Profit in the software export business depends on more than the quality of the code written. Currency movements, employee turnover, and cost discipline all play important roles. Anyone studying IT Stocks will quickly notice how these factors can swing quarterly profits even when demand remains stable. Likewise, a long-term chart of the Wipro Share Price reflects not only deal wins but also the effect of wage cycles, currency trends, and talent management. This article explains how these elements interact.
How the Rupee Affects Earnings
Most revenue is invoiced in foreign currency while most expenses (especially salaries) are incurred in rupees. Hence, a weakening rupee increases the value of every unit of revenue in rupee terms and vice versa.
Companies hedge some of this exposure by buying forward contracts to lock in a certain exchange rate. While hedging reduces the variability in profits, it does not eliminate it entirely, and the resulting profit and loss on these contracts shows up in the income statement. Investors must read the forward contracts note carefully to understand how much of the FX exposure has been hedged.
It is important to remember that currency tailwinds are usually short-lived and a margin expansion driven primarily by a weaker rupee is unlikely to last as long as one driven by operational improvements or higher pricing power.
The Salary Cycle and Its Effect
Wages tend to increase annually (although the timing varies across companies). The quarter in which companies decide to give salary hikes usually witnesses a noticeable drop in margins. Promotions, retention bonuses and special allowances for key personnel further add to these costs.
During periods of strong demand, companies compete harder to retain and attract talent and salary increases tend to be larger. During weak periods, hikes may be deferred or smaller than budgeted. Watch out for any changes in the commentary on compensation to get a sense of where margins may be headed.
Understanding Attrition
Attrition rate measures the percentage of workers who leave the company during a financial year. A high attrition rate is expensive since replacements have to be hired and trained and existing clients may be wary of the instability within the company. Loss of experienced engineers also impacts the depth of the engineering team.
However, it is important to analyse the context in which these numbers have to be analysed. During a tight labour market, attrition rates tend to rise as employees jump ship to take advantage of the situation. During a downturn, rates fall as there are fewer opportunities. Hence do not jump to conclusions based on absolute numbers. Compare the attrition rate with that of the past as well as other companies in the sector.
Utilisation and Pyramid Management
Utilisation measures the percentage of employees who are actually engaged on a billable assignment. The higher the utilisation, the better it is for margins. However, extremely high utilisation leaves no room for training employees or taking up special projects that may come in. There is also a trade-off between utilisation and employee morale.
The shape of the pyramid (the proportion of entry level employees to mid-level and senior-most level) impacts costs as well. A wide pyramid implies that a higher percentage of the workforce consists of freshers who have to be trained. Companies that hire directly from campuses and spend heavily on training have advantages if the market is willing to absorb these graduates.
Subcontracting and Location Mix
Subcontracting can help during busy periods but comes at a higher cost than full-time employees. Thus, a decline in costs towards subcontracting consultants usually impacts the margins positively. Similarly, a shift towards lower-cost locations (both within India and outside the country) can improve margins although it entails significant set-up costs. Thus, take a look at the composition of work done from various centres and watch out for any improvement in utilisation.
Putting the Numbers Together
While analysing a quarterly results report, do not forget to ask a series of questions – did revenue increase in constant currency?, was the jump in margins due to currency fluctuations, wages, utilisation or pricing power? Did attrition rates increase or decrease? What does the management have to say about headcount and compensation?
Watch out for situations where expansion in margins has been primarily driven by FX gains since such situations are unlikely to repeat themselves for an extended period of time. If the story is one of higher utilisation and pricing power, it is likely to be sustainable.
Implications for Your Portfolio
Given the cyclicality of FX and attrition, it makes sense to stagger purchases of such stocks over a period of time across multiple companies in the sector. Such a strategy reduces the risk significantly although one should not invest more than one can afford to lose. Dividend policy and cash generation capacity are worth watching out for since cash provides a cushion during periods of stress.
Review the portfolio after every set of results and revise the thesis if circumstances change. Summing Up The seemingly mundane aspects of rupee value, attrition and wages, have a significant impact on the bottom line. A reader who is aware of the subtleties can separate out the noise from the underlying performance of the business.