Technology: Crosses - an additional headwind in FY2016E :: Kotak Sec, report

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Crosses—an additional headwind in FY2016E. INR has appreciated by 13-26% in the past 12 months against EUR, GBP, AUD and other currencies. Without the compensatory benefit of INR depreciation against USD, Indian IT can face margin headwinds of 60-75 bps in FY2016 at spot rates. Offsets from currency headwinds are limited to either pricing (not easy) or growth (new contracts at higher price). We maintain our constructive view on the sector—rupee appreciation is the key risk to our call. Infosys and Tech Mahindra are our top picks.


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Relative strength in rupee creates margin headwinds for FY2016E The INR has appreciated by 26%, 13% and 13% against spot EUR, GBP and AUD in the past 12 months. The Indian IT derives 32-49% of revenues from non-USD currencies. Appreciation of the rupee against non-USD currencies presents 60-75 bps margin headwinds at spot rates in FY2016E. As a rule of thumb, a 1% change in any currency impacts EBIT margin by 30 bps for the respective billed currency. The general compensatory benefit of strength of USD against other currencies is weakness in the rupee; so far it has not played out. Companies that have the highest exposure to non-USD and non-domestic revenues (HCLT, Tech M, TCS and Wipro) face the maximum margin headwinds in FY2016E at spot currency rates. Possible ways for mitigating pressure, especially in Europe and Australian markets The impact of a strengthening rupee against non-USD currencies will create 180-360 bps margin headwinds for the respective geographies (assuming that billings are done in respective local geography’s currency). Some impact was visible in the 3QFY15 numbers—for example Infosys’ December 2014 quarter Europe margin declined 90 bps on a sequential basis even as overall EBIT margin increased 60 bps. We present our thoughts on possible mitigating steps and the overall view.  New clients will be automatically priced at new currency rates. Pricing with new clients is normally structured on the basis of defined margin targets. One of the inputs for defining these margin targets is rupee to respective local currency rate (or to put it differently, USDINR-local currency rate). Appreciation in the rupee automatically leads to pricing being set up according to the defined margin band, assuming everyone in the industry is rationale. However, new clients do not contribute much to overall revenues in the first year (<5 2-3="" a="" accentuated="" account="" achieved="" allow="" alone.="" also="" although="" among="" amp="" and="" application-development="" appreciation="" are="" argument="" aspiration="" assumed="" at="" band="" based="" be="" believe="" beyond="" bid="" bids="" business.="" by="" can="" cannot="" card="" case="" cases="" challenge="" challenging.="" challenging="" change="" client="" clients="" combination="" companies="" contract="" contracts="" currency="" deal="" deals="" defined="" discussion="" either="" europe="" existing="" exposure="" fixed="" for="" form="" from="" gain="" go="" greater="" have="" hclt="" high="" however="" ims="" in="" increase="" increased="" increases="" indian="" is="" it="" large="" leads="" level.="" long-tenured.="" long-tenured="" loss="" many="" margin="" material="" may="" most.="" movements="" multi-year="" nature="" nominal="" not="" of="" on="" once="" operating="" or="" other="" outcome-based.="" p="" particular="" portion="" possible.="" price-="" priced="" pricing="" project="" projects="" provisions="" rate="" rates="" rebid="" revenues="" risk.="" risk="" rupee="" select="" short-cycle="" swing="" t="" that="" the="" these="" things.="" this="" through="" time="" to="" traditional="" turn="" twin="" unlike="" up.="" using="" usually="" value="" we="" where="" which="" will="" with="" years.="">

LINK
http://www.kotaksecurities.com/pdf/indiadaily/indiadaily28012015po.pdf