Riding out volatility

THE CHIEF FINANCIAL OFFICER of Tata Consultancy Services (TCS), S. Mahalingam, doesn’t seem to feel the weight of managing the finances of a $50.5 billion (Rs 2.67 lakh crore) information technology behemoth. But the 64-year-old chartered accountant, looking perfectly relaxed in his trademark white shirt and blue trousers, has a lot to worry about and little he can control. When Mahalingam took over as CFO in 2003, the country was entering a growth phase: GDP grew at an average of 8.5% in 2003-04, and the services sector grew by 9.1% according to data from the Federation of Indian Chambers of Commerce and Industry. Now, close to a decade later, TCS is looking at an era of turbulence and turmoil, falling growth rates, and wildly volatile currency. It’s up to Mahalingam to steer the company through.

Last year, TCS clocked a record revenue of $10 billion even as competitors such as Wipro and Infosys faced headwinds due to the economic slowdown in the U.S. On the whole, TCS’s growth story seems untarnished; even when it lost Rs 746 crore in currency fluctuations in 2009, it was seen as the result of the global turmoil after the Lehman collapse. Most IT firms lost money that year.

But what’s worrying is that despite reporting record profits this year, TCS is losing money on foreign currency trades. Worse, the IT giant is not alone. Software exporters, especially the large ones, earn much of their revenue in dollars, so any movement of the rupee against the dollar affects their bottom line. The margins of companies such as TCS and IT major Infosys should increase automatically every time a dollar fetches more rupees (that is, when the rupee depreciates). When the rupee appreciates, dollar earnings are hit. Given that the rupee fell 12% between October 2011 and March 2012, IT companies ought to be sitting back and raking in the profits. Last year, India billed $87 billion worth information services, contributing a quarter of all export income for the country. Any big depreciation should send this top line zipping up when calculated in rupees.

But this is not happening. In March 2012, TCS reported record profits of Rs 2,932 crore but its treasury desk reported losses of Rs 433 crore in foreign currency trading. Then, the operating margins of Infosys actually dipped by 1.1% in the fourth quarter ended March 2012, despite having gained Rs 81 crore from currency trades. Bangalore-based Wipro lost Rs 526 crore in some foreign currency transactions while gaining Rs 345 crore in some others.

This is partly because customers in the U.S. and Europe, strained by the slowdown, held on to cash and placed fewer IT orders. Also, due to the U.S. government’s increased scrutiny of visa rules, Indian IT players increased their onshore presence, leading to higher foreign exchange expenditure. The outgo for TCS increased from $1.5 billion in FY10 to $2.4 billion in FY12. For Infosys, it increased from $1.7 billion to $2.5 billion during the same period. This runs counter to what IT companies have done every time there’s sustained currency fluctuation: “When there is huge volatility, we [generally] work with the client to do more offshore work,” explains V. Balakrishnan, CFO, Infosys.

Big IT is going back to basics in a bid to cushion itself from wildly fluctuating currency movements. Companies are getting conservative when dealing with foreign exchange earnings, and few see value in holding dollars, betting on the future movement of the rupee. While such conservatism means they may lose the profits created by spikes, it insulates the company from the negative fallout of bad bets. And in an iffy economic environment, IT companies prefer the safe haven of steady earnings.

Of course, such prudence is not popular with short-term investors, who want dramatic returns. However, the finance officers at the big IT firms are not particularly worried about this; for them, income is from the core business, not from treasury operations. “The moment an organisation looks at foreign exchange hedging as an opportunity to trade and make money, it brings in an entirely new risk element, which is not integral to being an IT services player,” says Sonjoy Anand, CFO of Tech Mahindra, a $1.2 billion IT services company headquartered in Mumbai. This is something that most other IT leaders have said at various points of time.

The problem for IT companies is that pricing will take a hit. Sid Pai, partner and managing director of client advisory services company Information Services Group in India, says the prices of services will come under pressure sooner than later. “The client is now aware that services are that much cheaper in dollar terms (because of rupee depreciation) because IT companies are paying in rupees,” says Pai. However, Mahalingam argues that since clients don’t take any currency risks they can’t seek reduction in contract values on account of the rupee depreciation. Yet, Mahalingam says: “Hedging currency can give the leeway to change the basics of the business—from cost structures to business mix.”

ANY LARGE COMPANY that has clients abroad and earns foreign exchange needs to hedge—that is, compensate for any shift in the value of the currency it earns or spends. Depending on the company’s accounting practices, and on how conservative it wants treasury operations to be, the company can opt to enter forex forward contracts or currency option contracts, or, as is more common, mix the two. In a forward contract, the company locks in a price at which it will sell the currency at a future date. These contracts are non-negotiable, and work well when currency movements are steady and predictable.

Since volatility defines the forex market these days, companies prefer to take currency option contracts. Options give them the right, not obligation, to sell at a particular price on a specified date. If the currency rates are unfavourable, the company can choose not to exercise its option. The most conservative companies, in times of extreme volatility, choose to mark prices to market on a daily basis. Profits and losses are totted up at the end of each trading session. The thing is, hedging is not an option. For a CFO, it has become crucial to prepare for all eventualities. “Even though the accounting currency is the rupee because you are registered in India (and you have to present financial statements in rupees), if you have an exposure to revenues and expenditures in dollars or pounds, and do not hedge, you are taking a speculative position on how the currency might move,” notes T.V. Mohandas Pai, former CFO of Infosys.

Most IT companies have not had to work at currency trading, given the steady 4% depreciation in the rupee for the past several years. But the sudden 25% depreciation in the last 12 months and swift regulatory moves by the Reserve Bank of India to lure more dollars to India has now put the spotlight on Mahalingam, Balakrishnan, and their peers. Even mid-sized companies, such as Hexaware, are suffering from the ill effects of currency fluctuation; for the year ended December 2010, Hexaware saw profits drop to Rs 92.83 crore, after a loss of Rs 25.86 crore foreign exchange-related losses. “In the past two years, the finance function has become a key contributor to profitability,” says Atul Nishar, Hexaware’s chairman and managing director.

In the last one year, IT companies have started looking at ways to reduce the business’ currency risks to give returns anticipated by investors. “Gambling is totally out of the question,” says Mahalingam, commenting on the earlier practice of arbitrarily delaying billing and keeping foreign currency incomes in designated accounts till the maximum stipulated time before converting them into rupees. But, he adds, “The investor is upset if we don’t capture the upside of the currency when the rupee depreciates.” So, like commodity companies Reliance and Essar, Indian IT companies are building their currency desks to find ways to maximise gains from the volatile rupee.

The hedge strategy is intertwined with the growth appetite and management style of the corporation. In the past year, Cognizant Technology Solutions has been setting the pace for the IT services market. Because it is incorporated in the U.S., it adopts the U.S. Generally Accepted Accounting Practices (GAAP). Most of its income is earned in dollars, and because it is an American company, there’s no need to convert to rupees.

However, 80% of its employees are based in India, and account for some 33% of its expenditure—exposed to currency fluctuations. A 1% change in the rupee rate can mean a 0.27% fall in operating margins. In the past year, margins would have taken a large hit when the rupee fell 20% if Cognizant had not had a hedging mechanism in place. As on 30 June, the company had over $3.8 billion in outstanding hedges of rupee expenses, which will mature each month through 2016 at an average rate of approximately Rs 52.9 a dollar.

At TCS, Mahalingam is spending more time than ever before with the foreign exchange desk. The need for such a desk has increased since 2009, when the rupee went from Rs 44 to Rs 52 a dollar, when foreign capital fled the domestic stock markets. Routinely, the hedging desk takes positions each day, squaring off or starting new hedges. Balakrishnan of Infosys adds that his four-member hedging desk has become much more active.

Companies get into forward contracts or sell options based on their estimated revenue over the next few months. The quantum of hedging is a management decision. Mahalingam’s endeavour is to hedge up 100% of TCS exposure but at one point, for a brief duration, he had decided not to hedge at all. In the case of Infosys, which has an average quarterly revenue of $1.8 billion, the net exposure would be $800 million to $900 million. The company has a policy to hedge two quarters of net exposure or $1.8 billion. But, in reality, Infosys takes a hedging cover of $800 million to $1 billion.

THE ACTIVITY AT THE hedging desk rises along with currency volatility. When currency movement is steady, the trading desk at a typical IT company creates an end-of-day summary for the management. But on volatile days, it’s common to see CFOs such as Mahalingam in constant touch with the desk, approving deals and making sure losses are cut. In the coming months, analysts believe that this kind of interaction could get more frequent and intensive. Mahalingam says that in the Indian context, an inflow or outflow of $20 billion to $30 billion of foreign institutional investors’ money makes a large difference in exchange rate volatility to a $1.5 trillion economy. This has been the case on two occasions: In 2008-09 when investors pulled out close to $10 billion after the Lehman collapse. The next was in 2011-12, when the quick outflow of funds sent the rupee tumbling.

The sudden slide made the central bank amend rules that made it mandatory to bring their export income within two months of earning them. Earlier, companies could keep foreign exchange in overseas accounts and bring it when the exchange rate was more favourable. Says Balakrishnan: “You have to anticipate regulatory action that can move currency in and out of the country.”

A recent report by brokerage firm Kotak Securities outlines the issues for IT firms such as TCS and Infosys in the year head. The report points out that these companies have barely been able to retain their margins despite a 20% depreciation of the rupee against the dollar. This indicates that competition and clients may not allow full retention of the benefits of rupee depreciation. The report recommends that investors reduce their investment in these companies.

Balakrishnan thinks that the IT industry is hedged on both sides though—this is because of the large contribution to Indian exports that affects the trade deficit and current account deficit. “If IT does well, currency will appreciate. If it doesn’t, the rupee will depreciate.” Call it a natural hedge if you will.