| India IT Services Impact of INR-USD on demand/growth: The demand curve is not inelastic and responds inversely to secular INR movements | ||
· We see undue investor focus on Indian IT companies’ FY15/16 margins and EPS due to the strengthening INR. To us, a greater worry from structural INR appreciation is the impact that this has on secular (or medium-to-long term) growth of the Indian IT industry (and thus, the impact on P/E of stocks). This possibility is hardly discussed at all as it is commonly believed that INR-USD dynamics do not affect secular demand and revenue growth (which is not the case, in our view).Demand is not an inelastic/inflexible curve ‑ investment capacity and pricing philosophies also shape the secular demand curve for the industry and for individual companies. These factors are susceptible to secular shifts in INR/USD trends. For example, the advantages of a weak INR regime are clear. Besides the short-term boost to EPS, the weak INR will likely release excess margins that (a) are invested in accelerating market-share penetration in newer markets/service-lines and in lower-margin contracts/geographies, (b) allow greater pricing flexibility and (c) afford leeway to take more bets - vendors will likely shy from exercising these levers at stronger INR-USD levels (they would probably do much less of these if for example, the INR-USD was at 55 than they would if INR-USD was at 60). A weak INR regime, thus, hastens the process of expanding the addressable market and results in potentially higher revenue growth over the medium-to-longer term (though with differing results among vendors).
· The reverse is true in a structurally stronger INR environment. In a stronger INR environment (more specifically, when the strength of the INR takes it to a higher stable level), 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 as much in a weaker INR environment. Thus, unless the industry takes a margin reset, we see somewhat of an inverse relationship between INR-USD levels and secular growth rate of the industry contrary to the belief of some (though we can’t quantify this or draw the precise nature of this relationship; see figure below for a representation).
· Thus, the industry’s secular growth in an exchange rate regime reverting tightly around INR-USD of 60 will be different from that with exchange rate mean-reverting tightly around INR-USD of 55. Correspondingly, this should impact the P/E of the industry and companies therein. Investor expectations of a structurally strengthening INR-USD also impact P/E of the industry/companies but such an impact on P/E is likely to be only temporary if these expectations do not become reality. (Note: A structurally stronger INR is NOT our base-case; we still work with average exchange rate of Rs 59-60 for FY15/16 - hence, we stay OW on Tech Mahindra, Infosys, HCLT on moderate valuations and improving demand trends in the coming quarters.)
Figure 1: The industry’s secular (medium-to-long term) growth varies inversely with the INR’s secular strength with consequences for industry & company P/E – demand is not inelastic, a weaker INR regime releases ‘excess’ margins that gives firms substantial leeway on investments, pricing, and ability to take multiple bets - all of which help quicken the pace of addressable market expansion resulting in better secular top-line growth – room for pulling such growth levers gets squeezed by a structurally stronger INR unless the industry (or the influential players) take a margin reset – this is a bigger worry than near-term EPS/margin impact; but we are not building the case for a structurally stronger INR
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