Hidden Risk in Indian Tech

One of my hobbies is to poke holes in stock ideas of analysts. Recently, these talking heads have put out strong buy ratings on Indian tech companies, the likes of Infosys, Wipro, TCS and even Satyam (post scandal). Here is what I need to know before I can be certain of such a trade.

Winning contracts in currency uncertain environment

Indian IT companies have been winning technology contracts from top companies, most recently Walmart. Now imagine a US company that knows USD will depreciate. So how would this impact my sourcing strategy? I, personally, would accelerate all the supplier contracts in today's dollars. Iron-clad them in legal fine-print to mitigate risks from demand collapse and currency fluctuations. The longer such a contract the better it is! Now the question for me is, sitting on other side of this agreement, how have IT companies managed this risks?

The currency risk

This is the most potent business killer, if ever one exists, in Indian IT companies. A lot of analysts have sensitivity analysis ranging from INRUSD of Rs 30/ USD to Rs 50/USD. A few smart investors have already stressed the financials till INR 20/USD and seen the impact. Even smarter investors know that the impact is non-linear in nature. Such currency volatility needs business model innovation (as above) rather than simple currency hedges. The volatility implied in such scenarios may actually test counter-parties in hedged transactions.

Survival Necessities for coming years

Given our current situations, IT companies will have to prepare differently to survive.

• Multi-location operations will be an advantage: This implies having robust processes to create and manage scaling issues well. Companies like ones mentioned above are operating in various countries thus helping them react better. 
• Flexi-sizing will be key: If the currency valuations reach new normalcy, it will be important to relocate manpower to cheaper locations. Companies will have to be quick to rapidly expand, move or lay-off employees. While, all the companies above have what it takes to do it, we should realise it is not an easy process.
• A bit more fat! The crisis is upon us and the IT companies are cash rich. The key is to keep higher than normal cash reserves and not fall into the acquisition trap at this early stage. 

The best time for investment is not now!

Once the currency crisis hits, there will be more clarity on winners and losers. At that point valuations will be saner and those that survive will definitely give better results. Till such time, I would keep a safe distance between myself and IT stocks.