Outsourcers Weather the Political Storms
Outsourcing, a hot political issue during the presidential race, has drifted off the front page. But like it or not, business is better than ever for the India-based companies that did so much to raise the ire of labor advocates in the U.S.
Shares of three of the largest offshore information technology outsourcers,
Infosys Technologies
(INFY) - Get Report
,
Wipro
(WIT) - Get Report
and
Satyam Computer Services
(SAY)
have soared since mid-May, appreciating 98%, 63% and 33%, respectively.
And despite pressure from rising salaries, a stronger rupee and a politically charged climate in both India and the U.S., all three posted year-over-year revenue gains of more than 40% in calendar 2004, while earnings in the December quarter rose by an average of 44%.
Has the plethora of good news pushed the stocks too high? Analysts who follow the sector don't believe so. Ashish Thadhani of Gilford Securities says that based on his forward estimates, all three are trading at P/E multiples ranging from 25 times to 40 times, "which are in line with historical trends."
Trip Chowdhry of FTN Midwest Securities said, "Because the potential market is so much larger than has been penetrated, there will be upside over the next five years."
But Chowdhry quickly added that "there will also be volatility. Now that these companies are playing in the world market, they will be subject to geopolitical uncertainties, as well as political uncertainty at home. However, the volatility will not be a sign of fundamental weakness."
Chowdhry's warning is on point. The roller-coaster ride that investors in India were forced to take last spring illustrates the danger -- as well as the underlying strength -- of the outsourcers.
The outsourcing sector, along with the rest of the Indian stock market, was hit hard by fears that the
Congress Party government, newly elected in May, would veer to the left and roll back years of economic development.
Strong Finish for Indian Outsourcers |
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The widely watched Bombay Sensex Index (also known as the BSE 30) by mid-June dropped nearly 20% from its April highs; on one particularly bad day it shed 15.5% intraday. The Bombay Exchange suffered its worst-ever one-day drop, and heavy inflows of cash from abroad plus pressure from an accelerating economy pushed the rupee to its highest levels against the dollar in about four years.
The Economy That Didn't Derail
The unease spread beyond India. The benchmark Morgan Stanley Capital International Emerging Markets Free Index, which was also hit by the bond meltdown in the U.S., dropped 20%, said Howard Simons, president of Rosewood Trading and a
RealMoney.com
contributor. It looked like the wheels might come off of the outsourcing juggernaut.
That didn't happen, and to those familiar with the political economy of India, the recovery was no surprise.
First and foremost, said Rafiq Dossani of the Asia-Pacific Research Center at Stanford University, people who saw the Congress Party as antibusiness were far off base. In fact, Prime Minister Manmohan Singh, who took the job when Sonia Gandhi declined, is widely seen as the architect of India's economic reforms of the 1990s.
Although the communist members of the government have some influence -- they were, for example, able to stop the privatization of India's major airlines -- fears that the leftists would derail foreign investment were largely overblown. The communists have even pushed economic development, including technology products, in states they control.
Since taking office, Singh has poured time and money into improving the country's infrastructure and has pushed successfully for the delicensing of parts of the spectrum, including 2.4 GHz, used by popular Wi-Fi devices, said Dossani. Also reassuring, noted Thadhani, were the privatization of a major power company and widespread expectations that the national budget due this month would be business-friendly.
And then there's the issue of salaries. It's a cruel paradox that economic development is supposed to improve living conditions in Third World countries, but when wages get too high, local companies have difficulty competing with their more developed rivals.
Sridhar Ramasubbu, general manager of finance at Wipro, says salaries jumped 10% to 12% in the last year. (Some analysts believe the range is more like 15% to 18%.) In any case, the increase is not spread evenly over the workforce. The largest beneficiaries of wage inflation are the trained workers, known as lateral hires, who typically make up about 65% of new employees, said Ramasubbu.
Because recent college graduates command lower salaries, Wipro is lifting what Ramasubbu calls "the rookie factor" to 65% of new hires, while lateral hires will soon make up just 35%. The juggling act has kept Wipro's real increase in salary expenses to just 2%, he said.
Indian IT Big Three |
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Still, salary pressure is likely to continue. "With continuous wage inflation, India's cost advantage will narrow down over a period of time. Indian companies have to invest into expansion of solutions offerings to move up the value chain and have multicountry delivery capabilities to create a long-term competitive advantage relative to large
multinational peers," wrote an analyst at India-based Kotak Institutional Equities in an unsigned report.
Wipro, for example, is moving into the testing of software and hardware, said Chowdhry. The new product has generated about $200 million in sales in its first few months of operation, but that should increase sharply over the next two years, he said.
Another success-driven problem: the stronger rupee. "Based on the promising long-term outlook for the Indian economy, it is difficult to argue against a rising Indian currency vs. the U.S. dollar," Gilford's Thadhani said. Although a stronger rupee historically correlates with a higher BSE 30, it obviously causes difficulties for outsourcers who are forced to pass on the cost or suffer a hit to margins.
Just how difficult? As a rule of thumb, a 1% rise in the rupee erodes operating margins by up to 50 basis points, said Thadhani. Last quarter the rupee appreciated by about 4%, "but we expect more in the long term," said Wipro's Ramasubbu. And in the short run, expect volatility over the next few quarters, he said.
If these stocks are so good, why don't more people buy them? One big reason is the lack of liquidity in the shares; the vast majority of them are traded in India. But that should ease later this year. Infosys has filed for a secondary offering of up to 16 million American Depository Shares, which is equivalent to about $1 billion, said Thadhani.
And because average volume for the stock over the last three months has been roughly 540,000, the addition of 16 million shares will sharply boost trading. Satyam is expected to file for a smaller offering later in the year
That the shares are being repurchased by the company at a premium in India and then sold in the U.S. means no dilution. And with interest high, there is little likelihood of a glut, although there could be some short-term softening.
After the chaos of 2004, who would have thought that investing in India would move back to the front burner?