The following article cites these stocks: SAP AG (SAP), Cognizant Technology Solutions Corp. ( CTSH - Analyst Report ) , Genpact Limited ( G - Snapshot Report ) , Infosys Technologies Limited ( INFY - Analyst Report ) , Wipro Limited ( WIT - Snapshot Report ) , AIG (AIG), Credit Suisse Group AG (CS), BT Group Plc ( BT - Snapshot Report ) , Patni Computer Systems Ltd. ( ) and Satyam Computer ( ) .

The current global economic and market downturn has taken its toll on the IT Services group as a whole. The Business Process Outsourcing (BPO) companies were all under significant pressure even before the current economic malaise, with a slowdown in its growth trajectory for 2008, and the Street had already discounted the 2008 slowdown relative to 2007. In other words, the BPO companies were all trading with an early-2009 growth/recovery story in mind.

However, this thesis is now undergoing some re-evaluation, given that overall recovery prospects are being pushed towards the latter half of 2009. The current financial market fallout adds further uncertainty to their growth picture, with roughly 50% of market cap already shaved off for the BPO companies since the fallout.

There's no mistaking that the global financial crisis has found its way to India's shores at a time when the country is in no shape to weather it. With banks in USA and Europe struggling to survive, outsourcing is less likely to be a dominant theme going forward. It is expected that the BPOs may cut their dollar revenue forecasts due to a downturn in the U.S. market, which contributes more than half their revenue.

These companies have already said that customers were delaying decisions on new projects in the tough global environment. Additionally, German software maker SAP AG (SAP) warned that its sales had dropped, and has toned down its guidance going forward as companies curtailed business software spending. This is expected to negatively affect the Indian BPOs with increasing revenue dependence in Europe.

Impact of a Weakening Sector

Among the major players in the IT Services sector, the percentage of total revenues derived from the financial services vertical amounts to 46% for Cognizant ( CTSH - Analyst Report ) - Hold), 45% for Genpact ( G - Snapshot Report ) , 43% for Tata Consultancy Services (or TCS), 35% for Infosys ( INFY - Analyst Report ) - Hold) and 25% for Wipro ( WIT - Snapshot Report ) - Hold). Given that well over half of this exposure (more for the application outsourcing firms and less for the BPO firms) can come from "discretionary" software development and other projects, the Street has been justifiably concerned about the impact of even tighter bank IT budgets in Q4:2008 and in 2009.

The Indian vendors themselves have attempted to soften these Street concerns by disclosing the portion of this revenue mix derived from the more volatile investment banking sector compared to the more secure insurance or commercial banking sectors, or -- as in the case of Cognizant -- indicating that its largest bank clients continue to spend while its smaller clients may be more vulnerable. This sub-sector distinction, while useful, has lost some value of late as the contagion seems to have spread to every corner of the financial services vertical.

While Infosys, Cognizant, TCS, Wipro and most other Indian vendors have been quite candid about the impact of the weakening financial services sector (citing lengthening sales cycles, delays in project ramps, consolidation of vendors and/or the loss of pricing power), most Indian firms have actually posted relatively strong sequential growth rates in their financial services verticals. In Q2:2008, Infosys recorded a sequential growth rate of 3% in its financial services industry, while Cognizant reported a strong 7% sequential growth rate.

In early September, both Infosys and Cognizant sounded reasonably bullish about their respective financial services verticals and in meeting their overall 2H:2008 revenue guidance. This, however, did not do much for the stocks of these companies, since a large portion of growth recorded in 2H:2008 comes from the ramp of existing deals signed in 2007 and in early 2008. Additionally, the major impact of the weak new bookings and delayed project ramps experienced so far in 2008 won't show up until 2009.

Needless to say, most investors are now looking beyond 2008 and are weighing how the calamity in the financial services vertical will affect 2009 results. Investors are well aware that the March 2008 shock from the collapse of Bear Stearns caused several pending Indian BPO deal awards to get delayed, and there is no reason to believe that the September 2008 shock won't have the same effect.

OPPORTUNITIES

There is, however, a silver lining in the dark clouds. Some of the companies have indicated that the level of client discussions is still healthy, even though these discussions are converting to signed deals at a much slower clip. It also appears that deal activity in continental Europe and in the local Indian market is healthy, although neither region represents a material portion of the revenue mix for most of the Indian outsourcers.

It is also rumored that government-owned insurer AIG (AIG) has issued a RFP for a multi-billion dollar IT and back-office outsourcing deal in an effort to cut costs. It is estimated that new deal awards in the month of October were $15 billion, exceeding the level of new contract awards for the entire September quarter. Note, however, that this total is down 12% from October 2007, and a full $2.5 billion of it stems from the TCS-Citi deal and many of the deal awards were for network and IT infrastructure outsourcing that the Indian vendors often don't compete on.

The consensus view is that the current sluggishness will last at least a few more quarters and that Q2:2009 or Q3:2009 will be the recovery quarter, with the industry fully back on track in 2010. The fact remains that visibility is so low that no one really knows when companies will feel comfortable enough to move forward with strategic offshore outsourcing decisions. The new bookings recovery was initially pegged by the Indian vendors for Q4:2008 and then it was pushed to Q2:2009.

The CEO of TCS indicated last week that a Q3:2009 recovery is more likely. Also, the management of Infosys indicated recently that this year it is looking for growth for the IT industry at somewhere in the region of 15 percent, compared to 30% last year. However, Infosys also reiterated that it would hire the 25,000 people it has targeted for this year and that there are no plans to cut headcount. Although the company has seen delays in orders, there has been no change in its third quarter guidance so far.

WEAKNESSES

The current feedback from Indian and U.S.-based outsourcing companies are somewhat tempered, with most sources saying that things are still getting worse. Many existing clients of these IT Services firms are still reducing their headcount and looking to cut back on their offshore IT spending.

New deals and clients are extremely tough to come by given the economic uncertainty. While existing projects are still not being canceled, new deal activity has slowed dramatically. Infosys indicated recently that many clients are still pushing the company to reduce its delivery costs so as to lower clients total offshore IT spend. The fact that most Indian vendors have very large (30%-50%) exposure to the financial services sector doesn't help and some vendors have high exposure to clients that are reducing headcount materially. BT Group PLC ( BT - Snapshot Report ) , which recently announced a 10,000-person lay-off, is the largest single client of Infosys.

Similarly, Credit Suisse (CS), with a major lay-off in sight recently, is a client of Wipro, Cognizant, Patni ( ) - Hold) and Satyam ( ) - Hold). Many of the outsourcing advisory firms (which advise large enterprises on their deals with the offshore and domestic outsourcing vendors) are also reducing headcount and looking for strategic combinations. All of these do not point to a bullish scenario.

Based on the recent relationship between currency shifts and the adjustments to the company's revenue guidance, it is expected that the currency shifts since mid-October are likely to reduce the dollar-denominated reported revenue growth rate for INFY in the coming quarters by a further 3%. This currency shift alone would therefore reduce the midpoint of the company's growth guidance to 7.5% for the December 2008 quarter and to 1.8% for the March 2009 quarter.

CONCLUSION

We are supportive of a long-term bull case on Infosys, Cognizant and the shares of the other Indian outsourcing vendors. However, the prevailing argument leans towards a dismal scenario for a few more quarters, with a counter-cyclical recovery in offshore IT spending by late-2009 and return to 20%-30% growth rates by 2010.

Assuming they can hold margins relatively constant, investors today appear to have the opportunity to acquire 20%-30% earnings growth for a below-market P/E multiple of 10x.

There are a few counter-points to this argument: (a) given that the core Indian software services companies are at a mature stage, the prospects of a recovery to 20%-30% growth is questionable. Client penetration rates for these companies are already high in the mature industries such as banking, insurance and telecommunications and core offshore ADM services have become increasingly commoditized. (b) Industry pricing pressure and a flat or appreciating rupee could act as a counter to the stable margin assumption. (c) From an investment timing perspective, we see no rush to rating upgrades when the stocks of Infosys and its Indian peers are trading at (not below) the same P/E multiples of many other high quality technology companies.

Clearly, a trough is not yet in sight and companies are more likely to lower their guidance. Also, sell-side estimates are still too high, in our opinion, and may be curtailed as we move forward.