As more American and European companies ship specialized service and high-tech work to developing nations such as India, business looks bright for the outfits that supply the labor. Yet stocks of many major offshore consultants have been struggling. For instance, the American depositary receipts of Infosys Technologies (INFY ), India's second-largest outsourcing specialist, are down 13% so far this year. Returns for Cognizant Technology Solutions and Wipro (WIT ), two other brand-name offshoring companies, are down 4% and 27% respectively. Intensifying competition, concerns over rising labor costs, and worries about growth prospects have put pressure on stock prices.
The market's retreat may give an opening to investors intrigued by the sector's prospects but wary of nosebleed price-earnings ratios. Certainly these companies are well positioned to take advantage of a trend still in its infancy. For instance, market researcher International Data projects that by 2007, 6% of U.S. information technology services work will be done offshore, up from 3.1% in 2003. Not all of that goes to Indian companies. IBM, Accenture (ACN ), Electronic Data Systems (EDS ), and Keane (KEA ) are shipping work to India, too. The IT consultant Keane, based in Boston, had only 200 employees in India three years ago. It now has 2,000 workers there and expects to reach 4,000 to 5,000 within three years, according to Chief Executive Officer Brian Keane.
Still, to get the purest play out of the offshoring trend, Wall Streeters are turning to the biggest and best known of the Indian offshore players whose stocks trade in the U.S. -- Cognizant, Infosys, Satyam, and Wipro. Their software application and maintenance work has become synonymous with quality, in the same way Japanese auto makers have earned that reputation with cars.
All are changing their underlying business model. For years they thrived as American companies shifted high-wage jobs in the U.S. to low-paid Indian workers. Indian software professionals still earn only one-third as much as their U.S. counterparts, but the Indian outfits are moving resources into more sophisticated services with higher price tags: reading medical X-rays, analyzing equities, and processing insurance claims. "The business climate is very encouraging, and the ones growing fastest are the Indian specialists," says Ashish R. Thadhani, an analyst at Gilford Securities.
Infosys ranks high on Wall Street's list. It has a strong, multinational, blue-chip customer base in financial services, telecommunications, and many manufacturing industries. Its 30% average profit margin is about a third higher than those of its major Indian rivals, and its return on invested capital is an impressive 45%. Thanks to an employee stock-option plan, Infosys' employee turnover is about half the industry average.
Expensing those options is, in part, responsible for the company lowering its profit forecast for the 2006 fiscal year. So is uncertainty over future orders from American and European companies in the throes of mergers or reorganization. Still, Julio Quinteros, who follows the company for Goldman Sachs, estimates Infosys is primed for 30% to 34% earnings growth.
Other offshore companies compete for the same business, but each has a different profile. At Cognizant Technology, for instance, a high proportion of sales comes from existing clients. Satyam earns more than 50% of its revenue from work done at client sites or at a nearby facility. The tactic generates strong customer loyalty but keeps operating margins to around 20%. Giridhar Krishnan, an analyst at Morningstar, projects a 23%-a-year gain in annual sales over the next five years, with operating margins contracting to 18%.
Wipro, while a whiz in consulting, is in an odd mix of businesses that includes cooking oil, soap, deodorant, and hardware. These mundane products are cash cows, but they do temper Wipro's growth prospects. The company is looking to overcome that by taking over research and development efforts for large multinationals from the developed nations.
Outsourcing clerical tasks is one thing, but R&D is quite another. Analysts who follow the offshore consultants worry about political repercussions in the U.S. and Europe -- and how that may affect future contracts. Indian managers, on the other hand, are more concerned about labor costs, which are rising at a double-digit rate.
The worries are real, and that's a big factor weighing on the stocks. To buy them, the bet is that they'll continue to be able to help U.S. and European companies lower their costs. That need will not go away anytime soon.
By Christopher Farrell