Indian IT industry may be up against cross currency headwinds

In the last few quarters we have had a number of challenges for the Indian IT industry. Attrition has gone up sharply forcing IT companies to rely on an army of freshers. Manpower costs had gone up steeply as IT companies literally went overboard trying to attract the best of talent. Both these factors had contributed substantially to a sharp fall in the operating margins. In the last quarter there was also pressure building up on the top line as the fears of a recession in the light of Fed hawkishness also raised the spectre of lower tech spending. This was combined with pressure on pricing too.

Amidst all these problems, which are not going away in a hurry, the Indian IT sector has a new problem to contend with. That is not about attrition or moonlighting but about cross currency headwinds. Now, you may wonder as to why should the IT companies worry about currency at all when the dollar index is at an all-time high? After all, the dollar has today strengthened against all the major currencies in the world including the Pound, Euro, Yen and the Indian rupee. Since the IT companies earn in dollars, they should only benefit when the dollar goes up as they get more rupees for the dollars they earn. There is a catch.
Today, Indian IT companies are not as US dependent as they used to be in the old days. Today, for most of the large IT companies, UK, EU, Japan and even India contribute a substantial portion of their revenues. That means, Indian IT companies not only receive payments in dollars but also in Pounds and Euros too. Now all these European and Asian currencies have been losing value against the dollar and so it does happen quite often that what IT companies gain from dollar earnings is offset by losses on Pound and Euro earnings. That is the cross currency risk that is so prominent for Indian IT in the Q2FY23 quarter. 

Most of the brokers have stayed cautious on IT sector. The general forecast is that the top line revenues should still grow between 3% to 4% on a sequential basis in constant currency terms. However, there is almost a consensus that the EBITDA margins would certainly be under pressure due to cost pressures and cross currency headwinds. However, most brokers have underlined that September normally tends to be a quarter of robust EBIT margins. What is not clear is the extent to which the manpower costs would pan out. One thing is clear that the attrition story may not be as mean as the previous quarters.

The consensus is that the global currency volatility would be among the most critical factors impacting profitability. Most IT companies are likely to gain from a stronger dollar, but that would be more than offset by corresponding weakness in currencies like the Euro, Pound, Yen and Australian dollar. These cross currency headwinds are likely to wipe out most of the gains of the dollar. The Pound and Euro have lost over 5% vis-à-vis the dollar and that is likely to dent the operating profit margins of these IT companies by around 150 to 200 basis points. That weakness of non-US currencies looks like to continue.

What companies and the analysts will really watch out for is the TCV (total contract value), the big deal wins, pricing pressures and the management commentary. Apart from business strategy, the area of interest would be how the IT companies handle the delicate issues like attrition, opportunities and more sensitive issues like moonlighting. The bad news is that the worst may not be over. However, the good news is that this sector is already more than 28% down from its peak levels. That indicates that most of the top line and bottom line concerns may be obviated by the relatively cheap valuations of IT stocks.