-À-vis the dollar.

So what does all this mean for a young investor like you?

The movement of the rupee is one among the several factors affecting the revenues of an IT company. However, it does help to be aware of its effect on earnings before taking a call.

The fundamentals, as judged from, among other things, the business prospects, internal operating parameters and efficiencies, the macro environment and the execution capabilities of a company, are still important factors to watch out for before investing.

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