Why Rupee weakening isn't helping our IT vendors...

That was the question I got from a client yesterday.

Her question wasn't out of place.  A weak Rupee should help Indian exporters as much as it dents our importers.  But she has been constantly hearing a weak Rupee will worsen India's fiscal deficit since it will go to fatten our oil import bill. And she is worried why this double whammy.

IT vendors like Infosys and TCS have negotiated price increases at a time when Rupee was appreciating. Now the trend has reversed, now it's their clients turn to ask for a wind down. Under normal circumstances, it should cancel each other out but it doesn't since 70% of their revenues come from US and Europe where there is a major social, economic and fiscal crisis.  Also the general weakening of demand is felt more in their major bread-winning vertical i.e. Financial Services.

Another reason is, during low demand situations, companies will hedge their revenues to protect their margins by booking forward covers for their forex exposure.  As a result, our IT vendors would have booked these covers (sold Dollars forward) when the Rupee was Rs.44-46 against the Dollar.  Not many would have expected Rupee to weaken so dramatically (20% in 3 months) and throw a spanner in their works.  Now Rupee is weakened to a low of Rs.55 against the Dollar, they are left to lick their wounds.

Nobody said Life is easy, after all.

Strange things the Rupee does

The relentless run up of the Rupee has one major outcome. It drove xenophilic Indian companies like Infosys to focus on burgeoning Indian markets. Even as IBM, Accenture, Microsoft, Oracle, HP and other IT majors drove in to have a slice of the Indian market, Infosys was unmoved, stayed riveted westwards. It didn’t like the low margins. Sat smug under the illusion that juicy 25-30% margins that it kept gouging from overseas clients will remain forever.

I had written earlier about the short life of those obscene margins here and here and the folly of ignoring the domestic market. After getting dented in earnings and sensing a fast eroding market cap (and the worth of his own holding besides that of other co-founders), it looks like Kris Gopalakrishnan has heard me.

.

It's another thing that he hardly had another choice...

.

Will India's IT vendors turn realty players?

Pune factories going the Mumbai Mill-land way… Turning into expensive real estates. Bajaj Auto looks like exploring turning its Akurdi plant into developed real estate.

Judging by the little or no R&D investment by India’s famed IT vendors, recently endorsed by Indis’s distant 46th ranking in global IT map, what are the odds for Infosys, Wipro and TCS to junk their businesses and turn realty plays? Satyam already has its "Maytas " group (got by reversing “S.a.t.y.a.m”) of companies into which it can morph any day.

Going by the large swathes of land and building they hold, You can’t grudge them that… Benefits? Besides the huge value that they can unlock, here they don’t have to face up to an IBM, Accenture and EDS or to brood about higher visa costs, rising wage costs, Rupee depreciation, poor skill levels, shrinking margins, attrition levels….

Aside of that, few will see any great organic upsides in the near term to their shareholders…

.

Go short on India's IT vendors

Wharton’s Jitendra V Singh advises Indian companies to recast their business models to suit the rising Rupee than to expect the RBI to intervene. In support of his argument, he draws the parallel of how Japanese Automakers during the `80s reacted to the rising yen by shifting their low margin operations (and costs) to manufacturing locations in the US. That had the twin advantage of margin protection and reduction in protectionist backlash since the jobs have now turned American.

Is that a good comparison, Mr.Singh ? Check some facts out.

India’s leading IT vendors like TCS, Infosys, Wipro and Satyam squeezed out higher margins (27-30%) from clients not just because of availability of low cost workforce or a weaker rupee, they have also been benefitting from complete exemptions from Indian Income Tax (33.6%) on export income till recently. If operations are shifted out, the tax savings foregone will dent their margins.

.

Many state governments also gave them land on long term low leases to build massive complexes to house their army of coders in thousands. These benefits cannot be expected from foreign governments. Moreover, the resale value of their Indian real estate would tumble triggered by the sudden over supply because the governments may choose to terminate their leases if they move out. Now that's a double whammy.

As of now bulk of the revenues of India’s IT vendors come from mainstay operations like ADM, BPO, low end process automation, testing and validation services. Revenues from high end segments like consulting, process automation, license fee, and remote infrastructure / Data centre management have been insignificant. With competing global majors like IBM, Accenture and EDS setting shops in India, wages are also on an upswing. Shrinking supply of competent engineers, higher visa costs and attrition have also not been helping matters either.

.

Thus changing their product mix now would mean India's IT vendors having to make significant investments in R&D (read future) to develop high end utility products and building deep domain expertise in clients’ businesses that guarantees productivity improvements upfront (in other words, to partake in clients' business risks also) like the global majors do. These adjustments may (or not) yield gains in the long term, but right now they call for larger cash outlay and would also mean giving up on margins. Neither can the Indian IT vendors be too sure of their own ability to cope if pitted against the behemoths that knew this high end terrain better.

That's why I recommend a sellout. And if they don’t, go short'em all....

.