NEW YORK (CNN/Money) -
Offshore outsourcing has been a controversial topic during the past year. But so far, the political furor over offshoring has not hurt large Indian tech services firms.
One of the largest of these companies, Infosys Technologies (INFY: Research, Estimates), reported better than expected second-quarter earnings Tuesday morning and gave an upbeat outlook for the third quarter.
The news lifted shares of Infosys nearly 5 percent Tuesday. Rivals Wipro (WIT: Research, Estimates), Satyam Computer (SAY: Research, Estimates) and Cognizant Technology Solutions (CTSH: Research, Estimates) all rose as well.
Still, there are some risks that investors in these firms need to be aware of.
One big one is the risk that Indian-based firms will not be able to hold on to top talent as major U.S. tech firms begin to increase their presence in the lucrative Indian market.
Look out for a brain drain
According to an article in the Times of India last week, companies like Wipro and Infosys are starting to lose key software developers, project managers and high level executives to leading U.S. tech companies such as IBM, Oracle and Accenture.
"On average, companies have done a good job of managing attrition so far. But this is a big execution risk that will be worth watching," said Mayank Tandon, an analyst with Janney Montgomery Scott.
* based on calendar 2004 EPS estimates and prices as of 7/12 | Source: Thomson/Baseline |
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But even if the Indian companies are able to hold off a potential brain drain, there's also the issue of how expensive it will be to do so. One of the reasons why earnings have been so strong for the Indian IT firms is because of how low salaries are compared to U.S. tech firms.
Ashish Thadhani, an analyst with Brean Murray, said that current earnings estimates for the major Indian tech firms already factor in healthy increases in compensation expense.
But increased competition from American tech firms could lead to higher-than-expected increases, and thus, pressure on profit margins.
"There is a talent war. For project managers, salaries are experiencing some inflation," said Thadhani.
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The recent rash of software company warnings over the past few weeks is also worth watching closely. A prolonged slowdown in software spending could hurt the Indian outsourcers down the road since part of their business depends on what is known as package implementation, helping clients pick out new types of software to purchase and then installing it for their customers.
"The software pipeline is still strong but software license weakness could affect the Indian services companies in a couple of quarters," said Sameer Nadkarni, an analyst with W.R. Hambrecht.
The stocks aren't cheap
Finally, the stocks have all run up dramatically over the past 12 months, and valuations are quite rich.
Infosys, Wipro and Cognizant all trade for more than 35 times calendar 2004 earnings estimates. Because the stocks are trading at premium earnings multiples, investors need to pay even closer attention to the risks.
You don't have to look any further than what happened to Yahoo! last week for evidence of how an expensive momentum stock can get punished even after posting extremely solid results.
Plus, the risk of a political offshoring backlash hasn't gone away just yet. Sure, it's highly unlikely that U.S. companies are going to stop the practice of offshore outsourcing. But Tandon said the shares could still get whipsawed in the next few months if outsourcing becomes a contested issue during the U.S. presidential campaign.
That's why it might pay to sit back and wait on these stocks.
"In the near-term there will be volatility," said Tandon. "The earnings will be strong but there could be another opportunity to buy the stocks cheaper as we get closer to the elections."
Analysts quoted in this piece do not own shares of the companies mentioned and their firms have no investment banking ties to the companies.
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