NEW YORK (CNN/Money) -
The term "offshore" has long had unsavory connotations.
Environmentalists have railed against offshore oil drilling; prosecutors lambaste companies for creating offshore tax entities; and today, a backlash is forming against tech's infatuation with offshore outsourcing.
Tech investors should pay close attention to how U.S. companies implement offshore outsourcing. It's a trend that could introduce some fairly radical changes into the economic makeup of the software and services industry.
Investors should also monitor public and political opinion of moving offshore. With job growth not yet apparent in the country's nascent recovery, offshore outsourcing is an easy target for public outcry. Finally, there may be investment opportunities in offshore outsourcing.
One thing's for sure: nary a week goes by these days without a high-tech company launching or adding to an offshore outsourcing initiative. As recently as Monday, the Wall Street Journal reported that IBM is planning to offshore 4,730 jobs starting in 2004.
Big Blue joins a veritable army of tech heavyweights, including Accenture (ACN: Research, Estimates), Google, Oracle (ORCL: Research, Estimates), SAP, Verizon (VZ: Research, Estimates) and dozens more, that contract with, or run, offshore operations.
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The ugly side to this, of course, is that workers here will lose their jobs. Who wouldn't shudder at the specter, reported by the Journal, of soon-to-be-displaced IBM (IBM: Research, Estimates) workers training their offshore counterparts to take over their jobs? But this is business, and sending jobs offshore makes a lot of bottom-line sense.
The fact is, offshoring has been going on for some time, and according to every analyst I spoke with and every report I read, it will only grow in the foreseeable future. Research firm IDC predicts that offshore outsourcing will grow from 5 percent of IT jobs today to 23 percent in 2007.
In the short term, going offshore can help a company realize 20 to 40 percent savings in operating expenses, primarily through lower operational overhead. However, widespread use of offshoring could have a negative impact on revenues as software and service prices begin to drop, taking the same path technology hardware has trod for the last 10 years.
When 20 to 40 percent of operating expenses is removed, companies can -- and likely will -- begin competing on cost. Long term, revenues could increase in a volume play as aggressive pricing leads more corporate customers to purchase software and services.
"The cost of a PC has free-fallen in the last few years," says John McCarthy, a Forrester analyst. "But it opened up the market by millions of PCs. If the price of software or of implementing a system drops by 25 to 40 percent, that allows a whole set of smaller businesses to implement the software and services that couldn't afford to before."
One variable in the offshore equation is the public response. Right now, public opposition is in the embryonic stage, and with the affected workers -- IT staff -- not unionized, it's unclear whether the outcry will be truly threatening.
"Companies need to be wary of a [public] backlash," says Andrew Efstathiou, an analyst with the Yankee Group. "If a firm goes offshore, they need to engage in scenario analysis to map out what could go wrong, and a backlash is one thing that can."
Investors should watch for more developments along the lines of what occurred last month, when public protest forced the state of Indiana to cancel an offshore outsourcing contract with a firm based in India. Note that in this case, the government was involved. Its outsourcing programs have a different set of rules, and the union representing state and federal workers is the largest in the country.
So are there opportunities to invest in the companies that provide offshore outsourcing assistance to U.S.-based companies? Shares in three of the leading offshore outsourcing outfits, Cognizant (CTSH: Research, Estimates), Infosys (INFY: Research, Estimates) and Wipro (WIT: Research, Estimates), are all very expensive right now, trading at or near 52-week highs and at price/earnings ratios of at least 50.
The offshore outsourcing trend and the corresponding hype -- combined with these companies' healthy profit margins -- have been kind to their stock prices. Recently, however, the companies have suffered from some high-profile client defections.
Lehman Bros. (LEH: Research, Estimates) and Dell (DELL: Research, Estimates), for example, announced that it is cutting back on some offshore operations, citing quality concerns. If more defections cause the stocks to come down significantly from their nosebleed levels, some investment opportunities may arise.
The problem most frequently cited as the reason for the defections -- concerns related to call-center expertise and quality -- is thought to be correctable.
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