What's Behind Cognizant's Outperformance?

Cognizant's (Nasdaq:CTSH) results have been greeted with cheer as its revenue growth (16% yoy) in 1Q09 has been way ahead of Indian IT peers - Wipro (Nasdaq: WIT) declined 8% while Infosys (Nasdaq: INFY) grew a meager 3%. The top-line growth chart below shows how Cognizant has maintained its industry-leading growth rates over the last few quarters.

Cognizant vs. Wipro / Infosys and Cognizant's higher SG&A spend

Before going into the crucial external factor behind this outperformance, let's take a look at how Cognizant stacks up against the peers discussed above and also revisit what Congizant's CEO claimed in the recent conference call (1Q09).

Excerpt from the CEO comments in the 1Q09 CTSH transcript (source: Seeking Alpha):

... we believe client engagement is of fundamental importance. Therefore, we are heavily focused on relationship management. For this end we have almost 750 account managers and client partners. This strategy of investing in front-led client relationships has proven itself out to us. Rather than pulling back during the down turn, we continue to invest in the interest of our clients...

The SG&A spend (as a percentage of sales) reflects this statement. Cognizant spent around 22% of sales for SG&A while Infosys and Wipro averaged 12-14% in the last two years. The higher SG&A spend has resulted in higher client additions resulting in Cognizant having as many clients as Infosys. As the chart below (source: Gridstone Research) shows, Cognizant has bridged the gap with Infosys in terms of client base. Wipro has inched up higher thanks to better inorganic growth - the Infocrossing acquisition being the largest among Wipro's many acquisitions.

So far so good. But from now on the charts don't look favorable to Cognizant. For all its talk of deeper relationships, the revenue earned per client is lower compared to peers. While both Infosys and Wipro have not improved the revenue earned per client relationship either, Infosys had and maintains a significant lead over Cognizant. Infosys looks even better from a profitability basis. The profit earned per client has in fact improved in the last 2-3 quarters helping it to expand its lead over both Wipro and Cognizant. So to catch up with Infosys in terms of profit dollars earned, Cognizant has to almost triple its client base even if Infosys has the same number of clients in the future.

Client additions is a concern

But Cognizant doesn't look like achieving that in the near future. In spite of its higher SG&A spend, the client base has declined in 1Q09. While Cognizant seems to have done marginally better than than both Wipro and Infosys in 2H08, it couldn't escape the tough environment in 1Q09. We also need to remember that Cognizant earns more revenue from maintenance services(non-discretionary spending and so less prone to short term changes) than peers and that could be the reason for the lag effect. The tighter client spending seems to get reflected from the last quarter for Cognizant too.

Cognizant: Better supply-side efficiencies but are they beneficial in the long run?

So from a demand perspective, all three have some serious worries and Cognizant fares no better than Infosys or Wipro. They have been successful in maintaining profitability margins by closing the gates on the supply side. Net employee additions has declined significantly (see chart below on headcount YOY change, source: Gridstone Research) and Cognizant has in fact been more swift in addressing supply-side surplus. Therefore from an operational efficiency perspective, they have done well and full credit to them for that.

However such supply-side efficiencies will come back to bite all the three in the medium term as none of them have managed to break the linear relationship between employee count and revenue earned. Cogizant has definitely improved employee productivity (chart source: Gridstone Research) but that has come at the cost of adding 'future' capacity(billable employees). Looking at both the charts, it is clear that the greater the slowdown in employee net adds, the better the revenue per employee among the three.

From these operational metric trends, it is evident that Cognizant has quite a lot of catching up to do. But that doesn't still explain their better than anticipated growth rates in the last few quarters. Though they have always grown ahead of Infosys and Wipro, the outperformance is more stark in the last 2-3 quarters. One major reason could be this:

Source: Gridstone Research

Risk becomes an advantage?

What would have been considered a risk a year ago has come to Cognizant's advantage in the last 2-3 quarters. While Cognizant generates ~80% of revenues from North America (mostly US), Infosys and Wipro generate only 60-65% of their revenues from North America. The Euro has depreciated by ~14% (against the US dollar) from March 2008 to March 2009 (source: Google Finance).

A simple back of the envelope calculation suggests that currency headwinds would have impacted Wipro and Infosys growth rates by 200-300 bps more than the impact on Cognizant (in US dollar terms). But investors should bear in mind that revenue concentration is still a risk and the long-term downside of such a high concentration seems to have been largely ignored.

Yes. Cognizant has some catching up to do but short-term advantages remain.

In summary, the operational data does not suggest any significant outperformance from Cognizant in the last few quarters. A smaller base to grow on, more non-discretionary services and a huge boost from the largely dollar denominated revenue (relative to peers) are the principal factors behind Cognizant's growth. Cognizant can't challenge Wipro and Infosys solely depending on such factors. It really needs to focus on extracting more revenue per client to justify its higher SG&A spend and not depend on the dollar relationship alone!

Disclosure: Long positions in INFY and another Indian IT service provider (Tech Mahindra - listed in India)

Comments

[Bandwagon2009]

Naveen - good analysis, while CTSH has a lot going for it, I continue to believe it is a "bubble stock". I get the sense that there is a bit of spin in their commentary (more than normal). INFY tends to be fairly straightfoward in their comments.

Second I am concerned about the management bench strenght at CTSH. A very concentrated power structure with limited exposure or visibility at the next level is a cause for concern as well. While I don't believe DeSousa and Coburn are no where near retirement age- it would be useful see beyond them.

Third, lack of geographical diversity is a long term concern as you noted, as is their lack of interest in the emerging markets (including India, China, Brazil etc.) While TCS may seem over-extended - I think their strategy is rigth and if execution continues without any major glitches CTSH and others will never catch up.

Lastly, I know most will not agree, but I think CTSH lost the chance to change the game by not pursuing SAY aggresively. I appreciate there are risks, but as a US based firm they could have been given the benefit of the doubt and would be credible as they clean up the governance mess.

2009 May 14 09:54 PM

[Huskarl]

Naveen - You have established that Cognizant has added a significant number of clients recently and is almost close to Infosys in that respect. Is that not a reason by itself for revenue per client to be lower?
Clients can be added overnight but generating revenue out of them takes time. Naturally during the initial phases, the revenue per client is going to be lower as your client base has increased significantly but revenue is yet to show up. Add a recession and this makes revenue accretion even slower.
But through superior client engagement, Cognizant can, over time, generate that revenue with these new clients. An Infy or Wipro will not be able to do that as they are not investing in building client engagement.
With half the base of Infosys and one third that of TCS, Cognizant has added more revenue in 2008 in absolute terms (and not percentage terms). Clearly this cannot be because of dollar strengthening.

2009 May 14 10:43 PM

[Naveen Selvaraj]

Very valid comments, Huskar. As I has mentioned, Cognizant's short term advantage remains due to 3 reasons and not just $ strength.

But Cognizant has talked of 'superior' client engagement as a business differentiator for more than 4-5 years(their SG&A % spend validates that). But the gap in terms of Revenue per client(With Wipro and Infosys) remains and this is not just the efffect of recession but the effect of business model(more maintenance revenue). The gap is getting bigger in terms of operating profit per client between Cognizant and Infosys. So finally, if we are interested in 'absolute' profit dollars earned per client, Infosys has actually performed better during the last 2-3 quarters.

But I want to EMPHASIZE that my opinion is also that short-term advantages for Cognizant remains.


On May 14 10:43 PM Huskarl wrote:

> Naveen - You have established that Cognizant has added a significant
> number of clients recently and is almost close to Infosys in that
> respect. Is that not a reason by itself for revenue per client to
> be lower?
> Clients can be added overnight but generating revenue out of them
> takes time. Naturally during the initial phases, the revenue per
> client is going to be lower as your client base has increased significantly
> but revenue is yet to show up. Add a recession and this makes revenue
> accretion even slower.
> But through superior client engagement, Cognizant can, over time,
> generate that revenue with these new clients. An Infy or Wipro will
> not be able to do that as they are not investing in building client
> engagement.
> With half the base of Infosys and one third that of TCS, Cognizant
> has added more revenue in 2008 in absolute terms (and not percentage
> terms). Clearly this cannot be because of dollar strengthening.
>

2009 May 15 12:06 AM

[Huskarl]

I am not so inclined towards the revenue per client metric for a growing company. If you want to grow in large numbers invariably one has to be a little easy on the efficiency.
The bottom 10-20% of the clients can actually be closed without a dent to the revenue but that will take the revenue per client higher. I think Infosys has done that well and have stayed focussed on clients that generate the numbers for them. Cognizant cannot afford to do that now given that it still has to grow significantly to reach the size of even an Infosys or TCS. Even the low performing clients have to maintained as a couple of them can turn out big some day in the future.
I would tend to agree that CTSH is not placing itself for a long term play but I would arrive at that from a different direction. Cognizant's strategies are focussed on being flexible and reacting quickly to short term changing business dynamics. They carry a larger bench so that they can react faster. They have account managers who engage more frequently and are able to sense changes in the client direction quicker. Their business analysts are able to percolate and harness knowledge much faster than any KM tool in an Infosys or TCS.
As long there is a trend for global sourcing and the need for cheaper talent exists, Cognizant seems best positioned to take advantage of it. However what is worrying is that there is no fundamental capability (for e.g. a product) that can help non-linearize its revenue. Even in terms of revenue mix, it has the highest number of T&M contracts and therefore lesser motivation to be productive. I think TCS and Infosys score here though it means in the short term, they will grow less.
The question I have is - Does it make sense to think long term in the technology industry ?

On May 15 12:06 AM Naveen Selvaraj wrote:

> Very valid comments, Huskar. As I has mentioned, Cognizant's short
> term advantage remains due to 3 reasons and not just $ strength.
>
>
> But Cognizant has talked of 'superior' client engagement as a business
> differentiator for more than 4-5 years(their SG&A % spend validates
> that). But the gap in terms of Revenue per client(With Wipro and
> Infosys) remains and this is not just the efffect of recession but
> the effect of business model(more maintenance revenue). The gap is
> getting bigger in terms of operating profit per client between Cognizant
> and Infosys. So finally, if we are interested in 'absolute' profit
> dollars earned per client, Infosys has actually performed better
> during the last 2-3 quarters.
>
> But I want to EMPHASIZE that my opinion is also that short-term advantages
> for Cognizant remains.

2009 May 17 10:02 PM