Outsourcers: Coming Down to Earth

The once high-flying shares of Indian IT consultants have retreated, giving investors an attractive entry point

The years between 2003 and 2006 could be considered a golden age for Indian IT service providers. Demand for consultants and providers of other technology services was high as companies hired them to find ways to cut costs and improve operations, sending the shares of Cognizant Technology Solutions (CTSH) and Infosys Technologies (INFY) flying through the stratosphere. Now they've tumbled back to earth, as worries about an economic slowdown grip the markets.

So far this year through Jan. 18, the S&P IT Consulting & Other Services Index fell 18.8%, vs. a 9.8% decline in the S&P 500. That's on top of the 16.1% drop for consulting and services stocks for all of 2007.

Although the stocks have been depressed, so far outsourcers say demand is holding up. "Selectively they're doing a good job of managing margins in the face of headwinds," says Dylan Cathers, who follows IT consulting and services stocks for S&P's Equity Research. "When you factor in the good growth rates and attractive PEG ratios, we believe this is an attractive entry point."

BusinessWeek's Karyn McCormack spoke with Cathers on Jan. 23 about his view of the consulting industry and his favorite stocks. Edited excerpts of their conversation follow.

A few IT consulting companies recently reported quarterly results. How did they fare? What did you make of their outlooks?

So far, three of the Indian outsourcers that I cover have reported results. In general, they fared well—they met or modestly exceeded expectations. Guidance was generally good, but what I would call guarded—they hedged a little for their outlook for 2008.

It's worth noting that these companies report on a March fiscal year, so I won't get guidance on fiscal 2009 until April. So their recent comments were more short-term in nature: They said demand has continued to be good, and they haven't seen any notable slowdown in the U.S.

One thing they did say was some of their clients have yet to set their IT spending budgets for calendar 2008. They generally have an idea of what to expect by January, but it seems their clients are pushing off decisions as long as possible so they can get a better idea of the economic outlook.

Will the credit troubles at banks and other financial companies hurt them?

There could be a slowdown in demand for IT services from companies in the financial-services area. For some outsourcers, contracts with financial-services firms account for 30% to 50% of their revenue.

But so far the IT outsourcers haven't seen anything substantial—some clients have just delayed setting their budgets. Indian outsourcers did provide more details about spending habits and budget constraints than they did a year ago—I think they're trying to give analysts and investors as much information as possible.

One of my tenets for the group is if corporate profits are soft, this is the time that companies will be more likely to go ahead with projects to cut costs and get leaner. So if there is a recession, or we're in one, then IT outsourcing firms stand to gain ground as more work is moved offshore. Plus, noncore businesses are often done better by an outside party. We've seen these themes play out over the last several years.

What's your fundamental outlook for the IT consulting companies? What are the challenges they face?

My fundamental outlook for the industry is neutral. On one hand, you have strong demand for consulting services and outsourcing, but you can't overlook the problems in the economy. If companies are going to hold off spending, there's not much outsourcers can do.

In terms of revenue, the main challenges are out of their hands. There's always competition, and now there's the specter of reductions in IT budgets.

For Indian outsourcers, the biggest challenges are on the cost side. Wage inflation is rampant in India. And there's the appreciation of the rupee (which lowers the value of revenues when converted from U.S.