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This year's financial performance by India's top IT outsourcing firms will be tough to beat in the face of mounting competitive pressures, but an increasingly huge pool of global demand makes it a good bet they'll continue to outrun their larger rivals in 2006.

The current fiscal year, which ends in March, will mark a milestone for Indian offshore outsourcing firms Infosys ( INFY) and Wipro ( WIT), as their revenue crosses the $2 billion mark.

Those kinds of numbers are being fueled by the growing tendency of global businesses to seek ways to cut costs by farming out many of their basic -- and increasingly, not so basic -- operations.

And in fiscal 2007, the four largest offshore companies traded in the U.S. - Infosys, Wipro, Cognizant ( CTSH) and Satyam ( SAY) -- are expected to average a 32% jump in sales, according to Baseline. That's on top of an average 43% climb in sales in the last 12 months.

Earnings, meanwhile, are expected to grow an average of 27% in fiscal 2007, on top of a nearly 45% jump in the past 12 months.

That kind of showing isn't lost on investors, who have rewarded Indian firms by sending their shares up an average 21% 2005. But the show isn't over yet.

Record Sales

"Next year is still going to be a good year for the outsourcers," says Rich Parower, portfolio manager of the ( SHGTX) Seligman Global Technology Fund , which holds Infosys and Satyam shares. "I don't think this has run its course yet."

The streak will continue in part because Indian firms have just scratched the surface of potential demand. Goldman Sachs estimates suggest that the offshore model has penetrated less than 10% of Global 500 IT budgets for core application maintenance and development work, analyst Julio Quinteros recently wrote.

Beyond that, the Indian companies are expanding into new areas such as network and data-center management, consulting, and business process outsourcing of such departments as human resources and accounting.

Infosys had been a leader in introducing new services and developing a reputation for innovation, industry observers say. "It feels like it's getting to the point where you don't get fired for hiring Infosys," says Roopa Unnikrishnan, a manager with organizational performance consulting firm Katzenbach Partners, putting a new spin on an old IBM ( IBM) adage.

But expanding into new areas hasn't been a slam-dunk for the Indian companies, says Schmidt. "The results of that are extremely mixed," he says. "I haven't seen dramatic growth in those businesses for Infosys and others."

One reason: The Indian companies are moving into the domain of major multinational IT services providers like IBM, Accenture ( ACN) and Electronic Data Systems ( EDS).

Those heavyweights can offer greater depth and breadth of services, and have closer, long-term relationships with top-level executives, analysts say.

And at the same time the Indian companies are encroaching on the multinationals' turf, the multinationals are beefing up their own offshore offerings.

"The multinationals are definitely having an effect," says Rick Nathanson, whose Westport, Conn.-based firm Nathanson & Co. advises clients on outsourcing. "They're able to do business because they represent a step up in quality in the minds" of customers more than the Indian-only companies do.

Higher Pay

But for now, analysts widely believe there's so much offshore opportunity that the multinationals will have little effect on Indian firms' revenue. Where they are already having a notable impact, however, is on labor costs, which threaten operating margins.

It's a case of simple macroeconomics. As the multinationals build up their workforces in India, the competition and demand for labor has intensified, pushing up wages 10% to 15% a year.

"The market is very large. It's still expanding fairly quickly. So, I don't think any of these companies are in danger," Nathanson says of the Indian companies. But "if I was an investor, I would be more concerned about margin pressures."

Indian companies' operating margins currently average about 23%, far superior to the low-teen percentages of multinationals. And Satyam's margins have been improving as management has done a better job of running the business, investors say.

Consequently, Satyam shares have climbed nearly 50% since the beginning of the year. But it's not too late to join the party, some investors say.

"We still like it a lot," says Tom Kenny, senior portfolio manager with Munder Capital Management, which holds Satyam shares. "This is one if you look at the multiple, it's still a lot cheaper than other names out there on a P/E basis."

Satyam now trades at 24 times fiscal '07 earnings, while peers trade at more than 30 times forward earnings. Still, Kenny adds, "wage pressure is something that all of these companies will have to deal with."

It's also becoming increasingly difficult to get "great people" when the hiring is happening at such a dizzying pace, Nathanson adds. "When I think of competition right now I think the biggest issue is competition for talent," Nathanson says.

"You're starting to see turnover rates similar to the late '90s in the U.S."

Still, the underlying cost structure of India-based companies remains significantly lower than that of U.S.-based multinational IT services companies.

Richard Schroth, a senior fellow with Katzenbach Partners, also believes that the multinationals already have so many moving parts that adding offshoring to the mix is likely to be challenging.

And the multinationals still have far fewer employees in India than do the local companies. Accenture, for instance, now counts 16,000 employees in India -- roughly one-third of Infosys' workforce.

Soaring Staff
Source: Goldman Sachs

India's Net Workforce Growth
Source: Goldman Sachs

"We're keeping an eye on them multinationals , but everyone is growing at a fast-enough rate at this point that the Indian firms are all doing fine," Parower says. "And the Indian guys are winning bigger deals."

Indeed, while the multinationals are suffering from shrinking contracts as deals become unbundled, Indian firms are seeing their contract sizes grow.

Earlier this year, Infosys and Tata Consulting Services won their single-largest contracts to date as part of an even bigger package awarded by Dutch giant ABN Amro ( ABN ).

The China Challenge

Meanwhile, fears of China stealing business from India continue to swirl, although industry insiders doubt it will happen any time soon.

"China generally has a better infrastructure than India does because it's been a leading manufacturing center for so long," explains John Delaney, an attorney with Morrison & Foerster in New York who negotiates outsourcing transactions.

"But India, because it's a capitalist democracy, has a legal system that, although not perfect, is much more responsive to the needs of businesses and Westerners," he says.

Also not to be overlooked: India's English-language advantage over China. In China, English-speaking engineers command salaries 20% to 25% higher than India, according to Gilford Securities analyst Ashish Thadhani.

So, at least for next year, look to India to continue to remain the sweet spot of offshoring.

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