May 31, 2012

Evaluating the impact of rupee depreciation

The 22% drop in the rupee against the dollar is worrying to say the least. There are several ramifications for the Indian economy, if the slide continues.  Anything which impacts the economy, is bound to impact the stock market as a whole.
One can find a dizzying array of macro-economic analysis on the impact of the rupee depreciation and as many forecasts of the future levels of the exchange rate.
I personally consider macro-economic analysis too complex due to the huge number of variables involved in it and hence any analysis from my end is as good as yours. Instead I have been trying to evaluate how the rupee depreciation will impact my portfolio on an individual stocks basis.
I think there are three factors through which the fundamental performance  can get impacted
Factor 1: Level of Raw material / capital good import
What is the level of raw material / capital goods imported by the company?. If the company imports a substantial amount of raw material/ capital goods then it is likely to get impacted severely, if it cannot pass on the costs to the end user without impacting the volumes
Factor 2: Level of export
What is the level of export sales in the revenue of the company. A high level of export will benefit the company, if the company can maintain or improve its margins as a result of the rupee depreciation.
Factor 3: Level of foreign debt
What percentage of debt is ECB (external commercial borrowings) or FCCB? There are two key points to note here – What is the maturity schedule (payment timing) and the level of debt in comparison to equity / market cap?
The above three factors cannot be looked in isolation and have to be combined to come up with a final impact on your company.
For example – A company may have a high level of export and imports, with the exports exceeding the imports (due to value addition on the raw material). In such a case, the company will have a net benefit.
 A company using domestic inputs and exporting most of its output will gain the most from the depreciation (IT and pharma). Conversely a company using imported inputs and selling most of it domestically will be hurt badly (Oil companies).  Finally a company with high level of imported inputs, selling domestically and also carrying a high level of foreign currency debt is toast (to put it politely)
If level of export >= import + debt payment (ok)
If export < import + debt payment (trouble)
Let me give you two examples of the analysis I am currently doing on my portfolio stocks
Balmer lawrie
The company has zero debt and actually has excess cash of around 200 Crs. So we do not have forex related debt risk with the company
The company imported around 4% of its inputs and earned roughly the same amount in exports.  So at first glance, the company has close to zero risk from higher raw material costs due to currency depreciation. However the grease and lubes division uses various base oils which are petroleum based and will be impacted by the price of crude oil. As the division does not have much of a pricing power, the net margins of this division are likely to be impacted.
The other divisions such as logisitics and tours & travel are unlikely to be impacted directly due to the currency depreciation.  However the overall business will definitely be impacted by the overall slowdown in the economy.
Lakshmi machine works
The company has close to 700 Crs+ excess cash on the books and hence the risk of forex debt does not exist.
The company exported around 250 Crs of machinery and components in 2011 and imported roughly the same amount in terms of raw materials and spare parts. As a result , the company is unlikely to get directly impacted by the rupee depreciation. On the contrary, the company could benefit to a certain extent as the competitive pressure from imported machinery will reduce.
Finally I think that the textile industry level issues will have a bigger impact on the company performance than the currency depreciation.
Not a quantitative analysis
The above analysis is not a precise numerical analysis and I would be suspect of any such analysis, as there are too many variables which impact the performance of a company. The best one can do in the current circumstances is to figure out if your portfolio company falls in the high risk or low risk bucket (due to the currency depreciation).
If the risks are too high (even if not quantifiable), then one should consider reducing the position size even if it results in a loss

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog


Sachin Purohit said...

One problem in this analysis is:
You could be buying raw materials that are not imported. The petrol/diesel required for your plant may have been purchased from some refinery in India but the price of this raw material is a function of the imported commodity - crude oil. A direct comparision of import bills and export revenues of a company might hide a lot of such items from the analysis.

Gaurav said...

Good analysis Rohit. However I have few questions. However I believe that the companies having significant exposure to forex markets, keep that risk hedged. How do you take hedging factor into consoderation while analysing such impact? A company with significant exposure (lets say ~20-30%)on forex will be hedging the risks on a recurring basis. Do you factor it?

Rohit Chauhan said...

Hi sachin
that is true ...but if the energy requirement - oil or diseil component is high, then that is really a component of your RM itself. for example a distribution company has a high fuel cost and hence its inputs are imported.

so you are right...the definition of RM should expanded to include all major inputs


Rohit Chauhan said...

Hi gaurav
most company's hedge 3-6 months of revenue. anything beyond that is quite expensive in terms of hedging cost and the hedge can work against you (look @ NIIT tech in 2007-2009)

so i would say the hedge shields you for a few months and then you have to create a new hedge again at the existing exchange rate

at the risk of simplifying, i would say a hedge is a wash in time periods over 6 months


Vignesh said...

Hi vignesh
i am watching the company too, but i think the company is still stuck in an old mode of working. they are chasing margins which are difficult to get

all this story about premium service and infosys 3.0 just story put it politely

i have worked in this industry for too long and have yet to see anyone sell premium service in volumes. again indian IT companies have no IP at all unlike an IBM

i would not look at past profits and valuations to make a decision.


On top of the above discussion,

They are trying to create IP thru their products and platforms business and they claim that thru C&SI they are getting 30 % of their business where the margins are higher... Your thoughts on the above?

Rohit Chauhan said...

hi vignesh
to evaluate infosys business and possible future ...look at the 10-K (annual report) of IBM and accenture. these companies make around 10% net margins in their consulting/ service business

the product business where IBM has a high market share is a 30% net margin business

It takes time and risk to develop successful products in view of the other competitors, its diffcult to see how infosys can sustain 25%+ margins for too long. again with these initiative they can delay the slide, but a non product service company will find it difficult to sustain 20%+ margins