Foolish Forum: Bullish on Indian IT?

The Indian outsourcing market grew 33% to $23.6 billion in 2006, creating enormous opportunities for firms in India. Fool analyst Tom Taulli is here to tell us more about India's IT industry.

Joey Khattab: Tom, welcome to the Forum. Why has India been so successful growing its IT services industry? What advantages does it have over other countries?

Tom Taulli: India still provides a big benefit in terms of relative wage differences, and this advantage is likely to persist for some time. Michael Guilbault, senior analyst for Technology Business Research, estimates that India should maintain its cost advantage until at least 2025 -- despite the 18%-plus wage increases in some parts of the country.

India's success may also stem from its deep experience with outsourcing, its population's English proficiency, and the high quality of its engineers. While China, for example, has a large workforce, its English proficiency is still sporadic, and its government's occasional tendency to interfere in business makes geopolitical concerns more prevalent.

The Indian government also has lots of incentive to grow its outsourcing industry. It should be no surprise that the government provides tax breaks, invests in infrastructure, increases protections for intellectual property, and has policies to promote information technology (IT) security. In light of all these factors, I think it's a good bet that India will continue to be a major growth area for outsourced IT.

Joey Khattab: Let's look at the four main players. What value proposition do they offer an American CEO looking to outsource some software programming, for example?

The value proposition is vast. To stay competitive in the global marketplace, companies need to manage customer bases, cross-sell, provide customer support, meet regulatory disclosure requirements, communicate with partners and vendors, and on and on. It's not easy running a business nowadays, but a good IT staff can certainly help. Companies like FedEx (NYSE:FDX) and Wal-Mart derive key competitive advantages from their highly sophisticated IT infrastructure.

Mergers and acquisitions provide another big catalyst for IT demand. As more and more companies combine, it gets ever tougher to meld together their different IT systems, increasing the call for seasoned, savvy engineers.

IT is complex and expensive, and at most companies, it's not a core competency. That makes it an ideal function to outsource. A report from NASSCOM-McKinsey forecasts that offshore IT services will surge from $18.4 billion in 2005 to $55 billion in 2010.

Joey Khattab: You had mentioned that Wipro is constantly improving its processes and cutting costs. Do you see it emerging as the leader in the industry?

Tom Taulli: I recently wrote a book review for The Motley Fool on Bangalore Tiger, the amazing story of how 21-year-old Azim Premji built Wipro into an IT empire.

While no one doubts India's IT prowess now, it was a far different story 20 years ago. To compete and get the attention of skeptical customers, Wipro had to be incredibly innovative, developing an organization that was constantly mindful of saving money. For example, Wipro measured the usage of paper towels in restrooms and realized it could save money by installing air dryers.

Striving for quality was the other key element of Wipro's strategy. Back in the 1990s, the company got certified for International Organization for Standardization (ISO) 9000. The company is also a leader in Six Sigma business efficiency practices. To me, this is the same kind of focus that Toyota (NYSE:TM) has. Over time, it can add up to a massive competitive advantage.

Joey Khattab: Our CAPS community is bullish on these companies, despite the lofty P/E ratios. Do you agree with the community?

Tom Taulli: These companies are also selling at high multiples of sales, and on the face of it, they do look incredibly overvalued.

However, investors need to account for a few important factors. First, these companies are in fast-growing markets, and that growth should continue for many years. Moreover, they have strong competitive advantages in terms of costs, platforms, and experience.

I also think the revenues are understated. For example, if Wipro snags a $100 million contract, the company will need to spend the first year or so investing resources to execute on the project. But after a couple of years, the company will start realizing big revenue gains. The costs are front-loaded, but the revenues are back-loaded.

Joey Khattab: The cost of labor in India is on the rise because of enormous demand. How does this rising cost affect these firms?

Tom Taulli: This is definitely true, and I don't see the growth rate falling. Young engineers tend to move from job to job, getting a higher salary each time. Significant turnover and higher pressure on wages create a double whammy for Indian outsourcers, making it difficult to run a large organization. To deal with this, the major Indian outsourcers are moving operations into smaller cities, where wages tend to be lower and it's much more difficult for locals to move out of a job.

Joey Khattab: Not to be outdone, American firms like IBM (NYSE:IBM) and Accenture (NYSE:ACN) are pumping billions of dollars into India. What do you make of it?

Tom Taulli: These firms always seem to be a step behind. The Indian outsourcers have the home-field advantage, with which it's incredibly difficult to compete. Nonetheless, I think it's interesting that IBM has invested billions buying up software companies like ISS and Filenet. The acquisitions should result in higher-margin revenues, as well as lower dependence on the global services business.

Joey Khattab: That's a wrap, Fools. Join us next week in the Foolish Forum for more snappy opinions on hot investing topics.

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Neither Fool financial services editor Joey Khattab nor Fool contributor Tom Taulli owns any of the shares mentioned. Tell Joey what you think about the Foolish Forum. Accenture and Wal-Mart are Motley Fool Inside Value recommendations. FedEx is a Stock Advisor pick. The Fool has a disclosure policy.