Outsourcing Comes With Risks

Date: Wednesday, June 12, 2002 1:34 PM

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Taking Stock: Low-Cost Offshore Outsourcing Comes With Risks

Despite the missile threat, fundamentals hold investors.

By William Schaff, InformationWeek
Jun 10, 2002 (12:00 AM)
URL: http://www.informationweek.com/story/IWK20020607S0008

As if technology investing wasn't tough enough, now we have to start
thinking about the risk of a nuclear war.

Outsourcing continues to be a strong trend, even in a weakening economy.
A
couple of the most-attractive alternative technology consulting and
outsourcing companies are Cognizant Technology Solutions Corp. (CTSH -
Nasdaq) and Infosys Technologies Ltd. (INFY - Nasdaq).

One big reason for the success of both companies has been their use of
low-priced offshore talent in India. Anyone who's followed the headlines
is
well aware of the conflicts in the Kashmir region between Pakistan and
India, where some are beating the drums of war. This has been a hostile
area
for years, but the tension level has risen dangerously in recent weeks.
Thus, it shouldn't come as a surprise that share prices of Cognizant and
Infosys have declined precipitously in the past few weeks. Cognizant
traded
at $44.38 last week, down from $54.03 on May 7, while Infosys traded at
$54.35, down from $72.50 in March.

When IT managers make business decisions, most of the time they review
the
technology, services, personnel, and company risk. Nowadays, in a more
global IT world, they have to strongly consider political and geographic
risk as well. In the case of Cognizant, most of its Indian offices are
located in the southern half of the country, far from hostilities in the
Kashmir region. Unfortunately, they still fall within the range of
Pakistan's nuclear missiles.

Despite India's strength in application development and implementation,
IT
managers may be leery of going to a region that the State Department is
warning U.S. citizens to leave. India-based outsourcers such as Satyam
Computers, Tata, and Wipro will see similar pressures on their business.

Cognizant's business and share price have held up reasonably well until
now,
mainly because of client loyalty. Most of the company's customers will
wait
to see if hostilities wane, as they have in the past. However, I expect
that
more than a few IT managers are making contingency plans. And without a
doubt, new plans for offshore outsourcing will be put on hold until the
picture becomes clearer.

Fundamentally, Indian application-development companies remain strong
contenders for many requests for proposals because of their ability to
provide expertise and low-cost software development and E-business
offerings.

Cognizant still had 3,400 billable employees as of the first quarter of
this
year, of which more than 70% were located offshore. Its business model
yields gross margins of 48% and operating margins of almost 20%. These
are
very high numbers for a service company. Utilization rates for
Cognizant's
offshore consultants are running above 60%, with hourly billable rates
of
$24. Compare this with domestic projects that are billed at upward of
$70
per hour. That's not a bad incentive to go offshore. The company
maintains
more than $90 million in cash on its balance sheet, not bad considering
that
it generated $173 million in sales last year. It also has no debt.
Cognizant
earned $1.10 per share in 2001 and is projected to earn $1.51 per share
this
year. At $44.38, the forward price/earnings multiple stands at 29.4
times,
so its stock isn't exactly cheap.

Infosys, also located largely in southern India, reported earnings of
$1.24
per share in its 2002 fiscal year, which ended in March, on $545 million
in
revenue. The company offered higher earnings estimates for fiscal 2003.
Analysts' consensus estimate stands at $1.47 for fiscal 2003. At $53.65
per
share, the forward price/ earnings multiple stands at a hefty 36.5. Few
technology companies are more upbeat. Utilization rates for Infosys'
consultants were around 72.4% in the fiscal fourth-quarter of 2002, up
from
65% in 2001's fiscal fourth quarter. Like Cognizant, Infosys has no
debt.

With the potential for missiles to fly, investors clearly are showing
they're concerned about the politics. But that hasn't been a big-enough
worry to get them to sell off one of their best-performing technology
stocks.

William Schaff is chief investment officer at Bay Isle Financial LLC,
which
manages the InformationWeek 100 Stock Index. Reach him at
bschaff@bayisle.com.

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