Description

Description:
As investors take note of a slowing US economy with implications for failing growth at US tech companies, the question naturally arises: are there any areas in technology that have a secular growth outlook which might minimize the impact of an IT slowdown in the US? I believe that the eServices sector in India is one of the best ways to play the dynamic and fast-growing business of building software in India for US companies. There are several stocks that trade on US exchanges that allow an investor to play in this sector. Some are pure-plays on companies based in India; others are based on US consulting companies that employ an offshore-based software development approach. We will look at four major players (in my opinion) in this sector and pick the best stock that could be an investment for the next 12 months.

Market Opportunity:
The global software development market (professional services), in which the India-based eServices sector is a part, is worth an estimated $100 billion per year (C’2000). However, the eServices market that these companies service is a much smaller pie because they compete mostly based on offshore capabilities in India. The offshore eServices market is worth close to $5 billion per year (C’2000).

Major players in the eServices sector in the US include behemoths such as EDS and the Big Five. In addition, there are several dot-com players such as DiamondCluster and Scient. It is a very competitive sector but one in which companies based in India or which have their primary operations in India have a major advantage: India has a large pool of talented software professionals who are paid much less in India than in the US for performing a similar role.

Of the major players in the eServices sector in India with a US based stock listing, are the following:
· Infosys (INFY): One of the first names that comes to mind in the sector. Blue-chip giant on the NASDAQ as well as on the Indian stock exchange.
· Wipro (WIT): An equally impressive eServices provider even though it is overshadowed by Infosys.
· Silverline Technologies (SLT): Not as well known as the other two, but with its recent acquisition of SeraNova in the US, is poised to be a major player in the sector.
· Cognizant Technology Solutions (CTSH) is one of the larger players in the US with a strong management and long history.
There are other players such as Syntel (SYNT) and CBSI (CBSI) but they have frequently disappointed in the past that they are best avoided until their management changes.

Competitors:
Currently U.S.-based eServices providers such as Scient, Viant, DiamondCluster and the Big Five companies are competitors to the above companies but frequently they are partners as well. However, the competition between the four companies reviewed here is intense and is more likely a frequent occurrence.

Valuation:
Based on a price to sales ratio comparison, the valuation gap between the haves and the have-nots in this sector is huge. In this case, India-based pure-plays such as Infosys and Wipro trade at nearly 4-17 times higher than US-based plays. Though some amount of this valuation gap can be attributed to two major factors:
1. India pure plays afford investors the opportunity to invest in India
2. India pure plays are assumed to have world-class management.
But I wondered if in addition to the above whether there was any premium associated with operating margins since India pure-plays should have higher margins than US-based plays. Astonishingly, the valuation premium didn’t seem to have anything to do with margins. The company with the second highest margins in the business (SLT) had the lowest P/S ratio. Hence, we can safely assume that most of the market cap inflation for India pure-plays comes solely from the two factors mentioned above.

INFY WIT SLT CTSH
Mkt Size 5000 5000 5000 5000
Sales 357 579 128 120
Mkt Share 7% 12% 3% 2%
Mkt Cap 12800 13500 366 667
P/S Ratio 35.85 23.32 2.86 5.56
Operating Margn 31.4% 18.9% 23.8% 19.0%
P/Sratio/Margin 1.1 1.2 0.1 0.3

Based on the above table, it becomes clear that SLT is the most undervalued of this group. If the stock market provides a reasonable valuation to SLT based on a more positive outlook on the company (after its Sera Nova acquisition is completed), I believe that (based on relative valuation) SLT can trade anywhere between $15 and $42 in the next 12 months, which should provide close to a 50% return at a minimum from current levels within a year. The other stocks are worth waiting at best; are worth aggressively shorting at worst.

Outlook:
While worries about a global slump brought on by a tech slowdown in the US have crushed the valuations of the India eServices sector, these stocks have held up better than most US eServices stocks which have declined nearly 90% in most cases. Today’s earnings announcement from Infosys (01/10/01) indicates that it sees no slowdown in corporate IT spending in the US with regard to its services. If that is the case, these will be the first stocks to recover in any NASDAQ recovery.

Risks
It is believed that the US is currently headed towards a hard landing (recession). If that were the case, these stocks, especially INFY, WIT and CTSH could slide down further. SLT is less likely to be hit further since its valuation already reflects a tech slowdown and some execution issues. If SLT can provide an upside surprise in its next earnings report, it is likely to make up its valuation gap with its peers rather quickly.

Catalyst

Look for earnings report next month to run the stock higher. I expect a 20-50% return in 12 months.