The spectacular rally in the rupee over the last few days, marking a reversal in trend as the worst-performing currency in Asia until last week, is likely to put pressure on the stocks of software services exporters considering their valuations have topped multi-year highs.
The impact of gains in the local currency will depend upon the nature of foreign exchange hedging strategies adopted by the companies and their business fundamentals.
Infosys, traditionally the most conservative on hedging strategies, is expected to be relatively less impacted. In contrast, TCS and HCL Technologies have reported higher forex losses in the past when currency movements have been choppy. IT stocks have been on a winning streak for about a month, largely due to a lack of investment avenues as investors wary of a slowing economy and its knock-on impact on many manufacturing firms opted for stocks of software exporters, with growth rebounding in the West, coupled with a weak rupee.
The sharp depreciation in the rupee against currencies such as the dollar, the euro and the pound helped boost valuations of these companies. Until last week, the rupee had depreciated by over 16% in the two months ended August. A 1% drop in the currency boosts the operating margin of IT exporters by 30-40 basis points.
A low exposure to the local markets was another positive . The Indian IT sector earns over 80% of its revenues from the overseas markets.
Hence, the heightened prospects of a recovery in the US economy augurs well for Indian IT exporters. This has helped the valuations of top-tier IT firms zoom. The trailing 12-month price-earnings ratio of TCS, the largest Indian IT exporter, is at a five-year high of 27. The P/Es of Infosys, Wipro, and HCL Technologies, the three other bigger IT players in the order of annual revenues, are at three-year highs.
Apart from high valuations, what will also mar their performance is high volatility in the currency market. The rupee has gained more than 6% in just over a week. Religare Institutional Research estimates TCS to lose over . 500-700 crore on foreign exchange hedges. This will negate the benefit of a weaker rupee. Infosys has traditionally taken a short-term view of currency movements while hedging future cash flows. It hedges for six months. In contrast, TCS and HCL Technologies tend to take positions in the currency forward markets beyond a year.
A highly volatile currency environment increases losses in case of contracts with a longer maturity. Currency movements, however, tend to impact stock performance only in the near term. The fundamental strength of the business model and projected future growth in revenue and profits are the major factors that drive long-term valuations.
Both TCS and HCL Tech look well poised to take advantage of the uptick in the US market. For Infosys, with its founder NR Narayana Murthy back at the helm, it will be crucial to sustain demand traction in the next few quarters. High current valuations and a rising rupee may restrict the increase in valuations of IT players further from current levels.