Affect of Rupee appreciation on Indian IT Companies

Yesterday we had a guest lecture by Kaushal, Senior BDM at Satyam on the "Effects of Rupee appreciation on Indian IT companies". It was optional to attend that lecture, still I attended it because the topic interested me. I have been tracking this Industry since my B-School preparation days late 2006. So, I felt I knew everything he had to say. Still it is worth documenting them.

Firstly he clarified that it was not just Rupee appreciating but more of dollar depreciating. Indian companies need to worry about this because for top companies like TCS, Infosys, Wipro, Satyam and HCL, 60% of the revenues are from US that are earned in dollars. Remaining are from Europe and Asia Pacific with different mix for different companies.

He analyzed the effects in 4 perspectives
Profits
It has been observed that every 1% appreciation of Rupee against the Dollar resulted in 0.5% drop in Net profits of IT companies. I asked the speaker, "Why is the drop not 1% but only 0.5%?", he said that companies are going to just watch the dollar sliding, they will do something about it to minimize its effects.

Income statements in US GAAP and Indian GAAP don't tell the shareholders in US and India the same story. When Rupee appreciates, same business from US will show lesser value in Indian accounts. On the other hand, same non-US business done will show higher value in US accounts.
E.g When $10 million of sales in US will show Rs. 48 crore in the 1st year when $1 is Rs48, the same $10 million business will show Rs. 40 crore when $1 is only Rs. 40 next year. Indian investors see the drop when the US investors don't see it.
Similarly, domestic business of Rs. 48 crore raises from $10 million to $12 million when dollar drops from Rs 48 to Rs 40. Now American Investors cheer on 20% growth in $ terms while Indian investors have nothing to cheer.

Costs
80% of costs of Indian IT companies are the direct salary cost. This is understandable in a knowledge based industry where people are the assets and there are not much of fixed assets as such. So any raise in salaries will hit the company's bottom line seriously. Salaries have been increasing at 15-20% YoY.
Higher Attrition rate increases the cost of Hiring and Training the new employees.

Business Model
The Business model so far had been offshoring and outsourcing or simply arbitrage of labour. Low value back office work like coding, testing and maintenance are outsourced to third world countries where labour is cheap, while the US keeps with them the high end work like products, consulting, design, strategy, Research and development. This model creates value to both the parties, one gets work done at a lesser cost and other party gets a lucrative Business opportunity. He said the fathers of Indian IT Industries were not risk takers or innovators, they plainly worked on the basis of cost difference between US and Indian labour.

Competition
Effect of competition should be compared between the Local peers like Infy, TCS, Wipro and HCL and Global Peers like IBM, Accenture, Cap Gemini and HP. It is obviously affecting the local peers in the same way as all of them have same Business Model and similar revenue mix in terms of geographies. But even the global peers have large operations in India with the same Business Model and hence their Indian Business will suffer the same fate. Suddenly their home Business becomes 10% more attractive compared to that it was earlier to Rupee appreciation.

The big Tier 1 companies have the financial muscle to bear the rupee appreciation, but the smaller companies have to really suffer.

The solutions that are taken by the IT companies to counter the threats are
Profits
1) Negotiate with clients on higher billing. This is not easy though. It depends on host of factors. If the job being carried out is a low end one, then it can easily be transferred to another company by the customer. If it is high end job, lot of dependency has been created and customer has made enough investment in the offshore center then switching to another vendor becomes costly and difficult. He will then as well pay the existing vendor 10% more than looking at new vendor
2) Add Escalation clauses into the contract saying if the salary increases or the rupee depreciates the billing rate will be adjusted. That is the billing rate will depend on the movement of a certain index.
3) Quote higher rates for new Businesses if the existing contracts cannot be changed. If the vendor is strong enough this can be done and it need not worry about the competitors

Costs
1) Hire locals - If the client is located in China, instead of hiring people from India to do the work in India, have a development centre in China itself hiring local talent. He would be better able to communicate and understand the customers. Also he has become 10% cheaper than he was earlier.
2) Improve Utilization - Freshers were hired in masses to fulfill the requirements for whole year and they were trained only to bench them later. This is a colossal loss to the company. They can instead ask them to join in batches. Since the lead time for recruitment of a candidate is long, companies are forced to hire early and keep them on bench. The transfer of people across project taking longer time reduces the utilization rate. This needs to be seriously worked out and improved to save costs.
3) Reduce operating costs - Lots of money is wasted on stationary items, print-outs, parties and other luxuries. When the times are not as good as it was, these operational expenses needs to be controlled.
4) Reduce Salaries and Hikes - How long can the industry sustain with 20% rise in salaries? Act of luring employees from other companies and industries by simply paying higher pay packages needs to be reconsidered. Reduce the salaries, others in the industry will follow you in these difficult times.
5) Expand operations to Tier II and Tier III cities where lots of hidden talents are available. They come cheaper but need to be trained. They will stick longer with the company. Company in the process will add lot of value to lives of those people and the economy of the city.
6) Most of the jobs done in the IT companies don't need Engineers to do them, why not hire B.Scs and B.Coms. They could very well do the job without cribbing at a lower cost.
7) Reduce Training costs by tying up with Educational institutes to pass out industry ready employable products. This shifts the costs from the Company to the educational institution. such programs are called Campus2Corporate.

Competition
1) Move up the value chain into consulting, product development, Research and innovation. This is easier said than done. It involves much more risks. Israel being such a small country generates more revenues than Indian in IT through their products.
2) Get into Newer Segments with Latest offerings
3) Focus on non-US markets like EU and APAC. I would say more importantly domestic markets especially SMEs. They are the fastest growing markets which are fed by MNCs operating in India while Indian companies are busy serving overseas markets.

Business Model
1) Forward cover for dollar - Hedge for dollar against Rupee so that any fluctuations does not have adverse impact on Profits. Infosys tried doing this and lost to the tune of 100 crore rupees when Dollar appreciates.
2) Relocate Development centres - This may save cost for the time being but strategically we are actually developing talent in competitor countries and help them fight us.
3) Pressurize government to give export incentives. IT companies have been pushing NASSCOM to continue Tax holidays beyond 2009 when it ends. But there has been no extension as per this Budget.