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Summary

  • Cognizant Technology is one of the fastest growing IT service companies in the U.S. with an expected revenue growth of 16.5% in 2014.
  • Gartner forecasted that the worldwide IT spending will grow 2.1% in 2014 and around 3% each year for the next four years.
  • Cognizant has a growing client base due to the increasing demand in its IT and consulting services.
  • The stock is likely undervalued. I have estimated the company's fair intrinsic value to be around $36 billion in market cap or $58 per share.

The Information Technology industry is one of the most important industries in the U.S. and is expected to grow further throughout 2014 as companies increase their spending on IT systems, infrastructure, software and services. According to Gartner IT Spending Forecast, the worldwide IT spending is projected to grow 2.1% in 2014 and about 3% each year for the next four years (see image below).

Source: Gartner

As an investor who likes to look for multi-bagger (e.g. 100% or more gains) investments, I like to find great companies that have good long-term growth prospects that operate in favorable and growing industries. In the IT service industry, I believe that Cognizant Technology Solutions (NASDAQ:CTSH) will perform well over the next five years because of the increasing demand in the company's IT and consulting services.

Here is a historical look at Cognizant's share price and diluted EPS growth over the past ten years:

About Cognizant Technology

Cognizant Technology Solutions is a leading provider of information technology, consulting and business process services that helps large organizations become more efficient in their operations. The company's core services include: Operations and IT Consulting, Application Development and Systems Integration, Enterprise Information Management, Application Testing, Application Maintenance, IT Infrastructure Services and Business Process Services (source: 2013 Annual Report).

The company's IT and consulting services focus on and generate the most revenues from these three industries: 1) Financial Services, 2) Healthcare, and 3) Manufacturing/Retail/Logistics.

(click to enlarge)

Source: Q1 2014 10-Q Report

In terms of revenue by geography, the company earns most of its revenues from the North America market (e.g. 76% of the company's total revenue in Q1 2014). It also operates in Europe, Asia Pacific, The Middle East and Latin America, which are largely under-penetrated with a lot of growth potential (see image below).

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Source: Q1 2014 10-Q Report

Although Cognizant earns most of its revenues in North America, most of its long-term assets are in India (see image below), which I will explain later to discuss the company's long-term growth prospects.

Source: Q1 2014 10-Q Report

Long-Term Prospects and Growth Potential

The most important factors that I believe will drive Cognizant's revenue and net earnings growth over the next five years are 1) the company's growing number of active clients-especially the strategic clients who contribute the most revenues for Cognizant, and 2) the clients' increasing spending on IT services.

Growing Customer Base

According to the management, the company added seven strategic clients in Q1 2014 and ended the quarter with 150 strategic clients and 1,223 active clients in total. As a reference, the company had approximately 1,197 clients in 2013, 821 clients in 2012 and 785 clients in 2011 (sources: Q1 2014 Conference Call and 2013 Annual Report).

Cognizant's client base will likely continue to grow over the next five years because there is a strong demand in Cognizant's core IT, infrastructure, business consulting and outsourcing services; Cognizant has a large number of service delivery employees in India who can provide IT services for large organizations at a lower cost; and the company has a strict mandate to invest profits above the 19% to 20% non-GAAP operating margin back into the business to improve its services.

As mentioned earlier, what surprised me the most about Cognizant is that 93% of its long-term assets (properties, plants and equipment) are related to its operations in India. The management stated that the company ended the first quarter with 178,600 employees globally, of which 167,300 were service delivery staff. The majority of the 167,300 service delivery staff likely reside in India because 93% of the company's long-term assets are related to operations in India and because the IT labor costs are much cheaper there. This means that Cognizant can utilize its large pool of IT professionals in India to deliver IT services to its clients at a lower cost. And clients are attracted to Cognizant's global delivery services to help them improve business operations and lower IT costs.

Increasing IT Spending

Gartner forecasted that the Worldwide IT spending will grow 2.1% in 2014 and around 3% each year between 2015 and 2018. Among IT services, the spending in this sector is expected to grow 3.8% in 2014 and 4.1% in 2015 (source: Gartner Press Release).

As long as the U.S. economy is growing (and not in a recession), the largest U.S. companies will continue to increase their IT spending in areas such as social networks, mobile devices, Big Data, IT systems, infrastructure and services, advanced analytics and cloud computing, in order to stay competitive in their industries. As a result, the increasing IT spending by large corporations should benefit Cognizant over the next several years, provided that the U.S. economy is expanding.

Net Earnings and Free Cash Flow Growth Potential

According to the latest Q1 Conference Call, management increased the company's full year non-GAAP earnings per share (EPS) guidance by $0.03. Moreover, they expect that the company will deliver a revenue growth of at least 16.5% and generate revenues of at least $10.3 billion for the full year in 2014. Note that the company's Q2 earnings will be released on Wednesday, August 6.

Over the past five years, the company's net earnings and diluted EPS grew at a compound annual growth rate (CAGR) of 23% each year and its free cash flow grew at a CAGR of 18% each year.

For the next five to ten years, I believe that Cognizant's net earnings and free cash flow growth rates will decelerate to a CAGR of 12% to 16% each year. I will this range to estimate the company's fair intrinsic value at the end of the article.

Here is a historical look at Cognizant's revenue net income, diluted EPS and free cash flow growth over the past ten years:

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Competition and Risks

Competition is Cognizant's biggest risk factor because the IT service industry is intensively competitive with thousands of small-to-medium size firms and many large multinational firms-such as Accenture (NYSE:ACN), HP (NYSE:HP), IBM (NYSE:IBM), SAP (NYSE:SAP) and Oracle (NYSE:ORCL) that are more well-known than Cognizant. Here is a list of the largest IT service providers by revenues in 2013:

Source: HfS Research

I believe that Cognizant's biggest competitive advantage is its global delivery model which consists of 1) client service teams at client locations (in order to facilitate client services) and 2) delivery teams at near-shore and offshore delivery centers in India and other countries (in order to provide cost-effective IT and consulting services). Cognizant has a large number of IT service delivery employees in India and is continually hiring more employees there.

Cognizant has a strong industry focus in two of the largest industry verticals: financial services and healthcare. These industries tend to hire consulting companies that are dedicated to those industries. As mentioned earlier, Cognizant also has people on site, which helps them build better client relationships and have a deeper understanding of their clients. This also leads to more opportunities and work, which in turn leads to even better industry knowledge.

The second risk factor is IT spending, which is largely dependent on the country's economic growth and individual companies' IT budgets. Cognizant earns approximately 76% of its revenues in North America. If a recession occurs in the next several years, U.S. companies will likely decrease their IT budgets, which will impact Cognizant and other IT service providers. Moreover, if the IT spending growth in North America slows for any other reasons (e.g. market maturity), then it will impact Cognizant's revenue growth unless the company expands further in its international markets (Europe, Asia Pacific, The Middle East and Latin America) in the upcoming years.

In terms of liquidity and credit risks, Cognizant has a very healthy balance sheet with minimum debt. For Q1 2014, the company had a large amount of cash and short-term investments ($3.86 billion), which alone were more than enough to pay off the company's entire short-term and long-term liabilities ($1.66 billion).

Intrinsic Value Estimates

To estimate Cognizant's fair intrinsic value, I used three free cash flow (FCF) growth scenarios with a discount rate of 11% (see image below).

  • A high-end valuation with a FCF CAGR of 16% over the next decade.
  • A fair valuation with a FCF CAGR of 14% over the next decade.
  • A low-end valuation with a FCF CAGR of 12% over the next decade.

(click to enlarge)

Based on my estimate, I believe that Cognizant Technology's fair intrinsic value is around $36 billion in market cap or $58 per share, assuming that its free cash flow will grow at a CAGR of 14% over the next decade. At the time of writing (July 31, 2014), the stock is traded at $49.05 per share. If the company's free cash flow grows at a CAGR of 12% over the next decade, its current intrinsic value should be around $32 billion in market cap or $52 per share. If my fair intrinsic value estimate at $58 per share is correct, the stock is undervalued by around 16%.

Note that a company's intrinsic value (along with its share price) tends to increase over time when the company has increasing earnings, EPS and free cash flows. Cognizant's stock's long-term growth should correspond to its EPS growth over the long run.

The Bottom Line

I believe that Cognizant Technology should perform well over the next five years as the company continues to attract more clients and to benefit from the IT spending growth in the U.S. The company is not as large and well-known as other IT service providers such as IBM and Accenture. However, the IT industry in the U.S. is fragmented and the market is large enough for Cognizant to gain more revenue share.

One thing investors should look out for is Cognizant's client base growth, especially its strategic client base. As long as Cognizant is growing its client base each quarter, the company's revenue and earnings should continue to grow over the long run.

Sources: Cognizant's 2013 Annual Report, Q1 2014 10-Q and Conference Call, Morningstar, Yahoo Finance, Gartner, HfS Research, Y Charts and Intelligent Stocks.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Cognizant Technology: A Growth Stock With A Lot Of Potential