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Stockmarkets: The 'outsourcing' theme.. - Views on News from Equitymaster
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  • Apr 19, 2006

    Stockmarkets: The 'outsourcing' theme..

    The markets have rebounded this week, after a short but fairly brutal correction last week. Software majors - Infosys and TCS - reported encouraging results, and, more importantly, they expect a strong year of growth ahead, with stable margins. Thus, on the back of this strong business outlook, the bulls have taken the markets soaring towards the next historical highs!

    At current levels, the BSE-Sensex trades at a price-to-earnings multiple of 21.5 times its trailing 12-month earnings. This is not cheap by any standards, and is a clear indication that the markets expect over 20% growth in corporate earnings from the Sensex companies over the next year (FY07). Any hiccups on this front could lead to a downward re-alignment of expectations. The FY06 results that are yet to come will provide some insight into where we could be headed.

    In this write-up, we give a perspective on a few sectors that we believe will be driven by the broad theme of 'outsourcing'. These sectors are typically driven by exports and are non-cyclical, with clients resorting to outsourcing/offshoring their processes, product development and back end manufacturing from low-cost countries like India. India's major competitive advantage - labour cost arbitrage - is the driving force for these activities and its superiority over competitors like China and Eastern Europe. Going forward, a move up the value chain is vital for the longer-term survival of these industries, as the labour cost advantage slowly but surely starts to erode.

    The success of the Indian software industry is well known by now. Companies like TCS, Infosys and Wipro have become synonymous with the success of India's 'new-age economy' and services sector. We chronicle here, a few major reasons as to why the industry has grown at such a fast clip over the past few years.

    Key factors and trends driving growth

    • Started with labour cost arbitrage - labour costs in India anywhere between 30% to 60% of labour costs in developed countries

    • The 'Global Delivery Model' perfected by Indian companies, resulting in considerably enhanced efficiencies and cost savings for clients

    • Increasing acceptance of offshoring by global corporations

    • A shift from billion-dollar 'total outsourcing' deals to a break-up of such deals to different vendors, a trend known as 'Strategic Global Sourcing'

    • An increase in the offshore component of global IT spending, and huge potential - the total amount offshored as of now is just US$ 30 bn, compared to the potential of US$ 330 bn (NASSCOM-McKinsey Report 2005)

    • Greater willingness of corporations to go in for 'discretionary outsourcing'

    • Strong growth in high-end services like package implementation and consulting, resulting in the next phase of growth

    Auto ancillaries
    While India's success in the offshoring of IT services is now globally known, the country also has the ability to replicate the success of the software sector in other sectors, such as auto ancillaries.

    Key factors and trends driving growth

    • Similar labour cost advantages of Indian companies - labour costs for Bharat Forge at around 6% of sales, while for global competitors, it is over 25% of sales

    • Strong design and engineering skills of Indian companies at lower cost, aided by good availability of engineering talent in the country

    • Overall cost synergies - setting up of a manufacturing plant in India would entail around 30% to 40% lower costs when compared to setting up of the same plant in developed countries

    • Greater involvement of auto ancillary companies with global clients, through production of more critical parts

    Such factors are also expected to drive industries such as pharma and textiles. Global pharma companies are resorting to partnering with Indian companies for activities such as contract manufacturing, contract research (collectively known as CRAMS) and clinical trials outsourcing. The labour cost advantage and strong technical talent in the country are critical factors that are driving growth in these areas.

    While we strongly believe in the long-term prospects of these sectors, we have not mentioned the risks that may impact their fundamentals. These could include factors such as a slowdown in the global economy, resulting in corporations tightening their wallets, spiraling crude oil prices, rising global interest rates, political factors, such as an outcry against offshoring, particularly in conservative regions like Europe, ever-increasing competition for scarce human talent, the emergence of other outsourcing/offshoring destinations, resulting in reduced competitiveness for India, and an unfavourable policy environment.

    Investors should understand that this is not a recommendation of any stock or stocks in the above-mentioned industries. We have given a broader, macro perspective about the major growth drivers for these industries over the long-term. As an investor, one should always look at individual companies in these sectors that are most likely to benefit from the growth story. Given that the BSE Sensex is at high levels, a bottom-up approach would be most appropriate. And finally, the last step would involve valuations - buying the business at lower than its fair value. Only then can the purchase be justified.



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