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MOSHE KATRI is a Managing Director and Senior Research Analyst at Cowen and Company, LLC.

TWST: IT services is a broad area. Where are you focusing your attention at this point?

Mr. Katri: The IT services universe includes five segments: infrastructure outsourcing, consulting, government IT, offshore outsourcing, and business process outsourcing or BPO. These are five segments in one category, which is IT services.

TWST: If we look at the broad category, what are the current interesting trends that you see taking place?

Mr. Katri: The biggest focus during the past three to six months has been the impact of a slowing economy on IT spending. If you look at the five segments that I've just highlighted, in our view, the segments that are relatively less exposed to that specific concern include BPO, offshore outsourcing and government IT. In our view, even if we go through a slowdown — and I think at this point there are still a lot of unknowns concerning whether we are going through that IT spending slowdown or not — this cycle is going to look very different from the 2001-2003 cycle in terms of the extent of the slowdown in IT spending.

In our view, the big reason why we are not seeing the massive slowdown in IT spending, which is what many hedge funds were betting on nine months ago, is that IT spending growth from 2003 until 2007 has been very disciplined at about 2% to 3% and that compares to 15% to 20% IT spending growth in the 1998 to 2001 time frame. That means that from 1998 to 2001, enterprise IT spending was significant, creating overcapacity, which was then followed with a moderate and disciplined spending trend from 2003 to 2007.

So far, the slowdown in IT spending has been predominantly confined to the equity capital markets portion of financial services as well as to some areas in commercial banking, specifically a handful of enterprise clients that are going through tough times, reflecting massive subprime related losses that are impacting their IT spending decisions. In our view, vendors able to provide clients with value as well as quantifiable returns are positioned to do well. In this context, the offshore outsourcing companies — Infosys Technologies (INFY), Cognizant Technology Solutions (CTSH), etc. — as well as some of the larger consulting and systems integration firms — Accenture (ACN) and even the services arm of IBM (IBM) —are well positioned. Year to date the group is up 15%-20% because, while many people on the buy side were betting that IT services would be leading the potential impact of an economic slowdown on IT spending, relative to other sectors in tech, IT services has been relatively resilient.

Then you have some other topics including what happens in the BPO space. Considering the proven cost savings associated with such engagements, we expect firm funding in this area. There are two companies that are very well positioned in this segment — Affiliated Computer Services (ACS) and Accenture. In the offshore outsourcing space, we generate significant data from our own quarterly, proprietary IT spending survey. Our recent 12th quarterly IT spending survey was published a couple of weeks ago. In our view, the most important metric in this survey pertains to the penetration rates of those offshore companies, specifically which part of an enterprise's IT spending budget is offshorable, i.e., IT functions, including application development or management. At this point, the penetration rates remain relatively low, roughly at about 20%.

During the past four or five years, IT spending growth has been about 2% to 3%. On the other hand, the average offshore outsourcing company has been growing 25% to 30%, which means that the growth rates of a lot of these companies don't necessarily correlate with IT spending growth but probably more with budget share penetration. We do feel that in this environment some of those offshore outsourcing companies are very well positioned to actually outperform.

Last year was a very tough year for the Indian offshore outsourcing companies and they had to deal with a couple of things, the main one being a very strong Indian rupee versus the dollar. The Indian rupee appreciated about 12% in 2007. The impact on EBIT margins from that appreciation has been anywhere between 250 to 400 basis points. What's amazing is that many of these companies have been able to offset the impact of the Indian rupee by actually raising utilization rates, so EBIT margins haven't been significantly impacted.

What's positive about this year is that year to date the Indian rupee has depreciated by a couple of percentage points while wage inflation in India is moderating. While results for some of the companies we track were impacted by one or two clients that operate in the financial services vertical, impacting the beginning of the June quarter, in our view, 2008 will be a very strong year for these companies. From a valuation perspective, this group trades at trough valuations in terms of p/e multiples (15 times to 17 times, vis-a-vis expected 2009 growth rates of 25% plus).

We consider the government IT space defensive. The major growth drivers in this area include firm funding from DoD and intelligence agencies. In our view, the infrastructure outsourcing segment is the weak link in this space. Demand in this area is moderating, as contracts are being unbundled because clients are concerned with vendors' poor execution. Electronic Data Systems (EDS) is the vendor with the largest exposure to this area. In fact, this year, EDS will post minimal top line growth.