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Get Four
|  | OCTOBER 29, 2004
By Stephanie Crane India's Outsourcers Gain Traction Infosys, Wipro, and Satyam are all poised to expand growth, margins, and markets, earning each a 4-STARS rating On a year-to-date basis, American depository receipts (ADRs) of Indian info-tech outsourcing leaders Infosys Technologies (INFY; recent price: $67) and Wipro (WIT; $21) have risen 43% and 35%, respectively, while those of Satyam Computer Services (SAY; $26) have leveled off slightly after hitting a high in early 2004. We at Standard & Poor's have accumulate (4 STARS) recommendations on the shares of these companies based on several factors. They have attractive valuations, using relative price-earnings-to-growth (PEG) ratios of 1.2, and double-digit earnings growth potential. They're seeing solid demand for offshore outsourcing as global corporations look to gain cost efficiencies across emerging markets. We also think these three companies have the ability to expand operating and profit margins at a double-digit rate by leveraging their cost efficiencies through a global delivery model. GLOBAL ADVANTAGE. Nonetheless, we also see some volatility in the shares coming from the threat of increased wages and geographic diversification away from India, both of which are a result of aggressive competition in the region for outsourcing clients and skilled labor. We believe these threats could dampen potential increases in margins. The Indian IT outsourcing companies have been successful at competing for application infrastructure projects as well as system and business-process outsourcing with behemoths such as IBM (IBM; accumulate; $90), Accenture (ACN; hold; $24), Computer Sciences (CSC; buy; $50), and Electronic Data Systems (EDS; hold; $21), partly by taking advantage of a unique global delivery model. Infosys, Wipro, and Satyam use a low-cost resource base within India on IT outsourcing contracts across the globe. More than 70% of Infosys' revenue comes from North America, while Wipro gets 53% and Satyam gets 73% of sales from the region. Both Infosys and Wipro employ a strategy whereby projects are divided into components, then executed simultaneously in several different locations: at the client's site, at development centers in India, and other areas that will soon include China. We believe this elaborate global network lets these companies optimize a lower cost structure and maximize efficiencies across time zones, reducing product delivery times. EMERGING MARKETS. Satyam uses a proprietary network called framed relay network along with Satyam Net to link a customer's on-site system with Satyam's off-site and offshore centers and provide real-time service. It divides projects into several different locations, at the client's sites, where 20% of a team remains on hand to supervise, and at development centers in India. As growth and business momentum for these companies likely accelerate, we also see some threats. Competition has grown rampant within India as the leading three outsourcers compete head-on with IBM, Accenture, Computer Sciences, EDS, and others, for localized IT development centers employing India engineers. As a result, wages have increased for mid-level employees by more than 15% in the most recent quarter. Satyam is raising wages from 18% to 20%, Wipro by 15% to 18%, and Infosys by 15%. Other efforts to manage attrition among these valuable employees include incentive compensation plans and stock options, which we believe are a recent concept in this region. We expect productivity to increase as much as 10% through this effort. With countries such as China, Malaysia, Australia, and New Zealand offering what we see as attractive locations for cost-efficient IT development centers, geographic competition has forced the Indian IT outsourcers to focus on emerging markets to capture cost efficiencies and market share. Infosys plans to develop a center in China to employ software specialists for Java-based programming and non-English work. Satyam says it will focus on other emerging markets such as Brazil and key countries in East Europe. Wipro is actively investing in Malaysia as well as mainland China. IMMUNE TO POLITICS? Of the three leading players, Infosys is our favorite due to its size. It's the largest of the three, with $1 billion of revenue in fiscal 2004 and a market capitalization of $18 billion. Infosys has a variety of clients, with the largest contribution to revenues in the September quarter coming from the insurance/financial (35%), manufacturing (15%), and telecom (18%) industries. Its top-10 clients provide 35% to 39% of sales. Within its service offerings, infrastructure development accounts for approximately 25% of sales, with maintenance making up 30%. In the September quarter (the second quarter of fiscal year 2005, ending in March), Infosys says 96% of its revenue ($379 million) came from repeat contracts, providing it with a solid recurring revenue stream, which we consider a key positive for investing. As IT spending grows in selected markets, we also expect Infosys to post solid bookings growth, and we expect it to exploit its growing position in business-process outsourcing. We project sales growth of 46%, to $1.5 billion, in fiscal 2005 and 20%, to $1.8 billion, in fiscal 2006, as we see demand increasing for IT services and outsourcing growing in the public, financial, consumer, and communications industries -- areas in which we look for an accelerated recovery as enterprise-based capital spending rebounds. Aggressive efforts by Infosys to invest in operations and clients in the U.S. and Europe will continue to show positive results, in our view, despite the risk of political pressures. We expect operating margins to continue to be around 30%, as Infosys minimizes operating expenses and makes the most of its global delivery model, with enhanced pricing options. We estimate net income of $392 million ($1.46 per ADR) in fiscal 2005, up from $270 million ($1.01 per ADR) in fiscal 2004, and $436 million ($1.62 per ADR) in fiscal 2006.
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