The case for investing in India’s technology services stars is gaining strength as U.S. and European multinationals outsource a wider variety, as well as a greater portion, of their office tasks to lower-cost, offshore locations.

The offshore outsourcing movement — which started with offshore software development and customer call centres — now includes sophisticated information-technology jobs ranging from consulting to the management of business processes, such as human resources and accounting. Essentially, if a job can be done in a cubicle in North America, it can be done for less in India.

U.S. consultant McKinsey & Co. estimates that India controls almost two-thirds of the market for basic offshore IT services and about 45% of the new market in higher-end services. Combined, the two markets pushed India’s exports of IT services to $17.2 billion (all figures in U.S. dollars) in the fiscal year ended March 31, 2005, compared with just $6.2 billion five years earlier. McKinsey says exports will continue to grow by 25% annually to reach $60 billion by 2010.

Is the McKinsey target realistic? Certainly there are a few risks that could limit India’s ability to reach that lofty goal. McKinsey partner Jayant Sinha acknowledges the industry could face a shortage of skills. Currently, only one in four technical graduates and one in seven general college graduates in India have skills suitable for jobs in the IT industry. Second, the management of India’s top IT firms could be hard pressed to balance the needs of rapid expansion with the increasing complexity of the projects they are taking on. Also, Sinha points out, the subcontinent’s antiquated infrastructure could prove to be a bottleneck to growth unless it is upgraded.

Terrorist threat

There is also the spectre of terrorism. In December, police in the capital of Delhi arrested suspects who had been planning attacks on the high-tech centres of Bangalore and Hyderabad. India’s very success in IT is making it a target for extremists. In the wake of the arrests, Bangalore-based Wipro Ltd. and other technology firms bolstered surveillance and security.

And, not least, there is a currency risk. If the Indian rupee rises dramatically against a weaker U.S. dollar, it would undermine some of the cost savings of outsourcing office work to India.

Yet, what strikes visitors to India is just how well the country’s top IT players have handled breakneck expansion so far. Bangalore-based Infosys Technologies Ltd. and Wipro — two of the country’s biggest computer services firms — have not only added impressive new campuses in most of India’s cities, but they have also expanded outside the subcontinent. Wipro, for instance, operates facilities in Japan, China, Europe, North America and, starting in March, Romania. The bulk of its employees — 78% — are still in India, where starting annual salaries for engineers are only $3,500 (although wages rise quickly with experience).

India’s top offshoring companies are gearing up to play a key role in this increasingly important global industry. Wipro and Infosys, along with industry leader Tata Consultancy Services Ltd. — which trades only on the Mumbai Stock Exchange — are each expanding staff by about 1,000 a month. Infosys is boosting the capacity of its main training centre in Mysore, India, to 14,000 from 4,500.

“We need to accelerate hiring,” Mohandas Pai, Infosys’ chief financial officer, told analysts on Jan. 11. “We’re seeing a trend of clients asking us to ramp up pretty quickly.”

Wipro, for its part, says its major customers are becoming more comfortable with outsourcing different parts of their businesses, such as software development, software maintenance, consulting and engineering, as well as business and consulting processes. Wipro notes that 84% of its clients now use three or more of Wipro’s services vs a year ago, when not quite 60% relied on the company for two or more services.

If investors are comfortable that India has what it takes to prevail in the offshoring business, they have several options. They can sink their money into one or several of the India-based majors, buy shares in U.S. firms that make extensive use of India’s pool of engineering and English-speaking talent, or employ some combination of the two.

Investors would be wise to consider buying into one or several of India’s major companies in this sector — such as Infosys, Wipro or Cognizant Technology Solutions Corp. , the New Jersey-based outfit that is India-run and has much of its workforce on the subcontinent — partly because outsourcing’s growth cycle appears to have many more years before it runs its course.

@page_break@Stocks with lower p/e

Although buying into the more expensive stocks clearly requires more patience of investors in search of solid capital gains, there are more choices available — including stocks with substantially lower price/earnings multiples. These include Patni Computer Systems Ltd. , the Mumbai-based firm that began trading on the New York Stock Exchange this past December, and Kanbay International Inc. , the Rosemont, Ill., company with extensive operations in India. Kanbay began trading on Nasdaq in 2004.

Here’s the outlook for some key India offshoring plays available on the NYSE or Nasdaq:

> Infosys technologies: This offshoring pioneer was co-founded in the early 1980s by seven individuals who resisted the urge to emigrate to the U.S. and so set about jump-starting India’s IT industry. They succeeded, but it took them longer than expected, thanks to a government that was blatantly anti-business until 1991. In 1998, Infosys became the first IT firm in India to obtain a listing in the U.S. (on Nasdaq) and it remains the largest, with a market capitalization in excess of $21 billion — although Tata Consultancy Services is slightly more valuable.

Infosys delivered solid results in its third quarter ended Dec. 31, 2005. Sales were up 6.7% to $559 million, from $524 million in the second quarter, while earnings increased to 53¢ per American depository receipt from 51¢ quarter-over-quarter. But analysts were disappointed with the company’s fourth-quarter forecast. Infosys executives told analysts to expect revenue of $582 million-$584 million in the fourth quarter, representing relatively modest growth of 4.1%-4.5% over the previous quarter. Earnings, the company said, would be 55¢-56¢ per ADR.

Infosys is doing well with traditional market segments such as financial services and manufacturing firms, but is surprisingly weak in the newer markets involving energy, utility and retail customers, says Kawaljeet Saluja, an analyst with Kotak Institutional Equities Research, the Mumbai-based unit of Kotak Mahindra Bank. Saluja continues to rate Infosys a “buy” — along with 21 of 26 analysts tracked by Bloomberg LP — thanks to the general health of offshoring. “A 25%-30% growth rate for the industry for the next two years appears feasible,” Saluja wrote in his Jan. 12 note.

> Wipro is India’s third-largest IT services exporter, after Tata Consultancy Services and Infosys. The company is 82%-controlled by Azim Premji, a workaholic billionaire. Wipro, originally a producer of cooking oil, was founded in 1945 by Premji’s father. Premji Jr. took over the family business upon his father’s sudden death in 1966, cutting short his engineering studies at Stanford University. Wipro expanded into computer hardware in 1981, four years after India expelled IBM Corp., then moved into computer software and services in the mid-1980s.

About 75% of Wipro’s estimated $2.86 billion in total revenue for the fiscal year ending March 31, 2006, will be derived from exporting a wide range of IT services. Wipro is similar to Infosys in size and geographical reach. Infosys got a head start in the important U.S. market by listing its shares there two years before Wipro did. (Wipro’s U.S. IPO was on the NYSE in October 2000.) But Wipro and Infosys take turns outshining each other.

Although analysts were mildly disappointed in Infosys’ fourth-quarter forecast, Wipro’s third quarter prompted analysts to upgrade its earnings forecasts. Ashish Thadhani, an analyst with New York-based Gilford Securities Inc. , notes that Wipro’s third-quarter revenue was $617.0 million — $10.5 million higher than expected. And net profit margins were 19.2%, vs his prediction of 17.9%. These better-than-expected earnings were a result of Wipro squeezing more revenue out of its top clients by persuading them to buy more services. The company also trimmed labour costs by increasing the percentage of employees with less than three years’ experience. Thadhani’s new price target for Wipro is $15, which was surpassed Jan. 30, just 11 days after he issued his report.

> Patni computer systems. This Mumbai-based company was founded in 1978 by Narendra Patni, an offshoring pioneer. But it failed to take advantage of the industry’s first wave, even though it won a significant outsourcing contract in 1990 from the U.S.-based conglomerate General Electric Co. In fact, it wasn’t until the company reorganized into business units that offer IT services for insurance, financial services and manufacturing corporations several years ago that it showed signs of promise. It did its IPO in India in 2004, following up with a listing on the NYSE two months ago.

Revenue for the fiscal year ended Dec. 31, 2006, is expected to hit $553.5 million — up 24% from 2005 and more than five times the levels of 2000. What investors may like even more is Patni’s stock; as of Feb. 1, it was trading at only 18 to 19 times its 2006 estimated earnings — a bargain compared with Infosys and Wipro.

But there are risks. Joseph Vafi, an analyst with New York-based Jefferies & Co. , notes Patni’s biggest customer, General Electric, constitutes 22% of Patni’s revenue. And GE’s account is no longer growing.

To get an idea of the drag created by GE’s business, Patni’s non-GE accounts grew by 57.3% last year for a company-wide revenue increase of 33.6%. And Vafi is concerned that Patni’s earnings will fluctuate in the short term as it invests huge amounts to expand capacity, making up for lost time. In its Feb. 1 conference call, Patni officials predicted 2006 earnings would be $1.24-$1.29 per ADR, up 40%-45% from 2005.

> Cognizant technology solutions. The former IT development subsidiary of Dun & Bradstreet Corp., Cognizant was a second-tier player until recently. The company was spun out of D&B in 1994 and went public four years later on Nasdaq. But by 2002, it could claim revenue of only $230 million. William Loomis, an analyst with Stifel Nicolaus & Co. of St. Louis, Mo., predicts Cognizant will deliver revenue of $1.26 billion this year — up almost 43% from his 2005 estimate for 2006. Loomis expects earnings will hit $1.42 a share, a 36.5% increase from earlier estimates. Cognizant was fairly careful in its early years, focusing on doing a few things, such as software application development and maintenance, well.

After the tech bubble burst in 2001, Cognizant considered its experience solid enough to expand into new services, such as R&D and telecommunications software, and acquired firms with expertise in these areas. With the U.S. and European multinationals outsourcing, the result was explosive growth.

Loomis, however, rates Cognizant as a “hold” based on its high valuation. He suggests buying shares if they dip into the “mid- to upper $40s.” IE