Outlook for Infosys Technologies

Will Infosys Technologies Inc. (NYSE: INFY) be pulled deeper into the vortex created by the implosion of the U.S. subprime industry, or will it manage to safely skim the surface? To be sure, the chief fear responsible for dampening investor enthusiasm for Infosys stems from the clouded outlook for outsourcing services given the turmoil within the U.S. financial services industry.

To what extent are these concerns justified? An in-depth look at the state of the offshore outsourcing and currency markets and the key risks surrounding Infosys are presented in the next section.

Outlook for Offshore Outsourcing Services

The U.S. Economy Will Continue to Grow in 2008

Consumer spending (70% of the U.S. economy) will hold up in 2008 as a result of low unemployment (4.8%) and moderate wage growth. In fact, data for November 2007 indicates that consumer spending was the strongest in ten months. It seems that the rumors of the demise of the American consumer have been greatly exaggerated. To be sure, economic growth is expected to decelerate to between 1.5% to 2.0% in 2008 (per consensus estimates from Briefing.com) as a result of the weakness in the housing market and higher energy prices. That is certainly below the U.S. long-term trend rate of 3% but still well above the dire forecasts of an impending recession.

Sovereign Wealth Funds Will Mitigate the Risks Confronting Financial Markets

Most observers are well aware of the ominous clouds encircling the U.S. financial services industry at this time. Indeed, even prominent firms have suffered significant sub-prime and CDO related losses. Despite this bleak scenario however, the overall picture appears to be considerably brighter than is widely believed. For example, MBIA Inc., a bond insurer, announced that it will receive a cash injection of US$ 1 billion from private equity firm Warburg Pincus to offset write-downs in the fourth quarter. Warburg Pincus is obviously betting that the credit crisis has reached a bottom. Similarly, as noted by BusinessWeek:

Citigroup recently turned to the Middle East, where SWFs have been amassing cash as a result of the boom in oil prices. The world’s largest SWF, Abu Dhabi Investment Authority, agreed to invest $7.5 billion in Citigroup. Other banks looking to raise more capital to offset these asset declines may also find willing partners in the Middle East and Asia. In general, SWFs have been frequent acquirers of bank stakes. In total, SWFs have an estimated $2.5 trillion in assets, which are expected to continue to grow rapidly on the back of the boom in oil prices and the torrid pace of economic expansion in China and the major oil producing countries. As U.S. and European financial services firms struggle to overcome the current credit crisis, one solution may be found in these state-run funds, which are increasingly looking for new places to invest their growing wealth.

This view is shared by Merrill Lynch,which, in a recent report, stated that assets under management in Sovereign Wealth Funds (SWFs) could grow more than fourfold by 2011, surging from U.S. $1.9 trillion to U.S. $7.9 trillion. The report further stated that:

Sovereign Wealth Funds are likely to direct far greater allocations towards riskier assets such as equities and corporate bonds with cumulative net flows of U.S. $3.1 trillion to U.S. $6 trillion into these asset classes. SWFs are also likely to mandate external fund managers to invest the bulk of their assets - providing a major structural boost for the global asset management industry.

In short, given their ever swelling reserves and growing appetite for risk, sovereign wealth funds are likely to continue to inject much needed cash into global financial markets, thereby mitigating the downside risks stemming from CDO related losses.

IT Budgets to Remain Buoyant in 2008

The pundits forecasting a demand contraction for offshore outsourcing services in 2008 have seemingly misunderstood the value proposition offered by India-based offshore services providers such as Infosys Technologies Inc. In fact, the challenges faced by the U.S. financial services industry actually play to the strengths of India-based offshore services organizations. For example, on December 12, 2007, newly appointed Citigroup (C) CEO, Vikram Pandit indicated that Citigroup would consider moving more work to lower cost locations in an effort to rationalize its cost structure and enhance productivity within the organization.

This view is also shared by Wipro Technologies (WIT) CEO, Mr. Azim Premji who, in a recent interview with AFP (December 11, 2007) stated that:

Whenever the world is facing cost pressures or facing a little lower demand, then US companies will face the need to take out costs, so the contrarian situation is that they could outsource more and that would benefit the software industry.

In addition, just as the Sarbanes-Oxley regulations resulted in more accounting being offshored to India, industry insiders believe that regulatory changes within the U.S. financial system will similarly boost demand for offshore outsourcing services. For example, Mr. Stephen J Rohleder, chief operating officer, Accenture (ACN), notes that:

Because of the sub-prime crisis, there will be a litany of regulations for loans in the US. So, that may be an area that will be industrialised, systematised, and outsourced to companies in India. It’s an area of opportunity in the near future. (Economic Times of India, December 5 2007).

Perhaps the most reliable insight into future IT spending trends is provided by a recent (November 27, 2007) survey conducted by the publication Wall Street and Technology of 140 senior technology officers from representative companies across the financial services industry. In brief, the survey reveals that 2008 IT budgets will increase by more than 10% across the industry. Specifically, the survey indicated that:

...capital markets firms are planning to substantially increase IT spending next year. On the sell side, almost half (42 percent) of the firms surveyed expect to increase their IT budgets by 11 percent to 30 percent in 2008. On the buy side, more than a third (35 percent) of firms plan to increase spending by 11 percent to 30 percent; another 35 percent plan to up IT spending 1 percent to 10 percent.

The survey further indicates that:

IT spending for 2008 among banks will see an overall increase. Though institutions of all sizes report IT budget increases for the coming year, the largest spending increases appear to be at midsize banks - 60 percent of survey respondents in that category said they would increase their IT budgets by at least 11 percent to 30 percent, compared with a minimum increase of 1 percent to 10 percent at small and large banks.

“This overall modest increase in spending among banks is in keeping with recent trends, according to Celent Senior Analyst Jacob Jegher. “Spending will be similar to trends over the last two or three years when we saw an average growth rate of about 4 percent. But it is moderate,” he comments.

More significantly, however, has been the change in composition of that spending. That is, the portion of that spending going towards offshoring has increased more rapidly than the overall increase in spending. This trend is likely to continue well beyond 2008 in view of the cost pressures facing the industry.

Pricing Power to Remain Stronger for Longer

One of the key findings from the Wall Street and Technology survey is that U.S. financial firms are facing skyrocketing labor costs as a result of a shortage of IT workers.

“A widespread IT labor shortage is driving IT salaries up, and basic IT infrastructure costs - particularly energy and cooling costs in data centers - also are rising rapidly. “The competition for skilled labor in the technology industry has rebounded from the dot-com bubble,” notes Steve Rapp, SVP and CTO of Nicholas-Applegate Capital Management, a global investment firm based in San Diego. “We’re finding the [pay] rates are back up for both consultant labor and for full-time employees. We have to remain competitive, so we’re trying to be on top of that.”"

Moreover, the IT labor shortage confronting the developed economies (i.e. U.S., Europe and Japan) may even increase further due to rapid population aging and declining enrollment in IT programs. As a result, India-based offshore services providers, the key beneficiaries of the global IT worker shortage, should continue to see a favorable pricing environment well beyond 2008.

Currency Outlook

Another concern that has unnerved investors in Infosys Technologies relates to the appreciation of the Indian rupee against the U.S. dollar. To be sure, the downside risk stems more from the uncertainty surrounding the pace of appreciation rather than the appreciation per se.

That is, given that a company’s intrinsic value reflects the present value of its future earnings, even a small change in exogenous variables (i.e. currency exchange rate) could have a material impact on its implied intrinsic value.

Some market pundits have attributed the sharp appreciation of the rupee against the dollar during 2007 to the sudden surge in foreign capital inflows into the Indian stock market. While technically accurate, this explanation does not tell the whole story. The rupee’s appreciation during 2007 can be better understood in the context of the Dollar’s sharp decline against major world currencies during the same period, largely driven by fears of an impending U.S. recession. However, recent developments are worth noting with regard to the outlook for the U.S. dollar.

U.S. Economy to Avoid Recession

Contrary to fears of a U.S. recession, the U.S. economy has shown remarkable resiliency in the face of significant headwinds. Significantly, consumer spending has held up as a result of low unemployment and moderate wage growth.

“Decoupling” Debunked as U.S. Credit Crisis Spreads to Global Economies

The sharp decline in the value of the U.S. dollar was based on the “Decoupling” theory propounded by Goldman Sachs (GS) and Morgan Stanley (MS), which argued that the credit crisis was specific to the U.S. and that the rest of the world would continue to enjoy robust growth even with the U.S. economy in recession. However, with the credit crisis spreading to banks in Canada, U.K. and Germany, the Decoupling theory has quickly lost favor.

Decoupling is “a good story, but it’s not going to work going forward,” Stephen Roach, chairman of Morgan Stanley in Asia, said in an interview in New Delhi on Dec. 2 2007 (Bloomberg, December 07 2007). Significantly, the Bank of Canada and the Bank of England have both lowered interest rates during December 2007, which is supportive of the U.S. dollar. In addition, global growth is likely to slow to 4 percent next year from 4.7 percent in 2007, according to a recent study by Goldman Sachs. The report sees the Euro zone growth slipping to 2.0% next year from 2.6% this year. As a result, Goldman Sachs expects the euro to fall back to $1.35 against the dollar over the next year, and sterling to tumble to $1.88 as the Bank of England cuts interest rates three times.

Coordinated Central Bank Action to Mitigate Risks of the Global Credit Crisis

The first coordinated central bank action since 2001, involving the central banks in the U.S., Canada, U.K, and Europe, is likely to mitigate the risks arising from the global credit crisis.

Shrinking Twin Deficits

The decline in the U.S. budget and trade deficits, which have been a drag on the U.S. dollar, may help to strengthen the dollar going forward. The United States budget deficit for fiscal 2007, which ended September 30, 2007, dropped to $162.8 billion, according to the U.S. Treasury Department. Many analysts expect the budget deficit to fall to $135-$150 billion in fiscal 2008. The budget deficit is down from $413 billion in 2004. Meanwhile, the trade deficit is also declining, dropping to $56.5 billion in September 2007 after hitting $67.6 billion in August 2006, according to U.S. Commerce Department data.

“I am confident that the dollar will have a significant rally next year, especially against the euro and the pound,” Stephen Jen, the London-based head of currency research at Morgan Stanley told Bloomberg News on Monday. Jen expects the U.S. currency to strengthen to $1.35 against the euro by December 2008. “The deficits are shrinking fast.”

Indian Rupee Outlook

The surge in capital inflows during 2007 from foreign buyers of Indian stocks has also contributed to the strengthening of the rupee. However, after the 50% rise in the BSE Sensex during 2007, foreign buying interest in Indian stocks appears to be waning over concerns that valuations may be stretched. Indeed, capital outflows have exceeded outflows during November 2007. Some of the Indian stock market’s biggest bulls have even turned bearish. For example, Sanjiv Duggal, Sr. Fund Manager, CIO and Director of HSBC Holdings Plc (HBC) overlooking US $ 11 Billion of investments, the world’s largest holding of Indian equities, expects the Indian stock market to decline over the next 12 to 18 month period.

This view is shared by Morgan Stanley, which in a recent report, assigned a 55% probability to a 26% decline in the Indian stock market during 2008. If such pessimism were to gain momentum, it could trigger a reversal in capital flows out of India towards more attractively valued markets. As a result, expectations of a continued rapid rupee appreciation against the dollar based on foreign capital inflows may be overly optimistic. While it is impossible to precisely forecast the value of the rupee against the dollar, expectations are being tempered.

For example, Mr. K.V. Kamath, CEO ICICI Bank, and Forbes Asia Businessman of the Year for 2007 in a recent press conference stated that the rupee was likely to appreciate against the dollar by Re. 1 or Rs. 2 per year, well below the 12% appreciation during 2007. Mr. Kamath also suggested that interest rates in India were poised to decline, which would imply a softer rupee/dollar exchange rate going forward.

Significantly, Indian offshore services providers have oft-repeated that a gradual appreciation of the rupee against the dollar was manageable. That is, to the extent that the rupee appreciation is within 3%-5% per year, offshore services providers can adjust various levers within their business model, including currency hedging, pricing, utilization, offshore/onshore mix, productivity and geographical diversification, to mitigate the risk of margin contraction due to rupee appreciation.

Conclusion

While investor enthusiasm for Infosys Technologies may have been dampened as a result of the weakness in the U.S. financial industry, an objective evaluation of the macro environment suggests that the risks appear to be overstated.

At this time, it appears that the U.S. economy will continue to grow in 2008 as a result of a low unemployment rate and moderate wage growth. Moreover, a weak U.S. economy may even accelerate offshore outsourcing as customers become more focused on driving operational efficiency. As a result, Infosys should continue to see robust demand in 2008. In addition, fears of a continued rapid appreciation of the rupee against the dollar appear to be similarly overstated. Slower global growth, particularly in Europe, and a deceleration in foreign capital flows into Indian stock markets are likely to result in a moderation in the pace of Rupee appreciation in 2008.

Infosys will likely surmount these challenges however, given the resiliency of its business model. Going forward, offshoring will steadily gain momentum, as providers broaden their portfolio of services to include everything from Business Transformation to Business Process Management.

In view of the buoyant outlook for offshore services, scalability will be the critical success factor in driving earnings growth. On this score, Infosys appears to have an edge over its peers. The company has made significant investments in training (it operates the world’s largest corporate training facility in Mysore, India) and is the industry preferred employer. As a result, Infosys seems to be best positioned in terms of leveraging India’s highly educated cost-competitive human capital advantage to drive growth.

Disclosure: Author holds a long position in INFY