Outsourced

The Stock

The Trade: Infosys (NSDQ: INFY)–Buy < 55.

Why Now: The stock trades at a compelling valuation, and the company’s earnings could surprise to the upside. Demand for Infosys’ IT services shouldn’t collapse if the economic situation worsens.

The Story

With Yiannis back in the Washington, DC, area after a summer in his native Greece, the two stock pickers agree to meet at BLT Steak. After a hard day of researching stocks for Global Investment Strategist, Yiannis pushes his way through the crowd of people and finds Elliott enjoying a glass of red wine at the bar.

Yiannis: I thought I’d find you here. Let’s get a table, man. I can’t talk stocks at the bar–too many people here.

Elliott: This is prime real estate.

Yiannis: For a drink. I’m starving, and there isn’t enough room at the bar for the spread I’m going to order.

Elliott: Wonderful. Try to get us a table toward the back of the restaurant. We have a lot to talk about for this issue. I’ll finish this glass of wine while you get it sorted with the maître d’.

Five minutes later, Yiannis and Elliott are seated in the middle of the restaurant with a bottle of red wine from the Saint-Emilion region of Bordeaux.

Elliott: Can you afford this meal? Or will you default before the check arrives? I’m not German; I won’t be bailing you out.

Yiannis: Good one, man. But your relatives in France are also part of the rescue squad.    

Elliott: My people emigrated ages ago, man. Let’s get down to business. Fear continues to drive the stock market lower. With the exception of the US dollar, there aren’t many places for investors to hide. Even gold has pulled back. What’s your outlook?

Yiannis: Economic growth in the US and other developed nations has slowed, increasing the risk of potential recession. The EU sovereign-debt crisis also threatens to touch off a global credit crunch, particularly if the contagion spreads to Italy’s bond market.

Chinese economic growth has also slowed, spurring fears of a hard landing. China’s economy should hold up, but all these headwinds make it tough to see much upside.

Elliott: You’re leaning toward a short play?

Yiannis: It’s too late in the game to go short. Stocks have pulled back a great deal at this point; it won’t take much to catalyze a year-end rally.

Elliott: We’re on the same page, but I’m a bit more optimistic. The US should dodge a recession over the next six months, though the risks are elevated. US economic data have also improved in recent weeks. For example, last week’s core capital goods orders beat expectations and serve as a reminder that business investment remains a pocket of strength. Initial jobless claims also fell to 391,000, suggesting that the employment market has stabilized. Finally, the Institute for Supply Management’s Manufacturing Purchasing Managers Index came in at 51.6 in September, up from 50.6 in August.

Yiannis: What’s driving stock markets lower?

Elliott: Fears that the EU sovereign-debt crisis will go global. The interbank lending market in Europe shows signs of stress, while high-yield bonds issued by US corporations have also pulled back.

Yiannis: Legitimate concerns. But EU policymakers should come up with a plan to alleviate investors concerns. Germany’s parliament recently approved a proposal that would expand the European Financial Stability Fund’s powers.

A waiter delivers two enormous steaks, fries, sautéed mushrooms and asparagus.

Elliott: Ah, our light snack has arrived. This place may be my favorite steakhouse in DC–look at this bone-in rib eye.

Yiannis nods in assent while chewing a mouthful of fries. There’s a prolonged lull in the conversation while the two tuck in to their meals.

Yiannis: Ok, we’ve discussed macroeconomic developments. What’s your outlook for the stock market?

Elliott: The S&P 500 has yet to fall below the critical resistance point of 1,100 to 1,120. But stocks will need some catalysts to pull out of this funk. An EU plan to recapitalize the banking system could be a major upside catalyst for stock markets. Policymakers may push to develop a definitive plan before the G-20 meeting in early November. If the EU can assuage investors’ concerns about Italy and EU financial institutions, some stock markets could rally by 20 percent through year-end. Third-quarter earnings season could also serve as an upside catalyst, especially now that analysts have lowered earnings estimates.

Yiannis: All this discussion of macro level factors is great, but we need a stock pick for this month’s issue. India-based Infosys (NSDQ: INFY) is my top pick right now.

Elliott: I like your conviction. What does the company do?

Yiannis: Infosys provides information technology (IT) consulting, engineering and outsourcing services to enterprises worldwide.

Elliott: Interesting call. The right technology pick could do well in this environment. Shares of IBM (NYSE: IBM), which we hold in the Personal Finance Growth Portfolio, have outperformed in the first nine months of 2011. Whereas the S&P 500 tumbled almost 9 percent over this period, Big Blue’s stock has posted a 21 percent gain. I like Infosys’ focus on enterprise customers, but intelligent investment decisions aren’t based solely on a one-sentence company description.  

Yiannis: That was just a teaser, man. I’m trying to build some suspense here.

Elliott: Right. What exactly does Infosys do?

Yiannis: For many years, the firm buttered its bread by developing and maintaining custom software packages that address a corporation’s unique needs and processes. For example, Infosys recently designed an order management system for a large global automobile manufacturer. This custom solution consolidated disparate software systems into a coordinated global platform. Infosys also trains the customer’s employees on how to use the system, and the client often hires the firm to ensure that everything runs smoothly and fine-tune the system.

Elliott: Sounds as though Infosys has expanded its suite of service offerings.

Yiannis: The business transformation unit provides traditional consulting services that focus on honing business strategies and IT processes. For example, the firm might help a corporation develop systems to collect and analyze customer data and improve digital marketing efforts. Infosys also helps companies improve the efficiency of their manufacturing processes and even assists with the engineering and design of some products.

Meanwhile, Infosys also enables customers to outsource certain business processes. A credit card company might enlist Infosys to man its collection services operations, or an insurance company might hire the firm to handle claims or process and analyze advertising metrics.

Elliott: Did you miss anything? Or can we start to talk about the firm’s business prospects and why you like the stock?

Yiannis: Patience, my friend. Infosys has emerged as an important player in cloud computing.  Businesses traditionally run a combination of prepackaged software such as Microsoft Corp’s (NSDQ: MSFT) Office suite–which entails a hefty, up-front licensing fee–and proprietary applications that are developed and updated by an in-house IT department. This antiquated model requires companies to purchase systems and data-storage equipment to support business functions. Hiring an extensive IT staff to maintain these systems adds to the cost.

Cloud computing provides software as a service. Cloud operators host software applications at a central location and provide access to enterprise users via the Internet for a subscription fee–an appealing proposition for small to midsize businesses.

This approach offers several advantages that appeal to enterprise customers. First, accessing software hosted on the cloud limits customers’ need to invest in data storage and server infrastructure. This yields a highly scalable solution that doesn’t require massive capital spending to support new users or applications. Central hosting also ensures that all users within the organization can access the most up-to-date version of the software, relieving IT departments from the time-consuming process of updating the programs on each individual computer.

Infosys partners with some of the world’s largest cloud providers to help customers implement cloud-based solutions.

Elliott: Ok, you’ve described the company’s business in some detail. But what makes Infosys a compelling investment in this environment?

Yiannis: In a challenging business environment, efficiency and cost controls are essential to success. By outsourcing software development and other IT functions, customers reduce their IT spending and accelerate the implementation of these solutions. Despite recent wage increases in India, experienced programmers and software engineers in the nation earn a fraction of what they would in the US and most other developed countries.

Elliott: What about the company’s business mix? The firm generates almost two-thirds of its annual revenue from US companies. Is that a cause for concern?

Yiannis: Nope. Many of the large US multinationals with which Infosys does business have amassed substantial cash positions and have enjoyed a low cost of credit for some time. These behemoths continue to invest heavily in critical IT solutions. Business spending on IT software and equipment added 0.07 of a percentage point to the change in US gross domestic product (GDP) in the second quarter and 0.08 of a percentage point to the change in first-quarter GDP.

Europe accounts for about 21 percent of Infosys’ 2010 sales, though the region’s contribution to overall revenue has declined gradually in recent years. Rising demand in rapidly growing emerging markets has offset some of this weakness.

Elliott: Infosys also does a lot of business with the financial sector, a group that faces major headwinds.

Yiannis: Financial services firms account from about 36 percent of Infosys’ sales. But between 75 and 80 percent of banks’ technology spending is nondiscretionary. Infosys estimates that about two-thirds of its financial-related revenue comes from mission-critical services, while the remaining one-third comes from risk-management and compliance functions–operations that face increasing regulatory scrutiny. We expect the recent turmoil in the financial sector to have a limited effect on Infosys’ earnings. The company reported that sales to financial services clients in the quarter ended June 30, 3011, were up 3.3 percent sequentially.

Elliott: What about the company’s exposure to cyclical industries such as manufacturing (20 percent of revenue) and retail (14 percent)? Will demand from these end-markets take a hit if the US economy slows?

Yiannis: Infosys’ service simplify manufacturers’ supply chains and production processes to cut costs and improve efficiency. Although an economic slowdown would lead to some demand destruction, the appeal of these services increases as manufacturers struggle to boost profitability.

Much of Infosys’ business with the retail industry focuses on developing online and mobile sales platforms, as well as managing and enhancing online marketing campaigns. US consumer spending has weakened, as households have allocated more of their income to saving and paying down debt. Nevertheless, consumers continue to increase the amount of money they spend online. During the Great Recession, investment in online marketing campaigns proved more resilient than sales of print or television advertisements.

Elliott: I now see why you’re so bullish on this stock. Infosys also posted strong results in its fiscal first quarter ended June 30, 2011. On-site work volume grew by 6.8 percent from year-ago levels, which suggests that the flow of new orders remains robust. The firm also inked contracts with 26 new clients during the quarter, including eight large deals. Of course, the economic outlook has changed substantially over the past three months.

Yiannis: Yeah, we also need to discuss the downside risks before we decide whether Infosys is this month’s Cocktail Stock. Discretionary IT spending accounts for about 30 percent of the company’s revenue. Management also noted that its clients grew slightly more cautious than usual in June. Recent comments from Infosys and other IT services outfits suggest that lingering macroeconomic uncertainties have prompted some customers to delay decisions on discretionary spending for 2012.

At roughly five times book value–compared to a long-term average of 5.5 times book value–Infosys’ stock trades at recessionary levels. The stock’s forward price-to-earnings ratio is also well below its long-term average. Infosys’ second-quarter results could surprise to the upside if spending on discretionary IT services holds up. We also expect the shares to be some of the first to bounce back once investor sentiment improves.

Elliott: Let’s do it. Do you have a buy target?

Yiannis: Buy Infosys up to 55.

Updates

August 2010: Vale (NYSE: VALE)–Buy < 30

Shares of the Brazilian mining giant continue to rate a buy. Although commodities prices will moderate if the global economy slows, blue-chip miners are the place to be for a potential turnaround.

September 2010: Teekay Tankers (NYSE: TNK)–Buy < 10

An almost 28 percent yield is Teekay Tankers’ only saving grace. We have been in this trade long enough that all the bad news has been priced into the stock.

November 2010: True Blue (NYSE: TBI)–Buy < 15

Our investment thesis for True Blue remains intact. Part-time work will account for a greater proportion of the US labor market. This high-beta stock should spike higher once it becomes clear the US economy will avoid recession.

February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 30

Betting against US Treasury notes has been a losing strategy. This position could recover some lost ground when investtors rotate funds from safe havens to equities.

May 2011: TAL International (NYSE: TAL)–Buy < 35

TAL International is the top company in its industry. The stock will rally if global trade doesn’t collapse.

June 2011: iShares MSCI Italy Index (NYSE: EWI)–Buy < 15

Clearly a play on Europe’s turnaround, with initially a lot better fundamentals than Greek related bets. Uncertainty still plagues the Italian market but the Greek “experiment” may force the EU to deal faster and more decisive with Italy.

July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < USD12

This small-cap oil producer has pulled back amid concerns that an economic slowdown will weigh on energy demand and prices. This speculative stock will outperform in a bull market and underpwerform in a bear market.

July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50

This exchange-traded fund has treaded water since we featured it in the July issue.

August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD1.45

National Bank of Greece is our most speculative play to date. This deep-value play is appropriate only for aggressive investors.

September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4

Our investment thesis for this stock remains intact, though the shares have taken a battering because of weakness in the broader market.

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