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Taking Stock: Low-Cost Offshore Outsourcing Comes With Risks

Despite the missile threat, fundamentals hold investors.

As if technology investing wasn't tough enough, now we have to start thinking about the risk of a nuclear war.

Outsourcing continues to be a strong trend, even in a weakening economy. A couple of the most-attractive alternative technology consulting and outsourcing companies are Cognizant Technology Solutions Corp. (CTSH - Nasdaq) and Infosys Technologies Ltd. (INFY - Nasdaq).

One big reason for the success of both companies has been their use of low-priced offshore talent in India. Anyone who's followed the headlines is well aware of the conflicts in the Kashmir region between Pakistan and India, where some are beating the drums of war. This has been a hostile area for years, but the tension level has risen dangerously in recent weeks. Thus, it shouldn't come as a surprise that share prices of Cognizant and Infosys have declined precipitously in the past few weeks. Cognizant traded at $44.38 last week, down from $54.03 on May 7, while Infosys traded at $54.35, down from $72.50 in March.

When IT managers make business decisions, most of the time they review the technology, services, personnel, and company risk. Nowadays, in a more global IT world, they have to strongly consider political and geographic risk as well. In the case of Cognizant, most of its Indian offices are located in the southern half of the country, far from hostilities in the Kashmir region. Unfortunately, they still fall within the range of Pakistan's nuclear missiles.

Despite India's strength in application development and implementation, IT managers may be leery of going to a region that the State Department is warning U.S. citizens to leave. India-based outsourcers such as Satyam Computers, Tata, and Wipro will see similar pressures on their business.

Cognizant's business and share price have held up reasonably well until now, mainly because of client loyalty. Most of the company's customers will wait to see if hostilities wane, as they have in the past. However, I expect that more than a few IT managers are making contingency plans. And without a doubt, new plans for offshore outsourcing will be put on hold until the picture becomes clearer.

Fundamentally, Indian application-development companies remain strong contenders for many requests for proposals because of their ability to provide expertise and low-cost software development and E-business offerings.

Cognizant still had 3,400 billable employees as of the first quarter of this year, of which more than 70% were located offshore. Its business model yields gross margins of 48% and operating margins of almost 20%. These are very high numbers for a service company. Utilization rates for Cognizant's offshore consultants are running above 60%, with hourly billable rates of $24. Compare this with domestic projects that are billed at upward of $70 per hour. That's not a bad incentive to go offshore. The company maintains more than $90 million in cash on its balance sheet, not bad considering that it generated $173 million in sales last year. It also has no debt. Cognizant earned $1.10 per share in 2001 and is projected to earn $1.51 per share this year. At $44.38, the forward price/earnings multiple stands at 29.4 times, so its stock isn't exactly cheap.

Infosys, also located largely in southern India, reported earnings of $1.24 per share in its 2002 fiscal year, which ended in March, on $545 million in revenue. The company offered higher earnings estimates for fiscal 2003. Analysts' consensus estimate stands at $1.47 for fiscal 2003. At $53.65 per share, the forward price/ earnings multiple stands at a hefty 36.5. Few technology companies are more upbeat. Utilization rates for Infosys' consultants were around 72.4% in the fiscal fourth-quarter of 2002, up from 65% in 2001's fiscal fourth quarter. Like Cognizant, Infosys has no debt.

With the potential for missiles to fly, investors clearly are showing they're concerned about the politics. But that hasn't been a big-enough worry to get them to sell off one of their best-performing technology stocks.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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