Which IT Outsourcing Stock is the Best?

Includes: ACN, EDS, IBM, INFY, WIT
by: Madhusudan Rao

The Indian IT companies have posted record growth in the past decade. However, if the past year's stock performance is anything to go by, then one can sense skepticism in the minds of analysts and investors regarding the future prospects. The key concerns are the rising rupee, domestic salary hikes, reduction in tax sops and whether these companies are capable of moving up the value chain.

The objective of this article is to determine whether Tata Consulting Services [TCS], Infosys Technologies Limited (NASDAQ:INFY) and Wipro (NYSE:WIT), the top three Indian IT companies qualify as a long term investment bet or should investors put their faith in MNCs like IBM (NYSE:IBM), Electronic Data Systems Corporation (NASDAQ:EDS) and Accenture (NYSE:ACN).

IBM has been in India for about a decade and a half now and is recruiting at an unprecedented rate. Despite several years of experience, IBM doesn't seem to be getting the onsite-offshore model right. Most engineers or consultants who work in IBM India play "passing the pillow" with the service requests, not due to lack of competency but because they are not authorized to work on them. After making a few rounds offshore these requests are finally resolved onsite ( USA or Europe). The volume of work done offshore is very low, and the resolution time very high, making the process inefficient.

Indian companies, on the other hand, have streamlined offshore processes. Most companies are CMMi Level 5 certified and ensure that more work is done from India. At the same time the aspiration of employees to work onsite is also taken care of. As the hub of activities for these companies is in India, most resources who work onsite are sent from here thereby reducing the onsite employee and overhead costs. Currently IBM has only 14% of employees in India.

The number of management layers (bands) at IBM is unbelievably high and no Indian can even dream of getting a foot into the IBM corporate headquarters. Infy's HQ is in Bangalore, only stone's throw from my home, that serves the career aspirations of the employees better. To put things in perspective, the attrition rate at Infy is about 13% (excluding Progeon) and in IBM India it is close to 22%, fifty percent of them leaving within the first six months.

The average salaries of Indian software engineers is about Rs 12000 per month and employees with prior work experience expect a monthly income of about Rs 25000 (that translates to $ 7200 per year). Even if these salaries double in the next 3 years, it will only be $15,000 per year. I cannot imagine IBM recruiting in US or anywhere in the world at that rate.

My guess is it will be impossible for IBM/EDS/Accenture to recruit massively in India and at the same time handle the Indian aspirations.

Another reason why Investment in Wipro, TCS and Infy makes more sense than in IBM and the likes, is the fact that these top tier IT companies can quite easily move up the value chain in the IT industry. The core high end IT consultancy market is huge, still vastly open and no single company has a monopoly. Since most of these (Indian) companies are cash rich and have zero debt on their balance sheet, they can raise huge amounts of debt and acquire companies much larger than they are. For example, Infy can acquire controlling stake in EDS (market cap $ 11.5 billion) by raising long term debt, making the debt equity ratio higher but yet keep it at comfortable levels. Or they can acquire smaller companies that form a strategic fit and provide competency in consultancy services, something that Wipro has already been doing in the past few years.

The only aspect that these companies need to gear up to, in my opinion, is the fact that the market for Indian and other Asian companies' IT needs is rapidly growing. Catering to the Indian and Asian companies' IT needs would not only add to the topline but also reduce the currency appreciation risk to a great extent.

Regarding the tax sops, withdrawal of these sops can in one way be a boon to the top tier companies, hitting the margins of smaller companies that cannot scale up easily and making them less competitive. Hence, the clients of these companies may also move to the bigger IT firms.

So, with the strategy in the right direction and solid execution capabilities in place, I think these companies can beat the MNCs. Maybe one will realize this looking at the rear view mirror.