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By Stephanie Crane 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.SOLD PROSPECTS. Based on valuation, as well as our expectations of revenue and earnings gains and market-share growth in key markets, we recommend accumulating Infosys shares. We're impressed with its plans to boost revenues in high-value areas, and we believe efforts to leverage a consulting venture and focus on hiring in China could lead to a revenue mix with improved margins.
Infosys is also raising wages and offering incentive compensation for mid-level jobs located in India to keep employees from leaving and inspire productivity. Our 12-month target price of $71 is based on a peer-based PEG ratio of 1.2.
Wipro had revenue of $1.3 billion in 2004, greater than Infosys, but it has a slightly smaller market capitalization of $15 billion. Wipro focuses on global IT projects, with this business segment garnering 75% of sales. We also see a solid push toward business-process outsourcing, which posted a 20% rise in sales in the September quarter from the previous quarter.
We expect Wipro's sales to rise 38% and 35% in fiscal year 2005 (March) and fiscal 2006, respectively, reaching $1.4 billion and $1.8 billion, thanks to aggressive expansion in the U.S. and Europe. While IT spending is growing in selected markets, with some early recovery in the U.S. and strength abroad, we expect Wipro to see solid bookings in upcoming quarters.
We believe operating margins will continue in the range of 20% to 25%. We estimate net income of $305 million (44 cents per ADR) in fiscal 2005, up from $231 million (33 cents per ADR) in fiscal 2004, and $381 million (55 cents per ADR) in fiscal 2006.
EUROPE, TOO. We recommend accumulating Wipro shares based on valuation, as well as our growth expectations for revenues and earnings, anticipated gains in market share, and advances in key markets in India, the U.S., Europe, and other regions of Asia. We have a 12-month target price of $26, which is based on relative multiple as well as historical valuation methods. We use a peer-based PEG ratio of 1.2 based on fiscal 2005 earnings.
Satyam is the smallest of the three companies, with sales of $506 million in fiscal 2004 (ended March) and a market capitalization of $4 billion. It specializes in IT services, with strength in software development, system maintenance, engineering design services, and packaged software integration. We also see a push into business-process outsourcing, although at this point Satyam gleans less than 1% of sales from this business. In the past two years, 84% of revenue has come from contract renewals, which we believe is a result of management's desire to branch out into Internet-based applications and offer clients dedicated service.
We expect sales to grow 31% and 20% in fiscal 2005 and fiscal 2006, respectively, reaching $750 million and $900 million, as we believe aggressive efforts by Satyam to gain share in the U.S. and Europe should begin to show positive results. We expect Satyam to post solid bookings in coming quarters, especially as it leverages its global delivery model. Revenue in the second quarter of fiscal 2005 rose 43%, driven by an increase in offshore contracts as well as stable pricing.
We expect operating margins to continue ranging between 19% and 23%. Wages increased by 18% to 20%, somewhat dampening its margins, and something we consider a risk to long-term operating profit growth. Fiscal second-quarter earnings rose 28% from the prior year on a solid order flow. On this progress, we estimate net income of $149 million (95 cents per ADR) for fiscal 2005 and $164 million ($1.04 per ADR) for fiscal 2006.
COMPETITION'S IMPACT. We recommend that investors accumulate Satyam, based on valuation as well as the growth potential of the fundamentals and that of the markets in which it operates. Our 12-month target price of $28 is based on relative multiple as well as historical valuation methods. We use a peer-based PEG ratio of 1.2 based on projected fiscal 2005 earnings per ADS.
Risks to our recommendations and target prices for Infosys, Wipro, and Satyam include increased competition in IT services, resulting in pricing pressures that could erode profit margins; attrition in midlevel employees; and political pressures in the U.S., where these companies do over 50% of their business, that could adversely affect revenue and earnings growth.
Note: Stephanie Crane has no stock ownership or financial interest in any of the companies in her coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst Crane follows technology outsourcing companies for Standard & Poor's Equity Research