Re appreciation could hit IT sector EBITDA by 40-60bps

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Ambit Capital has come out with report on rupee appreciation impact on IT sector. They say Rupee appreciation could hit IT sector EBITDA margins by 40-60bps.

Rupee appreciation continues to hit the software industry. In Q3FY07 the companies had taken a hit of 80bps-200bps on their operating margins on account of the rupee appreciation. This was coupled with a further hit on higher translation losses as compared to gains on hedges, which in case of Satyam has been as high as 210bps or 60bps for Infosys, which too was substantial. The overall impact on the companies was to the tune of 2-3% of their revenues, combining both the effects.

Q4FY07 is expected to be no different, though the scale of damage would be slightly lower than in Q3FY07. Rupee has appreciated on an average basis by around 1.9% against the USD (as on date). The blended impact considering a 70% USD contribution, 5% EUR and 25% GBP contribution would be of the order of 1.3%.

Considering almost 30-40bps margin impact is there for every 1% change in rupee. The impact on operating margin is expected to be in the range of 40-60bps and revenue impact would be around 1.3-1.5%, depending on the growth. This would be further accentuated by a much higher translation loss impact with the blended appreciation of the rupee by 2.1% on a greater close basis.

During FY07, the rupee has appreciated by 3.45% against the USD, the saving grace though has been rupee's depreciation of 6.11% against the EUR and 9.05% against the GBP. But the trend is disturbing with all the three currencies starting to depreciate against the rupee over H2FY07, as witnessed in the normalized currency movement graph alongside.

Though on the business and operations front, we hold a positive outlook on the industry. We believe that due to concerns like,

• Rupee appreciation
• Continued wage inflation
• Declining return ratios progressively over the years.
• Declining EBITDA margins on a year to year basis (in most of the top rung counters)
• Higher effective tax rate expectations from 2010 onwards, as section 10A benefits expire and the industry grapples with moving as much of the incremental business as possible into the still hazy world of SEZs.

Any expansion of PE's from historical levels appears unlikely at least for the top rung counters. We though believe that select mid caps do present this opportunity for a PE re-rating based on improved operational performance and continued growth momentum.

Within large caps, we maintain our positive bias on Infosys and TCS and a hold on Satyam . Within mid caps, Mphasis , Prithvi Info and NIIT Tech remain our top picks.