Rates Ride Infosys

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Indian outsourcer Infosys (Nasdaq: INFY) reported fiscal 2008 second-quarter earnings Wednesday evening, highlighting:

• "improved" operating margins;
• a "milestone" passing of $1 billion in quarterly revenue;
• the addition of 48 new clients, including Dutch electronics powerhouse Philips (NYSE: PHG);
• and last but not least, increased guidance for the fiscal year.

The market was not amused.

I don't get it. What's so funny?
At first glance, nothing. Profits and sales both exceeded expectations as the firm booked in excess of the aforementioned $1 billion in sales, earning $0.48 per American depositary share, a 33% increase year over year. More impressive still, the firm's generation of free cash flow through the first half of this year rocketed 62% to $382 million (which is, admittedly, still far below GAAP earnings).

But here's the inside joke: None of the above matters, because Infosys must beg for mercy from forces outside its control. Namely, the exchange rates I mentioned earlier this week. Analysts argue that for every 1% India's rupee rises in value against the incredible shrinking dollar, Infosys loses 30 to 50 basis points worth of margin. And the rupee is already up 12.5% against the dollar this year, and climbing. No wonder investors got spooked.

The punchline
So here's the catch-22 that Infosys and peers like Wipro (NYSE: WIT) find themselves caught within: As the dollar devalues, two equally unattractive options emerge. They can accept shrinking dollars in payment for services at their usual rates, and translate them back into fewer rupees. Or they can raise rates to compensate for their clients' devaluing currency. Problem is, the more they do that, the more they diminish the cost advantages that attracted clients like Boeing (NYSE: BA) and Hewlett-Packard (NYSE: HPQ) to India in the first place.

Is the joke on U.S.?
There is, however, a silver lining to this stormy story. And this lies in the fact that in a flat world, Infosys doesn't necessarily need U.S. clients. It can dodge the currency bullet by landing clients from countries where the local lucre is actually worth something. Russia's VimpelCom (NYSE: VIP) would be one good choice. Canada's Research In Motion (Nasdaq: RIMM) another.

Speaking of which, did you happen to catch the identity of the one new client that Infosys named in Wednesday's report? That's right: Euro-zoned Philips.

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