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Thursday, December 20, 2007

Impact of rupee appreciation on margins of software companies

To continue the discussion on the impact of rupee appreciation that was begun by Swaminathan Aiyar a few days ago, the software industry is an interesting test case of the questions of interest. This is because the domestic firms are primarily export oriented. Hence, firm financial data is directly relevant for understanding changing export conditions and their consequences. The software industry is expected to have been hurt both by the slowdown in the US, and by the appreciating rupee.

The CMIE Internet system has interesting data about the aggregated quarterly results of software companies:

ParameterJul-Sep 2006Jul-Sep 2007
Operating profit margin (%)29.9828.46
Net profit margin (%)23.4921.58

While sales growth has dropped, margins have not yet dropped much. An operating profit margin of 28.46% is still a very large one by any standard - it is roughly ten percentage points bigger than the operating profit margin for non-financial firms as a whole. A glance at this table does not suggest that the INR/USD appreciation of 13.6% from Sep 2006 to Sep 2007 has greatly damaged the situation of these firms.

In understanding what is going on, a key aspect is the role of the exchange rate appreciation as an equilibriating mechanism. With INR/USD at Rs.46 a dollar, the economy was overheating. The INR appreciation has helped deliver more normal conditions on the labour market, in the investment of firms, etc. As an example, see this excellent article by Mobis Philipose in Mint about the responses at Infosys. The appreciation is not a shock which is demanding corresponding adjustments of the economy; it is the mechanism through which the economy adjusts. A distorted exchange rate - like distorted petroleum product prices - yields distorted behaviour on the part of a lot of firms and households. When the government comes in the way of the market exchange rate, it hinders the adjustment process on the part of millions of households and firms.


  1. Looking at the data between Sep 2006 to Sep 2007 to fathom the impact of rupee appreciation on the software industry can be misleading as the effect of the stronger rupee will come show more significantly in the present financial year.

  2. The INR/USD appreciation started on 15 March. The Jul/Aug/Sep 2007 quarter is the first full quarter where the stronger rupee is in play. Yes, the future will always hold valuable information, but then deeper in the future lots of things are changing which make the results harder to fathom. E.g. the slowing down of the US economy will hurt more in the months to come.

    My simple point is this. It is quite striking that a 10% INR appreciation did not give a sharp drop in margins, as is feared. This shows that there are many things that firms do, and can do, in order to adjust to currency changes. Currency movement is not a shock: it is part of the equilibriating response of the market economy.

  3. A valid point Mr. Shah but what I meant was that since clients in the software industry are generally charged based on past negotiated contracts, it is only when such contracts get renegotiated in light of the persistent stronger rupee that the full impact of the appreciateing rupee will be felt on the balance sheet of such companies.

  4. Okay, let's suppose a contract was fixed at $100. Earlier, this yielded Rs.4500. Now it yields Rs.3900. In the short term, there should have been a sharp drop in profitability. What the data is showing, however, is no big drop on profitability. This contradicts simplistic stories about the impact of rupee appreciation.

  5. Stock market don't like margin contraction at all for what ever reason. Software companies may have control costs to get margins back to previous levels, if not their PE contraction will continue...

  6. i agree with Dr.Shah that there has been no great margin contraction, even if one were to net out the 'other income' effect, which _not surprisingly_ was significantly higher in the September quarter (on a y-o-y basis).

    what is really causing trouble, and hence generating these 'simplistic' stories, is the sharp contraction in the price multiples IT stocks were commanding. At any time, Infy, WIT or TCS would always trade at close to 25-30 times, for the simple reason that they were growing at that rate. Now that those rates have tapered off dramatically (thanks to the rupee appreciation), the P/Es have dropped substantially (to around 20 times) leading to big under-performance over the past one year.

    Markets are simply factoring a _much_ slower growth in earnings for the sector, which is bound to happen for most IT companies that are heavily dependent on the US for their revenues.

    In fact, I think, the Dec'07 quarter will most likely witness a further contraction in margins for the IT companies, after netting of the other income i.e.


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