Infosys: Flat World, Flat Investment?

Nobody at Infosys came up with the phrase "flat world." Thomas Friedman invented the phrase and wrote a best-seller, weighing more than two pounds, called "The World Is Flat." Infosys adopted the phrase as a corporate mantra, and the stock has been exploding ever since. Fool contributor John Finneran explores whether the flat world is also a flat investment.

In Thomas Friedman's ode to outsourcing, The World Is Flat, he credits Infosys CEO Nandan Nilekani with coming up with the "flat world" phrase. Although Nilekani actually said the "playing field is being leveled," Friedman's rare exercise in saving words has paid off handsomely. Infosys (Nasdaq: INFY) adopted "flat world" as its corporate mantra, and the stock has appreciated 61% in the last year. And Friedman's book, which weighs more than two pounds and nudges 600 pages, has become a best-seller.

Growth rates from another world
The world may be flat, but Infosys' growth rate is anything but. Revenue has grown at a cumulative annual rate of 38% over the last five years, and net income has similarly jumped 33%. Results announced earlier this week -- revenues up 42% -- confirm this otherworldly growth story. Behind the growth, huge hiring and talent factories hum along. Infosys hired just 2% of the 1.4 million people who applied last year, and is reputed to have the largest training facility -- two words that frighten this Fool -- in the world. 

Flat-worlders come to India
Friedman forgot that the flat world works both ways -- India can come to America, but America can go there, too. 

Infosys is, like all its Indian IT peers, built on a fundamental labor arbitrage -- hire Indian IT staff at approximately one-sixth of their U.S. cost, and charge them to clients at the highest U.S. rate achievable. Chipping away at this advantage are the 20% wage inflation and high attrition rates in the Indian IT sector.

However, there is a faster way to level the playing field -- just hire more people in India and dilute the cost advantages of the native firms. Infosys has 66,000 total employees. In contrast, IBM (NYSE: IBM) has 43,000 employees in India, and plans to invest another $6 billion there over the next three years. Meanwhile, Accenture (NYSE: ACN) has 23,000 staff in India.  

The New World of old work
India may be the New World for IT services, but the work outsourced there is distinctly Old World. There are few signs of New World revenue, such as the transformational outsourcing services offered by IBM and Accenture. Here's the evidence.

First, reviewing Infosys' revenues by service reveals that maintaining software applications is the largest slice, at 29% of total revenue. Now, this revenue has the advantage of being delivered under long-term contracts, but it is typically for tired "legacy" systems, offering little upside to the client or outsourcer.

Second, though Infosys has invested in a dedicated consulting arm, total revenue from consulting is abysmally low at less than 4%. Consulting is critical to an IT services firm, because it helps shape client agendas and generate larger amounts of work downstream for the outsourcing and software factories. In contrast, Accenture earns 55% of its revenues from consulting, and 45% from outsourcing.

Third, the traditional pricing model of charging by the hour for every staff member dominates at Infosys. This model, called time and materials, accounted for 74% of Infosys' revenues in its last quarter.  

Finally, to sharpen the distinction, contrast the work Infosys and Accenture are doing in the airline industry. Infosys has announced it is implementing Oracle Financials for the finance function of a U.S. airline -- traditional implementation services for a well-established software package. In contrast, Accenture has set up Navitair, a separate, wholly owned subsidiary, providing technology and business processing services to 70 airline customers, including JetBlue and United. Navitair operates as an Application Service Provider (ASP), and provides services under multiyear agreements with a per-transaction or gain-sharing model.

"Flat world" investors, stay home
The good news is that investors in the flat world can stay home. It is much easier for Accenture and IBM to replicate the India-driven global delivery model than it is for Infosys and Wipro (NYSE: WIT) to make the round trip. You just take out your big checkbook and hire away -- no leadership institutes shaped like spaceships required. On the other hand, replicating the long-standing, consulting-driven client relationships enjoyed by the global brand names in IT services is much, much harder.

Valuations make the case for staying at home even stronger. Accenture has eight times the revenue and its return on equity is a third higher, but it trades at half the enterprise value of Infosys.

The world is still round
Infosys is a great company, but that does not make it a great investment. Buying its stock means a full subscription to the story of 30% to 40% growth in sales and earnings over five to 10 years. 

There are just too many pressures bringing Infosys' growth rate down. The frenzied hiring of staff by local and multinational firms will flatten the cost advantage in India, while the Indian firms will be slowed by the relationship and innovation assets held by firms like IBM and Accenture.

The world is still round!

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