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On October 11th, Infosys (INFY), which perhaps played a bigger role than any other company in the formation of the information technology (IT) outsourcing industry, announced stronger-than-expected revenues for the first half of 2013, and raised its 2014 revenue guidance. Its shares have risen of late, but investors remain wary of the company due to its increasingly volatile quarterly numbers and slower growth than industry observers had come to take for granted. Behind the nascent turnaround lies a strategic shift towards its core business of information technology (IT) outsourcing, after several years of focus on software. Indeed, the company has been competing for big IT outsourcing contracts even at the expense of near-term margins, which have dipped in recent quarters. The results illustrate that, while IT outsourcing is still a highly lucrative business, the space is becoming more competitive. Meanwhile, Infosys co-founder Narayana Murthy’s return to the company, in the role of Executive Chairman, has provided a morale boost and helped reinforce the back-to-basics approach.

IT outsourcing emerged as a growth industry in the early 2000’s and in the years since has both enriched investors and changed the face of India, where much of the industry’s leadership and manpower comes from. With Infosys and Cognizant Technologies (CTSH), two of the best-known players in the sector, each having over 150,000 employees, based largely in India, industry analysts are keeping an eye on rising wages and a tightening in India’s monetary policy. Due, in part, to laggard growth rates in what was once a fast-emerging economy, the rupee, India’s national currency, has been declining in value over the past year. In recent months, the Indian central bank, the Reserve Bank of India, has embarked on a program of quantitative tightening, reducing India’s money supply, in order to bolster the rupee. One of the risks here is that a rising currency may make India’s wage rates, which have already been rising, less competitive relative to other countries. That would be of great concern, as India’s combination of a highly educated, often English-speaking, middle class and exceptionally competitive wages has, in large part, made the IT outsourcing boom possible. A significant reduction in the wage disparity between India and the developed countries, which make up the bulk of the industry’s client-base by revenues, could be a game changer. However, India’s wages are still a long way off from even those in other emerging markets, such as China, and, as of right now, profit margins in the industry are still strong.

Infosys, headquartered in Bangalore, India, has seen average earnings growth of 25% a year over the past 10 years, and has maintained a still-staggering growth rate of 19.5% over the last five.  Indeed, its earnings continued to grow even throughout the recession of 2007-2009. Furthermore, with return on total capital in excess of 20%, it has not needed to take on debt, maintaining a clean and cash-rich balance sheet.

Impressive as the rise of Infosys has been, competitor Cognizant Technologies, which is headquartered in New Jersey but largely operates in India, has seen even more of a boom, with earnings rising at a 41.5% annualized rate in the past decade. It also maintains a return on total capital ratio in excess of 20%, and has a debt-free balance sheet with ample cash assets, as well. The company’s Financial Services division and its cloud solutions appear set to perform particularly strongly, and those business segments are likely to help Cognizant beat its own earnings guidance this year. 

While we expect the growth rates of these companies to slow down somewhat from the feverish pace of the last 10 years, they still appear set to deliver impressive share-net growth over the next half-decade, with both Infosys and Cognizant set for double-digit earnings growth rates over the next 3 to 5 years. As a result of their exceptional earnings growth potential, as well as their relatively low P/E ratios compared to their historical valuations, both stocks have attractive 3- to 5-year price appreciation potential.

With competitors such as Tata Consulting and Accenture (ACN) making for an increasingly crowded industry, some observers are worried that the favorable economics of the sector will be hurt. However, operating margins and returns on total capital have remained remarkably steady over the past decade. While it is unclear who will be among the winners in the sector over the long term, the exceptional economics of these businesses are hard to deny. On the whole, they are likely worth more than the merely-average valuations at which they currently trade.   

Despite the mixed near-term outlook for the IT outsourcing industry, as well as some risks ahead, we maintain that long-term investors can find solid long-term appreciation potential in the sector.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.