Thursday, July 15, 2010

Indian Outsourcers: How Well/Long Will They Perform Based on Labor Arbitrage Alone?

The following post from today's Financial Times promises continued financial success with Indian Outsourcers. However, on Tuesday Infosys reported earnings that are below analyst expectations. In my opinion, offshore model based on pure labor arbitrage economics does not create a sustainable source of economic value.  I tend to see IBM, HP/EDS and even Xerox/ACS having better chances of winning by applying proprieatry tools and technologies to brokoen or hard-copy centric worklfows and processes to first reengineer then digitize and automate forever. Perhaps Infosys might be signaling what lies ahead....

Things are looking up in the world’s back office. Accenture, the IT and consultancy firm, lifted operating profit by 10 per cent year-on-year in the third quarter; bookings from financial services clients are at record levels. In India, number two outsourcer Infosys is guiding for top-line growth of around 20 per cent in the year to March. Analysts, undeterred by the fact some of their own jobs have been outsourced to Bangalore, are big fans: Accenture, Infosys and Tata Consultancy, India’s industry leader, each carries a single sell recommendation to 20-40 buys.

Outsourcing is an easy industry to like. Theoretically at least, it thrives on economic downturns – when banks, governments and other clients find it cheaper to outsource than maintain their own bloated back offices – as well as in good times. The cost base, being mainly people, is flexible. The marketplace, while heavily tilted towards the US, is global. And the formula works. From 1996-2004 Infosys was increasing earnings at an average clip of 60 per cent a year; in the subsequent five years growth was still running at 36 per cent. The Indian trio, including Wipro, have generated total returns of 60-100 per cent in the past year.

But, as Infosys’ third-quarter numbers showed on Tuesday, even the gilded can stumble. Results fell short of analyst expectations; this follows a year where earnings growth decelerated to a mere 4 per cent. Increasing tentacles into budget-slashing nations such as the US and UK suggest slimmer margins. Tata Consultancy, for example, won the contract to administer the UK’s new personal pension accounts, worth maybe £600m, when other bidders could not make the numbers stack up.

Wages, devouring 44 per cent of revenues, remain the industry’s Achilles’ heel. No matter. The sector, having outperformed the broader Indian market massively last year, has lagged this year but global IT spending will grow 5 per cent, Goldman Sachs reckons. Add in some currency tailwinds and it will be hard as ever to keep the irrepressible bulls down.

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