A Different View on Indian IT Services Firms

It matters less and less that Indian-based information technology service providers are based in India. As the entrenched Western IT firms establish facilities in India and as the Indian firms open facilities around the world, the geographic source of IT services delivery is becoming blurred. What remains clear--in our opinion--is that the Indian firms will continue to disrupt the global IT services markets, post very strong revenue growth rates, and retain their high levels of profitability for many years to come. We recently took a fresh look at Indian firms  Infosys (INFY),  Wipro (WIT),  Satyam (SAY), and  Patni  and came away with a few interesting insights.

The Competitive Advantage of Indian IT Firms
Nasscom, the Indian IT software and services trade group, estimates that IT outsourcing in India will grow by 24% on average annually for the next five years. Indian firms are winning outsourcing projects that are larger and more complex, showing that North American and European corporations increasingly trust them. The firms are not winning such deals just because they have lower costs, but because they are also delivering high-quality (often higher)projects in a manner that customers like.

Contrary to popular belief, low labor costs aren't the source of the Indian firms' competitive advantage. Everybody is in India now. Here's how the Indian firms do it. For years, the entrenched Western players dictated a certain way--their way--of providing IT services to clients, relying on partners and their old-boy network to win business. Enter the Indian IT firms with no partners and few contacts, working their way up from low-level application maintenance in the early 1990s and gaining greater exposure during the Y2K software crisis, when Western corporations had to turn to them for help. The Indian IT firms had few clients and were often falsely perceived as low quality (which often goes hand in hand with low cost). As a result, they had to rely on their centralized, disciplined organizational structure, their best-of-breed project delivery processes, and their flexible, transparent contracts to wow clients. And wow them they did. Industry disruption began after the Y2K crisis abated, with existing clients giving them more work and other corporations giving them a seat in the proposal process.

As Indian firms gained market share and disrupted pricing--even on deals they didn't win--Western IT firms began opening facilities in India to take advantage of lower labor costs. However, most of these firms have not altered their fundamental business models to fully integrate global delivery ( IBM (IBM) and  Accenture (ACN) being the exceptions, in our opinion), persisting in the view that India is simply a cost management center. Meanwhile, the Indian firms have expanded beyond India, sending consultants and project engineers to U.S. and European clients, opening delivery centers in Canada and Eastern Europe (nearshore), and moving some work to even lower-cost countries (China, the Philippines, Malaysia). Even though Western players have moved strategically to compete head on, we think the Indian firms have remained a step ahead.

Future Challenges
The massive growth of IT outsourcing facilities in India has raised two issues: When will the demand for Indian software engineers outstrip supply and constrain growth? When will rising labor costs crush the Indian firms' profitability? We believe the answer to both questions is: not anytime soon.

As for supply, Nasscom estimates that by 2009, India's universities will not graduate enough engineers to meet demand. But the Indian firms aren't sitting around waiting for the inevitable--they remain the employers of choice for most Indian graduates because of their competitive compensation, their extensive training, and likely their national pride. Infosys only accepts 1.5% of applicants and Wipro accepts 0.8%. Both firms have long-term training programs, with Infosys' Mysore campus set to become the world's largest corporate training facility. Such training programs can take students with no engineering background and train them into software engineers. Indian firms are also hiring more Americans and Europeans for onsite work and more staff to fill their facilities outside of India.

As for labor costs, we do not doubt that they will drive operating margins down from their current high levels (20% to 30%) to be in line with Western firms (high single digits, typically). However, we believe this will take 10 to 20 years to occur. High revenue growth, attrition among higher-paid experienced employees, the perennial influx of lower-paid new recruits, and an increasing proportion of non-Indian-based employees must also be figured into the wage inflation discussion. Infosys, for example, estimates that wage inflation--when viewed across the entire employee base--exerts only 1.3 to 1.6 percentage points of pressure on operating margins. Financial results at the Indian firms support their contention. Our own analysis has shown that operating costs per average employee at most Indian-based IT services firms is actually declining, as operating leverage, greater scale, a larger percentage of higher-margin revenue, increased employee utilization rates, and foreign currency translation effects all get factored into the equation.

Overall, if any of the four Indian IT services firms' ADRs traded in 5-star territory, we would be eager buyers of the shares. Valuations aside, we would prefer Infosys and Wipro because of their larger size and lower risk ratings. While all four are currently trading near our fair value estimates, keep them on your radar screen: your grandchildren will remember you fondly.

  Infosys Technologies (INFY)
Morningstar Rating: 3 Stars
Moat: Narrow
Risk: Average
Infosys has expanded the breadth of its offerings. From application maintenance up to IT consulting, the firm spans the IT services value pyramid. With its processes assessed at the highest level by Carnegie Mellon's Software Engineering Institute (a highly respected designation), Infosys has a reputation for better, faster, and cheaper project delivery. It has a proven ability to hire top talent at will, and it trains new employees quickly in a standardized methodology. Management is respected at the highest levels of global corporations. The current challenge is to continue to raise its profile to win bigger deals. Since 1999, the firm has turned 17% of aggregated revenues into free cash flow.

 Wipro  (WIT)
Morningstar Rating: 3 Stars
Moat: Narrow
Risk: Average
Wipro derives 25% of its revenue from the research and development outsourcing of large, well-known clients such as  Intel (INTC),  Cisco Systems (CSCO), and  Sun Microsystems . It was the first software services company in the world to be assessed at the highest level by Carnegie Mellon's SEI. Chairman and CEO Azim Premji, considered to be one of India's top entrepreneurs, has guided Wipro on its path to IT greatness. Management has a demonstrated commitment to high returns on invested capital--even its legacy consumer products division delivers ROI in excess of 70%.

 Satyam Computer Services (SAY)
Morningstar Rating: 1 Star
Moat: Narrow
Risk: Above Average
About 55% of Satyam's revenues come from onsite work, which distinguishes it from its Indian rivals. The higher cost of onsite workers holds operating margins in the low 20%s. Satyam has established development and business continuity centers across the Asia Pacific region. Its processes, too, are assessed at SEI's highest level. However, we believe that it carries higher risk than its rivals, in part because of its relatively high levels of wage inflation and experienced-employee attrition.

 Patni Computer Systems  
Morningstar Rating: 3 Stars
Moat: None
Risk: Above Average
Boasting a 15-year, $100 million per year relationship with  General Electric (GE), Patni has developed processes that keep even the largest corporations happy. Client concentration risk is a concern--and the primary reason for its above-average risk rating--but the continued addition of new, large clients is slowly diluting this concentration.