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Outsourcing has been a prevalent trend over the last 5-10 years, especially in software, where the disparity between domestic and international software developer costs, along with a desire for lean IT organizations, has led to rampant outsourcing. Outsourcing enables CIOs to grow and shrink their IT project portfolio without the pain of hiring and firing employees, and in theory, in a defensible way from a cost viewpoint. There are multiple secular headwinds that suggest that specialty outsourcers such as Infosys (NYSE:INFY), Wipro (NYSE:WIT), Tata Consultancy Services (TCS.NS) and even Cognizant (NASDAQ:CTSH) might be on their way out as businesses, with that skillset being absorbed into the S&P Titans (see below for more).

So here are 5 reasons to hang up on the above and similar stocks, in case you were considering them:

  • Diminishing Pricing Power. Back when employees in Asia and Eastern Europe were making a third (or less) of US salaries, this was a market with little competition and large profit margins. As pointed out in 12 IT Outsourcing Preditions for 2012, the global labor arbitrage is no longer as compelling as it was a few years ago (more on that in 'Inflation').
  • Culture Gap & Business Risk. As has become evident from the Apple-Foxconn controversy, companies are held responsible for the deeds of their contract houses. So as pointed out by this article in CIO.com, if your outsourcer tries to circumvent visa rules or has serious HR problems, the client company shares some of the taint that comes from it. So what was a pure cost saving now becomes a smaller cost saving and an increasingly more concerning business risk from a corporate culture that the client has no control over.
  • 'Titan'ic Incursion. Over the years, large Titans like IBM (NYSE:IBM) and HP (NYSE:HP) have entered the consulting arena, and now provide not only the cheaper labor force than specialty outsourcers do, but also a proprietary product roadmap that they have control over. In cases like Accenture (NYSE:ACN), they cover both management and technical consulting, and therefore become a one-stop shop for many needs. They are competitors with differentiated services at an acceptable difference in cost, not to mention global brand identity
  • Inflation. With US salaries decreasing or flat in real and nominal rates, and above average pay raises in BRIC countries of 7-8%, the slam dunk cost of a programmer argument doesn't hold anymore.
  • Lousy Earnings. The decreased competitiveness and increased costs mentioned above are beginning to show up in earnings. In Q1 2012, Infosys issued a dour earnings report, while IBM and Accenture did quite well on a healthy mix of product and consulting, thus de-risking software projects with proprietary knowledge and proprietary products. The following two charts from TrendExhaustion.com, a site that suggests whether the trend on a stock is fresh or exhausted, make for an interesting read. You could take the optimistic view that these two charts show that INFY and CTSH still have life. Based on fundamentals, my takeaway from these is that if you're a 'bottom' picker, these stocks haven't seen bottom yet, until the 'exhaustion' number is well into the negatives.

So there you have it. If you must invest in outsourcing, pick stocks that are diversified across products and consulting, because being a specialized 'job shop' is not a viable growth business.

Source: 5 Reasons To Hang Up On Software Outsourcers