India Equity Research: J.P. Morgan

India IT Services It is déjà vu - but in an opposite direction; mapping out the inverse relationship between P/E and exchange rate

It is déjà vu – but in an opposite direction. Once again, we’re receiving queries from clients as to how FY15/FY16 EPS and margins look for different IT-Services players at various INR-US$ levels (this exercise is similar to what we did in Aug-Sep of last year (2013) when the INR was trending in an opposite direction and substantially weakening; Rs65+ to the US$ then). It is well known that EBIT margins for the larger, Tier-1 Indian IT companies typically move 25-35 bps for every percentage change in the INR/USD equation (or about 1.5-2.0% at the PAT/EPS level). Thus, it is somewhat easy to chart a “what if” sensitivity table highlighting FY15/FY16 margin & EPS at different INR/USD exchange rate levels for various players (see tables 1-5 below). For example, TCS’s FY16 EPS (assuming zero-offset) would stand at ~Rs 110 at Rs 56-57/US$, the same as we/consensus broadly expect in FY15 at Rs60/$; likewise for the other companies - in other words, all it would take is a further 4-5% appreciation of the INR from current levels for TCS’s & peers’ FY16 EPS to adjust at street’s current FY15 EPS at Rs60/US or simply put, no growth over the street’s current FY15 EPS.

· The linearity of such EPS projections for FY15/16 will not hold unless we assume that firms are unable to offset the impact of INR appreciation. This would obviously not be true, as firms do have levers that they can tweak more aggressively when the INR appreciates, be it (a) more discipline on pricing, (b) increased offshorization, (c) much greater intensity of fixed price/managed services projects, (d) increased use of automation, tools and other productivity measures. The degree of offset varies from firm to firm. Sure, we can argue that firms have been pulling these levers for some time now but there’s nothing like forced pressure to bring about such offsets (in this case pressure is forced by the appreciating INR).

· To us, a greater worry from INR appreciation (if indeed the INR stabilizes at stronger levels) is the impact that this has on secular growth of the industry (and thus, the impact on P/E of stocks). The advantages of a weak INR are clear. Besides the short-term boost to EPS, the weak INR will likely accelerate market-share penetration in newer markets/service-lines and in lower-margin contracts/geographies that some vendors might have shied away from (when the INR-USD was at say 50). This hastens the process of expanding the addressable market space and results in potentially higher revenue growth by FY15 (though with differing results among vendors). The reverse is true with a stronger INR. In a stronger INR environment, firms have less investment capacity, have less room for pricing flexibility, cannot afford to take as many major bets, may be warier of entering emerging/newer markets if economics don’t make sense – all of these constraints limit the pace of addressable market expansion and thus, revenue growth; most of these constraints would not hold so strongly in a weaker INR environment. Thus, we see somewhat of an inverse relationship between INR-USD levels and secular growth rate of the industry (though we can’t quantify this or draw the precise nature of this relationship; see Chart 1 for a representation). Correspondingly, this impacts the P/E of the industry and companies therein. Investor expectations of INR-USD also impact P/E of the industry/companies but such expectations are likely to be only temporary if they do not become reality.

· The volatility of the INR will test the strategic decision-making skills of Indian IT companies. It can play testing psychological games with companies. How often should companies change their currency assumptions in their regular contracting, planning & analysis and capital budgeting tasks? Should it be an annual once a year exercise or should it be more tactical like once a quarter? The former gives stability & predictability but the firm would end up missing/passing up good profitable opportunities if the INR depreciates in the course of the year. On the other hand, frequently revising the INR-USD (and other forex) assumptions in planning & budgeting likely leads to confusion & instability over time (an equivalent dilemma for us analysts/investment managers would be how frequently should/do we change Cost of Equity assumptions in response to volatility in interest rates – if anything, INR-USD is far more volatile by comparison). Large firms with established, disciplined processes generally tend to re-appraise such parameters/variables only if they can see some stability around the new assumptions and calculations.

· Investment view. We are not changing our INR-USD estimates yet and continue to factor in average level of INR-USD of ~59-60 for FY15/16 (consensus is broadly about the same or marginally higher). There could be bouts of near-term appreciation of the INR as we’re witnessing today but whether the INR-USD will stay structurally stable beyond the near-term at stronger than Rs 58/US$ levels is not our call (the stated preference of the RBI would be for the INR not to strengthen from current levels). That said, given low-to-mid teen % growth of the sector, even a 5% INR appreciation could substantially negate EPS growth in FY15/16 (different from impact in 2007/08 when the INR was appreciating during a phase of much stronger industry growth of 20%+). A stronger INR impacts sector P/E. But even investor expectations of a stronger INR impact P/Es in addition to sector rotation, both of which we’re seeing today. That said, if the INR does not stabilize at a reasonably stronger level, then current investor concerns impacting P/E are also likely to be temporary. We keep OW ratings on Tech Mahindra, Infosys and HCLT.

Figure 1: The industry’s secular growth varies inversely with the INR’s strength with consequences for industry/company P/E – a weaker INR regime gives firms substantial leeway on investments, pricing, and ability to take multiple bets - all of which help pace of addressable market expansion resulting in more robust top-line growth – room for pulling such growth levers gets squeezed by a stronger INR – this is a bigger worry than near-term EPS impact (representative curve only)

Source: J.P. Morgan

Table 1: TCS’s FY15/FY16 EPS sensitivity to exchange rate movement at different degree of offsets (i.e. recouping some of the margin loss from exchange rate movement); assuming zero offset, TCS’s FY16 EPS (at INR/US$ 57) broadly stays the same as consensus FY15 EPS (at INR 60/US$) – the yellow cell is our base-case

Source: J.P. Morgan estimates; Note: Shaded line shows our base case scenario i.e. USDINR exchange rate at 60.

Table 2: Infosys’s FY15/FY16 EPS sensitivity to exchange rate movement at different degree of offset (i.e. recouping some of the margin loss from exchange rate movement); assuming zero offset, Infosys’s FY16 EPS (at INR/US$ 56) broadly stays the same as consensus FY15 EPS (at INR 60/US$) – the yellow cell is our base-case

Source: J.P. Morgan estimates; Note: Shaded line shows our base case scenario i.e. USDINR exchange rate at 60.

Table 3: Wipro’s FY15/FY16 EPS sensitivity to exchange rate movement at different level of margin pull-back (i.e. recouping some of the margin loss from exchange rate movement) – assuming zero offset, Wipro’s FY16 EPS (at INR/US$ 56-57) broadly stays the same as consensus FY15 EPS (at INR 60/US$) – the yellow cell is our base-case

Source: J.P. Morgan estimates; Note: Shaded line shows our base case scenario i.e. USDINR exchange rate at 60.

Table 4: HCL Technologies’ FY15/FY16 EPS sensitivity to exchange rate movement at different level of margin pull-back (i.e. recouping some of the margin loss from exchange rate movement) – assuming zero offset, HCLT’s ’s FY16 EPS (at INR/US$ 56-57) broadly stays the same as consensus FY15 EPS (at INR 60/US$) – the yellow cell is our base-case

Source: J.P. Morgan estimates; Note: Shaded line shows our base case scenario i.e. USDINR exchange rate at 60.

Table 5: Tech Mahindra’s FY15/FY16 EPS sensitivity to exchange rate movement at different level of margin pull-back (i.e. recouping some of the margin loss from exchange rate movement) - assuming zero offset, Tech Mahindra’s ’s FY16 EPS (at INR/US$ 56) broadly stays the same as consensus FY15 EPS (at INR 60/US$) – the yellow cell is our base-case