Infosys: Globalization in Action (INFY)

May.25.06 | About: Infosys Limited, (INFY)

Infosys Technologies (NYSE:INFY) is globalization in action - the firm provides application development, IT consulting and business process outsourcing services to their clients.

Infosys uses what they call their "global delivery model" to deliver their services. Probably the best way to describe this model is to say that it's the consulting equivalent to Dell's just-in-time sourcing model. Infosys uses their global offices, and in particular their offices in India (where they are headquartered) to deliver services 24 hours/day with a highly skilled and cost effective work force.

Infosys hits the nail right on the head in their SEC filings - "customers are increasingly demanding improved products and services with accelerated delivery times at lower prices." So the business proposition is simple, hire enough qualified people at a low enough cost and solve the customers' problems effectively. Thus far, Infosys has been able to keep up; they have grown their workforce from 10,700 in 2002 to 52,700 as of March 31, 2006, they have been rated as one of the best companies to work for in India and they are currently rated at the highest level of the Carnegie Mellon Software Engineering Institute's Capability Maturity Model (SEI-CMM, which measures the quality of organizations' management system processes and methodologies).

The company has been performing well and though they finished out their 2006 fiscal year (ended March 31st) with a slight earnings miss, they showed strong sales numbers for the fourth quarter and the year. During their conference call, the management team attributed the miss primarily to the dollar/rupee exchange rate, a higher amount of depreciation for the quarter and getting more aggressive on the hiring front than they expected. They claimed that on a "normalized basis" that their margins were on target.

Of course, I can't imagine that this has been too comforting to investors as they watched the stock jump to $83.74 the Monday after they announced the quarter only to decline to $68.69 as of today. Since the quarter, the stock has been caught in the sickening slide that has hit pretty much the whole market, and Indian stocks in particular, over the last week and a half.

According to Gartner, the Indian IT-enabled services export market was $4.6B in 2005 and is expected to grow to $21B in 2009 - an impressive 46% compound annual growth rate [CAGR]. So simply growing with the market could give Infosys some pretty impressive results.

The primary drive behind this is going to be an increased willingness for businesses to outsource their IT and other business processes. In an increasingly globalized world, connected by satellites and optical fibers, even the larger companies are beginning to find that vertical integration might not bring the same value as it once did, and so they are beginning to work with companies like Infosys in an effort to become more efficient and cost effective. The great thing for the outsourcing companies is that this process compounds on itself; if, say, a major manufacturer is able to bring costs down by outsourcing some of their IT staff then 1) they are more likely to consider other areas where they could benefit from outsourcing and 2) competitors will have to consider doing the same to be able to keep up.

It's a tough time to be a tech stock and an even tougher time to be an Indian tech stock. Right now, Infosys is trading at 28x their forward calendar year EPS estimates with an expected 25% growth rate for a 1.1x PEG ratio. Cognizant Technology (NASDAQ:CTSH), probably the best comparable to Infosys, trades at 43.8x forward earnings estimates with a PEG of 1.25x - a significant level above Infosys. I also see Accenture (NYSE:ACN) and Bearingpoint Inc. (BE.) as good comps for Infosys and they trade at 16.6x and 28.3x their 2006 expected earnings, respectively, with PEG ratios of 1.2x and 2.8x.

So on both a comparable and an absolute basis, I'd say that shares of Infosys are trading at a pretty attractive valuation right now. And don't forget, you're getting a stock here with a 25%+ return on equity.

It's tough to get too aggressive on any stock with the market the way it has been the last couple weeks, but I think that Infosys offers a good value here to start slowly building a position. As business seems to be up and to the right, I'd say that any further pullbacks in the next couple weeks would represent good buying opportunities.

Longer term, though, I don't know that I feel quite as bullish on the model behind Infosys, or any of the Indian outsourcing companies for that matter. As we move towards a more globalized economy, prices are going to slowly but surely adjust to this change. More IT consulting getting farmed out to India means that there will be less work for the higher priced US consultants.

Simultaneously, more firms will crop up to try to take advantage of the profits that companies like Infosys are making, thereby increasing competition in the Indian labor pool. It may not happen quickly, but these two factors should slowly push down US IT consulting wages while bringing up those in India. As discrepancies disappear, so will the huge cost advantage that Infosys has. Ideally by that time, though, they will simply be a good outsourcing partner due to scale, efficiency and global reach.

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