Cognizant and Accenture: The IT Sector Continues to Shine

One of the tech sectors that makes the most sense to me under most economic scenarios is IT Services. The notion of consultative help - rather than keeping permanent staff - is attractive in any slowdown scenario.

Cognizant (CTSH) was clipped on Thursday on mixed fourth quarter guidance. Cognizant, as well as other Indian IT services providers enjoy an attractive cost advantage that could benefit from additional demand from an economic slowdown. Cognizant is known for its high quality consultative approach. What seems to concern investors about the outlook is commentary from CTSH that it was not seeing a fourth quarter "budget flush." As most of us have experienced, managers have a tendency to spend out whatever remains in their current year budget to ensure that this becomes the base for next year's budget. The flushing through of budgets does not appear to be occurring for CTSH. I believe that one area of particular concern for IT providers is the spending plans of financial services companies.

Concerns about financial services reducing demand for IT may be somewhat misguided in my opinion. Cognizant cited a survey to assess clients' budget plans for 2008 involving about 150 decision makers representing a broad cross section of clients. According to management, 92% of its clients do not expect their overall IT budgets to decline in 2008. Clients were also asked what would occur to offshoring budgets in the event of a decline in overall IT budgets. Only 19% felt that an overall budget reduction would meaningfully impact offshore spending plans. Among financial services customers, about 90% do NOT expect outsourcing budgets to decline.

Valuations in the sector are all over the map. CTSH has TTM EPS of $1.13 , equal to its operating cash flow per share, and its free cash flow is $0.56 per share. Its current FCF yield of 1.8% does not represent a bargain.

Accenture (ACN) has a trailing EPS of $2.06, an operating cash flow of $2.67, and a free cash flow of $2.58. Based on Thursday's close, that's a free cash flow yield of 7.3%! I like the high conversion of operating cash flow into free cash flow. Just over 10% of each dollar of revenue for ACN is free cash flow, which is slightly higher than CTSH's 8.6%.

Both companies have active buyback programs with Cognizant just having announced a $100 million buyback. Last fiscal year, ACN bought back a total of $2.3 billion in stock. There remains an authorization for $1.65 billion.

About 22% of ACN revenues came from financial services in the most recent fiscal year. About 57% of ACN's revenues come from outside the Americas. On the other hand CTSH, unique among Indian IT outsourcers generates some 80% of its revenues from the States. Its reliance on the financial services sector is also somewhat heavier at about 47% for FY 2006 and the most recent quarter.

Accenture has a market cap of $27 billion, and only has about $760 million in debt. In my view, this, coupled with its $3.5 billion in cash, represents an excellent value. Its enterprise value to TTM EBITDA is only 8.4 times.

Disclaimer: I, my family, or clients own a current position in ACN. None have a current position in CTSH.

CTSH vs ACN 1-yr chart: