Chuck Carnevale's  Instablog

Be Cognizant of Earnings

Being cognizant that it is a market of stocks, not a stock market, is an awareness that leading investors possess.  Cognizant Technology Solutions (CTSH) has been unjustly punished by a “stock market” that was misinformed about its potential.  That is fast being remedied.

Starting out as an in-house technology development center for Dun & Bradstreet Corp. in 1994, Cognizant Technology Solutions (CTSH) headquartered in Teaneck, New Jersey has persistently evolved into an Information Technology (IT sector) powerhouse in its own right.  Since its June 1998 IPO, Cognizant has consistently compounded earnings at over 45% per annum.  See Figure 1 below.

Figure 1: Cognizant 13 Year EPS Growth (see short video)

Be Cognizant of Cash Flows

As a public company, Cognizant (CTSH) has been able to fund their growth out of operating cash flows that have met or exceeded earnings per share through 2008.  See Figure 2 below.

Figure 2: Cognizant 13 Year EPS and Operating Cash Flow Growth (see short video)

Therefore, they have built and maintained a strong and healthy balance sheet with no debt and amassed just over $1.1 billion dollars of cash, short-term and long-term investments that increased by approximately $175 million quarter over quarter into 2009. Cognizant (CTSH) has a legacy of using their financial strength to fund growth and generate shareholder value.  They do this through aggressive investment in R&D, acquisitions and strategic alliances, and share buybacks.

Be Cognizant of  Earnings and Stock Price Correlation

With Figure 3 below, we see that Cognizant’s (CTSH) stock price closely followed its earnings growth until April of 2007.  (Red Arrow)  Then, even though their superior business model has enabled them to walk through the recession as if it wasn’t there, their stock price collapsed based on fear, not fact.

As Figure 3 also depicts, their price has recovered over 135% from its $14.38 (Red Circle) low in 2008.  After reporting strong earnings on August 4, 2009, Cognizant’s (CTSH) stock price advanced over 10% on that single day alone, which supports how undervalued it actually was.

Figure 3: Cognizant 13 Year EPS Growth Correlated To Price (see short video)

Be Cognizant of Historical Excellence

Cognizant’s (CTSH) historical excellence is no accident as it enjoys numerous differentiators versus its competitors.  For example, its strategy geared towards developing long-term customer relationships has facilitated an unmatched level of industry expertise and a deep understanding of their clients’ needs.  This vertical business model has allowed them to establish a strong presence with vertical industries like financial services, health care and life services, retail and manufacturing.

Thanks to their strong balance sheet they have been able to continue to aggressively invest in their future growth right through the recession.  As an example, their newly created online virtual workstation, Cognizant 2.0 addresses three critical customer challenges.  With this promising offering, clients can be assured of accessing the best talent, knowledge and business practices all delivered seamlessly by Cognizant.  Customer satisfaction from this new product should be greatly enhanced.

With Cognizant 2.0, management believes that this fully integrated global delivery platform based on Web 2.0 technology can solve the most difficult challenges of real time project and knowledge management their clients face.  The ultimate client benefit is increased productivity at lower cost.  Simply stated, Cognizant’s (CTSH) business is strong because they help their customers save money and function more efficiently as well.

Geographically almost 80% of Cognizant’s (CTSH) revenue comes from North American customers.  Cognizant is clearly benefiting from the global trend in outsourcing.  Even though 75% of their employees are located offshore, their domestic presence makes them unique versus their competitors.  This flexible culture of blending India and the west is very appealing to large global corporations.  There is ample opportunity for growth as penetration is still low in most markets.  Europe generates approximately 18% and Asia 2%.  Cognizant (CTSH) has been aggressively expanding their investment in China and India which we believe offers enormous long-term growth potential.

Cognizant (CTSH) operates through two primary business segments – Application Management (53% of 2008 revenue) and Application Development (42% of 2008 revenue).  From the first, they engage in long-term contracts that generate recurring and predictable revenue.  The latter is more opportunistic, but less predictable regarding revenue generation.

The vertical industries they serve allows Cognizant to develop strong relationships through a comprehensive understanding of customer needs.  Financial Services represents approximately 44% of revenues and is highly motivated to reduce costs.  Healthcare represents approximately 26-27% of revenues, and retail, manufacturing and logistics about 17-18%.  The remaining 13-14% is from varied industries.

The highly competent management team of Cognizant (CTSH) is committed to profitable growth.  For example, its normal 20% margin could be higher but it’s controlled through aggressive investment for the future.  To us, this is a testament to management’s dedication to the long-term growth of the business.

Be Cognizant of Long-term Opportunities

The growth opportunities for Cognizant are numerous.  A quote from their 2^nd quarter conference call transcript by Francisco D’Souza, President and CEO, highlights their market opportunity. 

For example, according to a recent NASSCOM McKenzie report, by 2020, the IT infrastructure services market is expected to be a $65 billion to $70 billion market opportunity.  Business process outsourcing or business services is projected to be a $340 billion to $360 billion market opportunity, and finally engineering and R&D services, which I’ll speak about in a minute in the context of Invensys, is projected to be worth $200 billion to $220 billion by 2020. 

The Invensys relationship referred to above is one example of numerous opportunities for Cognizant (CTSH).  This entry into engineering services is a new industry vertical that is obviously very promising.  Cognizant is investing in emerging geographies, technology and many underpenetrated high growth service lines.  Figure 4 below illustrates the current consensus estimated 5-year growth rate of 18.4% by 20 leading analysts reporting to Zacks.

Figure 4: Cognizant 18.4% Forecast EPS Growth (see short video)

We believe the consensus estimate is unduly biased to the low side due to recessionary pessimism.  However, this still implies an attractive long-term investment in Cognizant (CTSH).  In Figure 5 below we override consensus with the 5-year average growth rate for Cognizant (CTSH) of 25% which includes a lower than normal 2009 growth rate.  At this rate, which we believe is more realistic; an investment in Cognizant (CTSH) appears compelling.

Figure 5: Cognizant 25% Forecast EPS Growth (see short video)

Be Cognizant of Competition

We believe the information technology (IT sector) consulting and technology services industry is a great place for long-term investors to invest in. Of the leading players in this subsector, we believe that Cognizant (CTSH) represents the best combination of growth at an attractive valuation. However, given the correct valuation, we would be motivated to invest in any of the major players for long-term above average growth. Figures 6 – 9 look at the past 10 years (approx.) operating results and performance of the four major companies in IT outsourcing from the perspective of our fundamentals-at-a-glance research tool listed by largest cap size to smallest.

Figure 6: Infosys (INFY) 10yr EPS Growth and Price Performance (see short video)

Figure 7: Wipro (WIT) 10yr EPS Growth and Price Performance (see short video)

Figure 8: Accenture (ACN) 10yr EPS Growth and Price Performance (see short video)

Figure 9: Cognizant (CTSH) 10yr EPS Growth and Price Performance (see short video)

Be Cognizant of Valuation

We think that Cognizant (CTSH) is the clear winner based on size, growth potential, valuation and balance sheet strength.  Although the market is competitive, it is also large and increasing every day.  This industry helps businesses do business at lower cost and greater efficiency.  Given today’s economic realities, that spells investment opportunity.  Therefore, we believe that Cognizant (CTSH) is a terrific long-term investment at today’s valuation.

Full Disclosure:  Long CTSH at the time of writing.