Why weaker rupee hasn't lifted IT stocks

Companies pass on gains arising from currency depreciation amid subdued demand environment

Over the years, information technology (IT) stocks' correlation to sharp movements in the rupee has reduced, which is also reflecting in the recent bout of weakness in the local currency and stock movement. For instance, despite a 0.8 per cent fall in the rupee versus the dollar since September 7; the BSE IT index has fallen 1.74 per cent. In the past, the general thumb rule was that IT companies’ margins would get a 20-25 basis point boost with every one per cent fall in the rupee versus the dollar. But, things have changed.

IT companies have adopted the practice of not taking much of the impact (positive or negative) of strong rupee movements in their margins. In times of a weaker rupee, companies have chosen to either re-invest the same in growth areas and/or pass the benefits to the end consumers. Similarly, the hedges taken by these companies protect them, albeit partially, from a stronger rupee. Thus, with this limited impact of rupee movement on their margins, these companies' stocks, too, don’t react as much to volatility in the rupee.

Sagar Rastogi, IT analyst at Ambit Capital, says, “There will be some near-term benefits from a weak rupee. But, IT companies are hedged so as against the margin gains, they will also bear some hedging-related losses in the short term. In the long term, they will pass it on to the customers.” Notably, the IT companies get some price increases every year from their customers called ‘cost of living adjustments’, which is related to the wage hikes taken by the IT companies. However, if the rupee has depreciated, customers will often adjust for it, eventually leading to flattish or lower pricing for these companies.

For IT companies, though, the bigger issue is the weak demand scenario and near-term headwinds such as Brexit (Britons voting to exit the European Union).

“Consensus FY17 Ebitda (earnings before interest, taxes, depreciation and amortisation) estimates for Indian IT have been trimmed by 10 per cent in the past two years despite the margin tailwinds from 14 per cent rupee depreciation. This suggests the pressures are prevalent in the underlying business, in our view,” write analysts at Citi in a recent report on the sector.

In fact, most analysts believe that despite passing benefits from rupee depreciation to the customers, Indian IT companies may not be able to prevent market share loss. “Over the past few years, the correlation between Indian vendors’ market share and currency movements has increased, but it has not stopped India’s IT revenue from slowing relative to the global outsourcing market,” believes Diviya Nagarajan, IT analyst at UBS Securities.

Thus, amid a deteriorating demand environment in the US and Europe, there seems to be no strong catalysts to drive IT stocks higher despite the fact that most of them are trading at historically undemanding valuations. While the jury is out on whether these valuations provide an attractive entry point, investors are better off awaiting some clarity on the demand front.