Indian Outsourcers' Inside Threat

As demand continues to boom, so do the wage costs for local IT firms.
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As U.S. companies continue to cut labor costs by outsourcing work to Indian IT firms, the outsourcing companies themselves grapple with high rates of attrition, rising salaries and growing competition for talented employees.

The trend is affecting all the Indian information technology firms, and with more U.S. companies -- even outside the IT services sector -- adding headcount in India and competing for brainpower, the issues show no sign of abating anytime soon.

"It's definitely a point in time where execution and HR ... in particular, are going to be very critical," says Julio Quinteros, a vice president on the IT services analyst team at Goldman Sachs. "That's what's going to determine the winners and losers in the space.

"It's about adding business value, and that starts with hiring and training the right type of people and moving them up the curve," he said.

While some are merely keeping an eye on the Indian staffing issues, others argue that their contribution to margin contraction, as well as a more limited room for upside to consensus expectations, increases the risk for a pullback in valuations this year for Indian IT services stocks.

And it seems to have already begun: Since the beginning of May,

Wipro

(WIT) - Get Report

has fallen nearly 17% to $11.77, and

Infosys

(INFY) - Get Report

has dropped 10.2% to $70.08, as shares of many Indian companies -- regardless of sector -- have gone into a recent free fall.

"Offshore market demand is tremendous," Bernstein Research IT services analyst Rod Bourgeois wrote in a client note in early May after meeting with a panel of leading offshore companies. "However, we think increasing employee turnover, increasing offshore competition and wage inflation problems will cause margin contraction for the aggregate of the major Indian players this year."

"I think people are going to (be) paying more attention to these margin-related metrics," he said.

Though not expected soon, Bourgeois notes, "Indian company margins (are) prone to drop substantially in the long run when revenue growth eventually slows."

In addition to Wipro and Infosys, the most closely watched Indian IT services firms include

Satyam Computer Services

(SAY)

and

Cognizant Technology Services

(CTSH) - Get Report

. (Cognizant's headquarters are in the U.S., but the bulk of its business is in India.)

"Those guys are still growing like weeds," Quinteros says. And to keep growing at the pace the Street expects, the companies will have to add 20,000 to 25,000 people a year, on average, making competition between the Indian companies more intense. Goldman Sachs provided non-banking-related services to Cognizant and EDS and has received compensation from Accenture and Infosys in the past 12 months.

Quinteros says that India has a big enough labor pool to support the demand, but how many "quality" workers a company is able to attract, maintain and train is a critical issue.

Companies are hiring two types of workers: Those fresh out of college and so-called "lateral" hires, which are experienced employees lured away from the competition.

Wage hikes are the most dramatic for those with experience. Analysts said, on average, wage inflation will fall in the range of 12% to 18% this year for midlevel employees.

Coupled with wage hikes is the problem of keeping employees around. Infosys (11.2%), Wipro (16%) and Satyam (19.2%) all reported rising turnover rates in the most recent quarter, Bourgeois said.

Cognizant has been the exception, which has lowered attrition over the past two quarters and recently posted

glowing quarterly numbers. For the March quarter, the company reported a turnover rate of 11%, the lowest rate since 2003.

Quinteros said he is "very positive" on Cognizant, and one of the reasons is its "industrialized" process of hiring. The company has very well-defined processes for recruitment, training and development.

"We know that our ability to quickly train and retrain our associates is key to our ability to manage our growth," Francisco D'Souza, chief operating officer for Cognizant, said on the company's first-quarter earnings call earlier this month. The company also touts its mix of new-technology projects and rewarding employees with bonuses.

Bourgeois says another reason workers are flocking to Cognizant is its current favorable reputation: "As people are willing to jump ship, they're particularly willing to jump ship to the hot company." Bernstein owns shares of EDS and Infosys and makes a market in Cognizant and Infosys.

Satyam President Ram Mynampati says his company has a new initiative called the Satyam School of Leadership, which is focused on employee development. In October, the company will introduce restricted stock units for selective employees, aimed at improving retention levels.

Last week, Infosys announced plans to hire 300 American college graduates this year and 25 from the U.K. to create a cross-cultural, diverse workforce.

But these initiatives by Indian IT firms are no longer limited to competing among each other. The large multinational corporations like

IBM

(IBM) - Get Report

and

Accenture

(ACN) - Get Report

have beefed up their presence offshore.

EDS

(EDS)

recently

made a bid for a controlling stake in Bombay-based

Mphasis

, for example, to give the company more street cred in India.

IBM's Indian headcount increased by 73% in the past year, according to Bernstein Research. Accenture reported that its Indian headcount totals 19,000, and it is hiring 800 new employees in the country each month.

Indian companies are preparing to meet the outside challenge and working to provide a higher level of service to their clients. That's essential, Goldman's Quinteros said, so clients don't just see "a body shop," but quality employees who can add intellectual capacity and business value.

Indeed, Bourgeois said that the average outsourcing-deal size is going up, and companies need more experienced employees to manage complex deals.

Dylan Cathers, an equity analyst with Standard and Poor's, pointed out that while the Indian firms are not quite at the level of the more established multinational companies, they are adding more services.

"The Indian companies are moving up the value chain," Cathers said. He pointed to Wipro's

recent acquisition of

Quantech Global Services

, a computer-aided design and engineering services firm. "I think it's a great example of where the Indian outsourcers are going." Standard and Poor's doesn't have any relationship with the companies mentioned.

"More value-added services will drive them in the future," Cathers said. "It's a real avenue of growth for them, and they have the added benefit of being less expensive."

Still, while the employee issues are ever-present and important to watch, some aren't sweating them just yet.

One portfolio manager says such issues shouldn't detract from the "tremendous growth and robust opportunities" in the sector. "At the end of the day, India graduates so many qualified college students that there seems to be sufficient supply for talent," says Robert Stimpson, who manages the Rock Oak Core Growth Fund. Cognizant is the largest holding in the fund.

But he admits wage pressures are a concern over the long term.

"As that gap narrows (between India- and U.S.-based workers), then the value proposition is less attractive," Stimpson said. "It's one of the longer-term risks to the group that people are constantly aware of, but it has yet to appear significant."