IT outsourcing has been a hot debate last few years.It is usually a hot button topic during elections.For investors this growing industry provides a great opportunity to add Foreign sector to their portfolio.
Infosys Technologies (NASDAQ : INFY) is one such India based company that has become the bellwether of Indian stock market.Its ADR is listed in NASDAQ and has grown at 30% CAGR last five years.Before jumping onto the bandwagon it is smart to weigh the risks associated with this company and with this industry in general.
What does Infosys sell: Infosys sells IT services ranging from software development to maintenance to package software development.But if we analyze carefully it sells man hours. Any company in IT consulting or services is based on the number of man hours it bills to the client. Infy (Its usually referred by this name in the market) had 10,200 people by Mar-2002. By Mar-2006 it had over 52,000 people. This unprecedented growth has helped the company to have sales of $2.1 bn by Mar-2006.Up from $545mn in 2002.
Infy is based out of Bangalore,India and uses the onshore / offshore model to sell its services. Its shares are listed in NASDAQ as ADS.It is also part of the NASDAQ-100.
BUSINESS RISKS :
Rise in Wage levels on Indian IT workers. The very basis of IT outsourcing lies in the fact that it gives the customers huge cost savings. The average salary of an IT professional with five years experience in USA is $60,000 USD per year. A similar IT professional working in India makes around $15,000 USD per year.With the present increase in wages around 20% per year , in just five years the corresponding IT professional would be earning a salary of $30,000 per year. This increase would face Indian IT companies either to increase their billing rates or to squeeze their profits. In either case it is bad news for investors.
Change in exchange rates. : Another important factor of cost saving is the foreign exchange rate between USD and Indian Rupee. Right now 1USD is around Rs 43. Just imagine if this were to be Rs 35 or Rs 16. Infy’s revenues would remain the same but its costs could almost triple. It is not un realistic to think that rupee would grow stronger in future. Because in 1995 1USD was Rs35 and in 1990 1USD was Rs16. The basic reason for present high exchange rate is the unprecedented growth of US economy in late nineties and the present monetary policy of Reserve bank of India to maintain the present exchange rate. But with the fast growth of Indian economy it is very much likely that the rupee would appreciate with respect to dollar.
Rise in Infrastructure costs. Infy’s 2006 capital expenses was $246mn compared to that of $185mn in 2005. This is an increase of over 30%. In order to continue this pace the company needs to invest a large amount of capital in building new facilities. With recent surge in real estate prices in India, Infy would face challenges in controlling its capital expenditures towards expanding its facilities.
Inability to increase the number of employees at the present pace. Infy’s strength in 2002 was 10,900 in 2002 . It grew to 52,700 by 2006. This amounts to 49% annual growth. This growth has fueled the company’s rise in revenues from 555 mn in 2002 to $2.1bn in 2006.If Infy wants to grow at this pace then its employee strength by 2009 should be 141,000, by 2011 should be 275,00, by 2013 should be 500,000 and by 2015 should be 1mn. The only company that comes to my mind that has around 1million employees is WALMART! The only difference between walmart’s employees and Infosys employees is that majority of walmart’s employees are entry level cashiers or store workers working for minimum wages compared to Infosys’s high tech employees that are in the highest bracket of India’s employees in terms of pay.
Backlash towards outsourcing in foreign countries. In theory outsourcing is about replacing a high earning worker with a low cost worker. This has raised some concerns with people in USA and other western european countries. Infy had 6,900 people working on H1B visas in USA. These work permits enable IT consulting companies to send people for long term assignments (2 to 3 years) . This way when the employee is back after his assignment then he or she can lead a project and train others. This model can have an issue if there is a cutback on work visas.
Inability to acquire foreign companies. The present Reserve Bank of India guidelines state that in certain cases Indian companies have to take the central bank’s permission to acquire a foreign company. This increases the lead time required to acquire a company.
Present Tax benefits are limited till 2009 : Most Indian IT companies are enjoying a tax holiday which exempts them from taxes on exports performed from designated export promotion zones. This helps Indian IT companies to reduce their tax rate.But this benefit is only applicable till fiscal 2009. After that the Indian IT companies would be taxed the same way as other Indian companies