By The Valuentum Team
A lot has changed at Genpact (NYSE:G) that past few years. Since 2007, the company has grown into a firm with ~$2.5 billion in annual revenue from ~$820 million, as its client base has expanded to more than 700 from 150 over the same time. Clients with hefty revenue-generating capacity ($5+ million annually) have increased to north of 100 from under 20 in the past decade, while adjusted earnings per share has expanded considerably as well, to $1.25+ from ~$0.50. Genpact has been doing a lot of things right, to say the least.
For those that aren't familiar with the firm, Genpact is a leader in digitally-powered business process management services and serves one-fifth of the Fortune Global 500 as clients. It performs a lot of duties, from managing client invoices to monitoring assets to managing devices to analyzing transactions for its customers. Word-of-mouth continues to be the driving engine behind the company's ongoing growth potential, and management is correct when they say that "clients act as (its) ambassadors." It monitors its "net promoter score" religiously and views it as a way of life.
This year is looking like another good one for Genpact, as it meets the needs of customers across a variety of industries where "disruption is the new normal." Lean digital initiatives have expanded the work that Genpact does, and we think it will set the stage for resilient revenue and earnings growth in coming years. Management is targeting earnings per share north of $1.40 in 2016, putting the company at 18 times earnings on expected constant-currency growth of 8%-10% for the year. Genpact is an asset-light business that throws off considerable free cash flow ($200+ million in each of the past 5 years). Leverage remains less than 1x (net debt/EBITDA), too.
In light of Genpact's consistent revenue growth and strong cash-flow generation, we think it's certainly one for the radar. We'll be watching shares closely, as its valuation is still a bit on the high side. Nonetheless, a fantastic company it is.
Genpact's Investment Considerations
• Genpact is a global leader in business process management and information technology services worldwide. It offers a wide range of finance and accounting services. The firm traces its origins back to the internal business process services operation for GE Capital in 1997. It is headquartered in Hamilton, Bermuda.
• The firm plays in a large and growing under-penetrated market, which management estimates at $390 billion. Increasing penetration of its focus verticals will provide additional avenues for expansion.
• Genpact has experienced solid bookings momentum in recent quarters, advancing ~20% year-over-year in 2015, which has helped the firm develop a healthy pipeline. Win rates continue to hold at high levels, and recent investment in its sales force has resulted in material sales productivity gains. Bookings trends are worth watching closely.
• As with many of its peers, its clients' needs are rapidly-changing, and this spells opportunity for the firm. Genpact has a strong, highly reference-able set of relationships with global blue-chip clients. Roughly 80% of its growth comes from existing clients, and repeat business will continue to be a key profit driver.
• Genpact is expecting strong top and bottom line growth in 2016, and cash flow from operations is anticipated to grow 6%-8% from 2015. This, coupled with ~3% of revenue being allocated to capital expenditures, should drive free cash flow growth.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Genpact's 3-year historical return on invested capital (without goodwill) is 46.9%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Genpact's free cash flow margin has averaged about 10.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Genpact, cash flow from operations increased about 5% from levels registered two years ago, while capital expenditures expanded about 27% over the same time period.
We think Genpact is worth $24 per share with a fair value range of $19-$29.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 6.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 9%.
Our model reflects a 5-year projected average operating margin of 16.7%, which is above Genpact's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Genpact, we use a 10.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $24 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Genpact. We think the firm is attractive below $19 per share (the green line), but quite expensive above $29 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Genpact's fair value at this point in time to be about $24 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Genpact's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $33 per share in Year 3 represents our existing fair value per share of $24 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.