I recently addressed concerns that Cognizant’s (CTSH) growth - as well as that of other Indian outsourcing firms - may be peaking. Now it seems that those in thee industry may be wondering the same thing.

Is the party over for Indian outsourcers? - Business - News - ZDNet Asia

A confluence of adversities is at play. They include an appreciating rupee that is cutting into earnings, a severe shortage of qualified talent at home, and a cap on H-1B worker visas to the U.S., along with pre-2008 election protectionism threats.

On top of that, there is the end of preferential industry tax benefits at home and the growing success of multinational competitors such as Accenture and IBM on Indian turf. Perhaps most challenging for the Indian players is the pressing need to move up the ladder into business consulting, a domain that companies such as IBM have dominated for decades. Indian outsourcing firms need to invest heavily to secure a position in this arena, and that will erode their fat profits, at least in the short term.For the first time, industry insiders are asking: Is the outsourcing game over for Bangalore? “The Indian IT companies have had an unusually long run in profits and growth,” says Siddharth Pai, partner and managing director of global tech advisory TPI Advisory Services India. But that is “an anomaly”, he adds. “As they mature, they cannot expect the same kinds of returns.”

It is healthy that industry insiders are beginning to worry about the issue. Nothing is more dangerous than cocky management teams. For investors, though, there still needs to be an adjustment to the risks that growth will not be what it used to be.

Infosys (INFY) profit rose 34.5% but its full-year outlook was cut due to a rising rupee, according to MarketWatch:

Net profit for India’s second-largest software exporter rose to 10.79 billion rupees ($268.8 million) in the quarter ended June 30, from 8 billion rupees a year earlier. Earnings per share for the quarter rose 31.5% to 18.89 rupees (47 cents).

Infosys said it was reducing its earnings-per-share forecast for the full year, in accordance with Indian accounting standards, to at least 78.20 rupees from its April forecast of at least 80.29 rupees. It made the revision because of a sharp appreciation of the Indian currency against the U.S. dollar.

In dollar terms, the company’s revenue of $928 million and earnings per share of $0.46 were better than the analyst estimates of $909 million and $0.40. However, full-year guidance of $4.0 - $4.05 billion in revenue and $1.92-$1.94 in earnings per share are disappointing. Analysts were expecting $4.07 billion in revenue already, and even though the official estimates were for $1.84 in EPS, $0.06 of upside was provided in the past quarter, and investors were surely hoping for more than another $0.02 for the remainder of the year.

When I previewed earnings on Sunday, I said “The $0.40 consensus estimate factors in slowing growth, but the degree of earnings surprise has been narrowing in recent quarters. Given my own experience with outsourcing recently and the general employee retention issues, I think we’ll see some disappointments in this sector over the next couple of quarters.”

So far, the company is blaming the crunch not on the tight job market but on the rising rupee - but the other factors were not written off entirely:

“The sharp appreciation of the rupee against all major currencies impacted our operating margins during the quarter,” said V. Balakrishnan, Chief Financial Officer. “However, our robust and flexible operating and financial model enabled us to maintain our net margins while absorbing the impact of appreciating currency, higher wages and visa costs.

These are all pressures on an employee-centric enterprise founded on the major wage discrepancies between their home country and those of their customers. If wages and the home currency both rise by 10% annually (in many cases it is even faster) relative to customers, it doesn’t take long for that disparity to reverse. And it takes even less time for the disparity to narrow sufficiently to stall out a 30% growth rate.

Conventional wisdom holds that magazine cover stories are contrarian indicators - by the time a company’s success or failure reaches the cover page of a major publication the story is so well known as to be completely reflected in the stock price. Therefore, all good news is priced in and the stock can only underperform or all bad news is priced in and the stock can only outperform.

While simplistic, the magazine cover indicator now has the support of recent academic research. This research did find that cover story headlines on Business Week, Fortune and Forbes tended to indicate that the mood (bullish or bearish) of the story was about to change in the market.

As a result of this research, we have decided to develop a portfolio of stocks based on using those three magazine’s covers as a contrary indicator. We also track this portfolio on StockPickr. This week’s results:

International Business News : Business News, Technology Industry News

The Real Cost Of Offshoring
U.S. data show that moving jobs overseas hasn’t hurt the economy. Here’s why those stats are wrong

Contrary Pick: Hmm. Is this headline negative about offshoring or the US economy? I’m going with offshoring and saying the contrary pick is to buy the offshore firms like Cognizant (CTSH), Infosys (INFY) and Wipro (WIT).
Forbes and Fortune, being bi-weeklies, were not updated this week.

Cognizant’s recent slowdown in net hiring has taken the wind out of its sails, and we have said several times that the biggest threat to the offshore IT providers is sustaining the employee growth that will be needed to sustain revenue growth - especially given the industry’s high employee turnover rates.

With several of the earnings reports from leading IT outsourcers and offshorers now in, we thought it an opportune time to peruse the conference call transcripts for clues.

First off, it is clear that demand remains strong.

George Price - Stifel Nicolaus

Where are we in terms of headcount in India? And then targets going forward by the end of the fiscal year?

Bill Green

I think I mentioned that we were in the mid-50s, in terms of total numbers. I think we were at 35,000 or targeting 35,000 by the end of the fiscal year. You know, the growth just continues, George, to expand there now with the management consulting expansion. We’re just going to see more substantive growth there. So we’re still on-target to hit the end of the fiscal year number that we’ve been throwing around.

(Excerpt from full ACN conference call transcript)

However, the demand is also putting pressure on wages.

We are increasing the offshore wages by somewhere between 13% to 15% and onsite wages for people outside India by 5% to 6%.

Overall, the impact on the margins because of the wage increases is something around 300 basis points, and we are assuming the rupee/dollar rate at 43.10. The average for fiscal ‘07 was 45. So, that could have an impact of something around 150 to 160 basis points on the margin.

(Excerpt from full INFY conference call transcript)

Margins are under pressure due to a rising rupee as well.

Now, this quarter our operating margin dropped by 100 basis points. This is primarily on account of rupee appreciation. But as we look forward, we have given guidance where we expect the profitability to be maintained at the same percentage level next year.

(Excerpt from full INFY conference call transcript)

Cognizant even claims that the slower hiring pace is just to protect margins:

And in the end, why are we slowing down hiring, because we want to stay within our target margin range, which we feel we can do without disrupting the business at all, because we are running such a low utilization today.

(Excerpt from full CTSH conference call transcript)

This explanation, however, doesn’t hold water with us. For one thing, low utilization has been the norm as the companies bring hires through the training program and prepare for expected turnover. Whether the margin impact is due to rising wages, currency issues or anything else is not the point as they are all symptoms of competition for workers. Instead, the point is whether the employees will add productivity or will allow revenue to grow only in line with employee count. We don’t see why it would be any more important to protect margin now than it would have been a year ago. To some extent it appears Infosys agrees.

S. D. Shibulal

Well, a higher utilization actually creates stress within the system because it’s like having a manufacturing plant and you cannot have people come just in time all the time. So, it made sense for us to have some amount of strategic bench, especially when you are bidding for large deals. And when large deals come into picture, there is one-time investment of people acquired. And today, on an average, every quarter we close some large deals, some multimillion dollar multiyear deal gets closed in every quarter.

So, it was important for us to build a strategic bench. At the same time, at this point in time, we have the fleet transferring too in the bench without impacting the business — including the utilization, without impacting the business.

(Excerpt from full INFY conference call transcript)

One key to continuing growth as the headcount increases is to reduce turnover. Some progress has been made here.

During the quarter, our annualized employee attrition declined to 15% from 17% in Q4. While we are pleased with our sequential progress in this area, attrition remains above historical levels. We continue to monitor employee attrition carefully and take necessary short and long-term steps to manage it.

(Excerpt from full CTSH conference call transcript)

Given Cognizant’s 43,000 employee count, a 2% reduction in annual turnover offers the same benefit as hiring 860 employees in a year. They also seem to be focusing on hiring the real revenue generators:

The increase in cost of revenues was due to additional technical staff for on-site and offshore required to support our revenue growth. We increased our technical staff by over 4,300 during the quarter and ended the quarter with approximately 40,800 technical staffs. This is a net increased of almost 15,750 technical staff from March 31, 2006.

(Excerpt from full CTSH conference call transcript)

Because of the ability to focus the hiring, because of increased productivity as employees gain experience and because of the low current utilization there is certainly some room for the companies to grow faster than they add employees. However, this ability is somewhat temporary. Long term, more sales will require more bodies. The question is whether those bodies can be found and retained.

Infosys Technologies (INFY) Announced Results for the Quarter and Year Ended March 31, 2007, and what struck us was not sales or earnings, but employees:

• Gross addition of 5,992 employees (net 2,809) for the quarter by Infosys and its subsidiaries
• 72,241 employees as on March 31, 2007 for Infosys and its subsidiaries

In our earnings preview we said “They will make the numbers, but investors will listen closely to the update on visas and employee retention.” Doing the math, 3,182 employees left the company (the difference between net and gross.) That number is 5.2% of the number of employees at the beginning of the quarter, which we figure to be an annualized attrition rate along the lines of 20%, in line with the rates that have concerned us for some time. However, instead of the more than 10,000 new hires in the July-September quarter last year (which admittedly may have been boosted by graduation timing) there were less than 6,000 this quarter. As a result, the total number of employees grew just 4% sequentially - perhaps a 16% annualized rate.

While still impressive, it is important to remember that IT outsourcing is a labor-intensive industry. Revenue growth is very much reliant on adding employees and making them more productive. While revenues can grow faster than employees in the short term due to improved productivity, in the long term the relationship will be fairly tight.

Infosys grew earnings per share by 64% last year and is forecasting 27% growth this year. If the current run rate of employee growth is any indication, investors should expect a significant slowdown next year as well.

The Economic Calendar looks pretty dull next week, with only Friday’s PPI report likely to get us excited. Look for our usual industry pricing power report.

Looking less dull is the earnings calendar, as earnings season officially begins.

• Research in Motion (RIMM) reports on Tuesday. Consensus is calling for $0.99 EPS on $933 million in sales, and guidance of $1.04 on $994 million for next quarter. We’re taking the under.
• Genentech (DNA - Annual Report also reports on Tuesday. Consensus wants $0.67 EPS on $2.75 billion in sales and guidance of $0.71 on $2.9 billion for next quarter.
• Lam Research (LRCX) reports on Thursday. Consensus expects this quarter and next to bring in about $1.06 on $645 million in sales. We are expecting order flow to disappoint.
• Infosys (INFY) reports on Friday.  Consensus wants $0.40 on $865 million in revenues, and guidance for $0.40 on $920 million. They will make the numbers, but investors will listen closely to the update on visas and employee retention.

William Trent currently owns put options against the shares of Lam Research (LRCX).

Given how difficult it has been for us to find an available web designer lately (let alone one we can afford) we weren’t especially surprised to see this nugget:

H-1B cap for fiscal 2008 reached in two days - 4/4/2007 - Electronic News

Only one day after starting the receipt of applications, U.S. Citizenship and Immigration Services (USCIS) announced Tuesday that it had already received enough H-1B petitions to meet the congressionally mandated cap for fiscal year 2008. Contrastingly, it took nearly two months for the cap to be reached for fiscal year 2007.

According to the U.S. Department of State, H-1B classification applies to persons in a specialty occupation which requires the theoretical and practical application of a body of highly specialized knowledge requiring completion of a specific course of higher education. This classification requires a labor attestation issued by the Secretary of Labor (65,000). This classification also applies to Government-to-Government research and development, or co-production projects administered by the Department of Defense (100). The H-1B visa is widely used among the IT outsourcing firms such as Cognizant (CTSH), Infosys (INFY) and others, who need feet on the ground on site to determine needs and communicate them to the coders back in India.

Whether the on-site team is itself Indian is of relatively little importance. The cost efficiencies still dictate that a good deal of work will be done offshore. Meanwhile, on-site staff are paid local rates, so they can be locals just as easily as not. And with the visa cap being met virtually the moment the doors opened, it is a safe bet that more of them will be locals this year. Which helps explain our difficulties finding someone to help us with our site.

The news may have a short-term impact on the outsourcing firms. The last time there were visa cap issues investors reacted harshly for a couple of months on the belief that the shortage of immigrant workers would affect the rapid growth in offshore outsourcing. It did not, of course, but it is unclear whether investors were completely disabused of the idea. This time is also somewhat different because the firms are also having difficulty finding (or at least keeping) workers in India as well.

The stocks have had a strong recent run and may be looking for any excuse to pull back. This visa cap offers one such excuse.

It’s been a while since we first started warning that the biggest problem for Indian IT outsourcing operations would be continuing to find enough employees to sustain their impressive growth rates. Now, however, it seems like it truly is becoming a problem. In the latest example, IBM sees growth in India but skill shortage a worry (Reuters.com):

But the rush for staff has led to rising wages and a skills shortage.”It’s (skill shortage) a challenge and we have got to address that … currently all of us are recruiting,” Annaswamy said.

“We know how to recruit quality personnel which are available in India, but we also know how to train them, how to give them career options and how to make them feel proud of being an IBM-er.”

The pain is being shared fairly evenly across all those who want a big presence in India. But that doesn’t make it any less difficult to hire and retain quality staff.

We have long been impressed with the ability of Indian outsourcing firms to hire enough new employees to sustain their tremendous growth rates. As we noted in May, 2006:

Think about it. A company that already had a large number of employees (17,050 at March 31, 2005) grew its employee base by 57 per cent in one year. Plus, if the 11 per cent annualized turnover the company experienced in the latest quarter is typical (by our recollection it seems on the low side) that means they would have lost 2,400 employees to attrition during the time (11 per cent of the average number of employees during the year.)

So to add 9,700 employees the company had to hire 12,000. Almost 50 new hires every working day. Even if they hire a quarter of all applicants that means interviewing 200 per day. And if they want to grow another 50 per cent next year they will have to hire 75 new employees each workday this year. By all accounts there are plenty of graduating software engineers in India to hire. But that is still one heck of a logistical exercise. And someday it will be too much to handle and the company will trip up.

If we had to point to one specific risk factor as being Cognizant’s greatest, it would be managing all of that growth. We don’t think it will happen this year, but it could. Or, just as likely, they could continue to coast for several more years. And in the meantime, it is a nice problem to have.

Since then, the stocks have continued to soar.

Unfortunately, the “one specific risk factor” has also grown in importance. Infosys turnover rose to 12.9% in the third quarter, and Cognizant said it was something management was monitoring. Now, based on Infosys’ fourth quarter report, “monitoring” may translate into “watching it get worse.”
Infosys faces quality problems in staff : HindustanTimes.com

Can there be problems when a company is surging a wave of plenty with $1 billion in cash? Apparently, yes.Infosys Technologies may be rich and hiring by the thousands, but has to compete with giants like IBM and Accenture in wooing engineers and programmers, and staff attrition is a looming problem.

The company’s attrition rate rose to 13.5 per cent in the latest October-December quarter compared with 10 per cent during the same period last year. But not all of them left on their own.

About 1.3 percentage points of the 13.5 per cent attrition are attributed to poor quality of work by trainees who could not match up to expectations.

Despite the recent rally, P/E multiples have remained near their recent averages (the stock price rise has been backed by fundamentals.) However, at the current rates of attrition the recent growth rates will soon prove unsustainable.

We have noted several times how impressed we are with the rapid hiring pace at Indian IT services firms such as Infosys (INFY), Cognizant (CTSH) and Wipro (WIT). In fact, we viewed the need to constantly hire more people one of the only obstacles in the path of their rapid growth.

Still, as cost effective as labor based in India may be, the firms need feet on the ground in its customer’s local countries to take the orders and coordinate efforts. So perhaps it is not surprising that the offshore firms are now preparing a large onshore hiring thrust. The Telegraph - Calcutta : Business:

Wipro plans to have more foreign employees as it expands its business in Europe and South America.The company expects foreign employees to make up 25 per cent of its total workforce in future against 5 per cent at present.

Wipro chief Azim Premji today said as part of its policy to go global, the company would have to employ more local nationals in the countries to which it was spreading its wings.

Let’s hope they get started soon. The employment numbers could use their kind of hiring spree.