Description

Investment Summary

We are long shares of Cognizant Technology Solutions (CTSH). CTSH provides IT, consulting and business processing outsourcing services to clients primarily in North America (~80% of revenue) and Europe. Several factors distinguish CTSH from its peers: i) overweight exposure to the high-growth financial services (42% of revenue) and healthcare (26% of revenue) sectors; ii) a hybrid onsite/offsite client delivery model that provides both sophisticated, high quality customer solutions as well as low-cost India-based outsourcing; iii) margin upside given the company’s historical focus on investing through the P&L, depressing past margins relative to peers; and iv) a competent, long-tenured senior management team, led by Francisco D’Souza, who is widely recognized as an innovative IT services leader. As an IT outsourcing business, CTSH’s 133,000 strong Indian and Asian workforce allows it to complete technical projects like application development, platform construction and cloud integration more cheaply than a U.S. workforce. CTSH is also committed to re-investing profits back into the business (EBIT margins are capped ~20%) at the expense of margin expansion; India peers TCS, Infosys and Wipro operate at 28%, 24% and 19% EBIT margins, respectively.

CTSH has outgrown its peers significantly. From 2006 to 2013, CTSH’s revenue CAGR was 30%, far higher than TCS (17%), Infosys (16%) and Wipro (12%) (margins for comps based on currencies converted to USD). Over the same period, CTSH never experienced a decline in annual revenue. Further, the impressive growth is virtually all organic. CTSH has benefitted from strong customer loyalty: revenue from existing customers have accounted for 95%+ of total revenue per year since 2006.

We believe that CTSH is well-positioned to continue to grow: IT outsourcing and consulting is a $150bn+ market opportunity. Recent successes, such as the announcement of a $2.7 billion engagement from Health Net (an existing customer of 10 years), the largest ever in CTSH’s history, demonstrate CTSH’s success in continuing to penetrate existing customers. We spoke to several people in the industry and the feedback has been consistent: CTSH’s approach is unique and will continue to grow in this fragmented market.

Management has demonstrated its willingness to return cash to shareholders and pursue accretive M&A. Since 2011, CTSH repurchased $1.2 billion of shares and recently expanded its buyback program. In November 2014, CTSH closed the $2.7 billion acquisition of TriZetto software, a platform that management estimates will result in over $1.5 billion of synergies and will be immediately accretive to earnings. Not only does the TriZetto acquisition benefit the bottom line, the added software platform enriches CTSH’s breadth of offerings beyond services and into licensed software.

Our work indicates that CTSH could generate ~$3.22/share in 2015 when adding back margin reinvestment. That would imply an ex-cash P/E of 15x, a market-multiple for an asset that is growing well above market. CTSH generates significant cash flow and based on our conservative DCF scenario, we believe shares are worth at least $70.

Company Overview

CTSH provides a full range of IT services with the majority of revenue coming from application services. Per Gartner estimates, revenue from consulting, implementation and IT outsourcing services was $7.7 billion in 2013, making it the 13th largest provider of these services.

CTSH derives the majority of its revenues in North America from three industries: financial services, healthcare and manufacturing/retail/logistics. CTSH’s strategy is to focus on key industries and continuously expand its service offering for these industries. The below is a snapshot of historical revenue by geography as well as by industry segment.

Cognizant's two largest sectors are the fast-growing financial services and healthcare industries, which accounted for ~70% of total revenue in 2013. Within financial services, CTSH benefitted from the industry’s improving health, characterized by stronger capital levels, increasing loan growth and strengthening business activity. Banks, which account for half of worldwide IT spending, are expected to increase spending on (i) outsourcing to reduce cost pressures, (ii) technology to improve bank transparency and security, (iii) meeting regulatory requirements set by Dodd Frank and Basel III and (iv) capitalizing on new technologies such as ones utilizing the cloud.

Within healthcare, CTSH serves healthcare payers, providers and pharmacy benefit managers. The healthcare insurance industry faces the challenge of improving quality of care at a lower cost, driven by the requirements set by the Affordable Care Act. Healthcare providers must address a broad range of regulatory requirements including compliance related to ACA and work related to state health exchanges, integrated health management, claims investigative services (aimed at preventing fraud) and operational improvements (claims processing, enrollment, etc.)

The majority of CTSH’s employees are based in Asia Pacific (majority in India). The company's strong reputation enables it to recruit top candidates within India’s large and fairly low-wage IT services market and results in high acceptance rate across India-based college campuses. CTSH earns revenue in USD but pays India-based employees in Rupees. This allows CTSH to regularly dole out 5-10% wage increases on USD/INR appreciation while not impacting margins.

CTSH competes within the IT services industry primarily against pure play India-based companies including TCS, Infosys and Wipro. To some extent, CTSH also competes with Accenture in mgmt. consulting, technology services and outsourcing solutions and with IBM in consulting and BPO. As seen below, US IT services companies are much larger than the European and Indian firms, which creates a growth challenge for them due to the law of large numbers (Accenture and IBM grew at only 2% and 3%, respectively, in 2013). Moreover, India offshore firms have a structural labor advantage that is reflected in higher margins.

Investment Highlights

Highly Recurring and Diverse Revenue Base

Between 2007 and 2013, revenue growth was driven by increased revenue from existing customers. CTSH benefits from a stable base of customers and can attribute the high recurring revenue growth to its strategy to “penetrate and radiate” its clients. According to a former CTSH consultant, CTSH’s core strategy is to focus on fewer customers and will not chase high volumes of new accounts.

Additionally, CTSH’s customer base is diverse and no single customer accounts for more than 10% of revenue. From 2007 to 2013, revenue from its top 10 customers declined to 23% (2013) from 34% (2007), reflecting CTSH’s success in reducing concentration with its largest customers by further penetrating smaller clients and adding new clients.

Recent CIO Survey Shows CTSH Most Likely to Win Incremental Spending

Earlier this year, we held a survey of 20 CIOs and Senior VPs of technology to gauge their preferences for IT project outsourcing providers. We asked the participants to rank the competitors (namely CTSH, TCS, Infosys, Wipro and HCL) based on work quality, price, capability and functionality. Results from the survey were consistent with the feedback we heard from our channel checks: CTSH stands above the competition. Of the 10 participants that were familiar with CTSH, 6 of them ranked CTSH as the #1 or #2 provider based on quality of service and execution. Some specific feedback from the survey is below.

“Cognizant has a strong track record of delivery and does more to stand behind their work”

“Cognizant is extremely strategic and has a better handle on emerging tech. Their incubation business is very helpful in this area”

“Cognizant tends to be more strategic in terms of monitoring trends. Infosys is more of a body shop” – CIO of Technology at large financial services firm

“Cognizant stands above. All the rest it depends and they all face visa and turnover issues” – Director of IT at large media firm

“Cognizant and Wipro are always ontime/ahead project deadlines and please the client. TATA comes in slightly behind” – SVP of IT at large software firm

Separately, Morgan Stanley (in June 2014) surveyed 149 CIOs to gauge IT services spending plans for the next 12 months. The survey results showed that among 13 IT services firms (including CTSH), CIOs were planning on spending more with CTSH than any other service provider.

 
Notably, CTSH was one of the least willing firms to provide a discount, yet clients were still planning to increase their spending the most with CTSH.
 

Largest Engagement in CTSH’s History Demonstrates High Customer Value Proposition

CTSH recently announced a new engagement with Health Net, a leading California-based managed care organization. Health Net has been with CTSH for more than 10 years and the newly signed engagement is a seven year deal that is expected to represent $2.7 billion in total contract value, the largest in CTSH’s history. On an annual basis (assuming equal payments over the engagement period), the new engagement will result in incremental revenue of ~$386 million.

Health Net, on its latest earnings call, noted that the initiative with CTSH should generate $150 - $200 million in G&A savings per year.
 

“It will create new opportunities for innovation in products and services. It will strengthen our technology platform and allow us to use our capital more efficiently. In short, it will substantially enhance our capability to serve customers by using state-of-the-art technology, which we believe to be an essential component for future success. In addition, as we've noted before, we're targeting $150 million to $200 million in G&A annual run rate savings to be achieved over a 3-year period.” – Jay M. Gellert, CEO of Health Net on Q2’14 Earnings Call

The estimated cost savings from the engagement implies that certain of Health Net’s G&A was reduced from ~$536-$586 million to $386 million, representing 1.8% of Health Net’s total 2013 revenue. This landmark engagement illustrates the high value proposition of CTSH’s offerings and demonstrates customers’ desire to stay with CTSH (Health Net will have been a customer for 17 years after the end of the new engagement).

Strong Management Team with Forward-Looking Vision

“We have certain growth ambitions at Cognizant; we want to grow faster than the market. In today’s era of volatility, there is no other way but to re-invent. The only sustainable advantage you can have over others is agility, that’s it. Because nothing else is sustainable, everything else you create, somebody else will replicate.” – Francisco D’Souza, CEO and Co-Founder of CTSH

CTSH is led by Francisco D’Souza (who has been with CTSH since co-founding it in 1994), a well-known and respected leader in the industry. D’Souza, as well as other senior members of the management team, have been together for 5+ years and are responsible for shaping CTSH’s culture. Unlike TCS, Infosys and Wipro, CTSH’s primary peers who are based in India, CTSH and its management team is based in the U.S., driven by the company’s desire to be closer to clients. 

“Success also required clients both willing and able to embrace Cognizant not just as a vendor, but as a true partner. Frank commented, “Our business model is tailored to clients who want to partner with service firms instead of treating them as a vendor. Our culture, everything we are about, fits that model, and we actually do badly when we are treated as a vendor. There are firms that are built around being vendors. EDS is one. TCS is another. We are not.”

A key distinction between CTSH and its peers is the “Two-in-a-Box” (TIB) delivery model, a strategy developed so that CTSH could better service clients and deliver consistent results as the company globalized its scale. The TIB strategy requires an on-site client partner and an offshore delivery director on each project and its approach is described below.

“Cognizant assigns an onsite relationship management team with a strong industry background to work at the client’s place of business. A team leader, the client partner (CP), works at the customer location and absorbs the client’s culture, operating processes, challenges, and business goals. The CP nurtures deep relationships with the client’s key stakeholders and their management.

Once the project kicks off, the CP works closely with a dedicated global delivery manager (DM) to ensure that IT services are delivered with precision and customized to the client’s particular needs. DMs . . . are dedicated to key client projects and help coordinate service delivery back to clients. On a tactical level, the CP acts as the communications conduit, effectively translating the client’s IT requirements to Cognizant’s offshore DM, helping to coordinate service delivery back to the client.” – Harvard Business School Case Study on CTSH

CTSH’s approach has been successful and is evident by how much CTSH has outgrown its competition since 2006. A former CTSH consultant we contacted spoke highly of the TIB model and affirmed how this strategy differentiated the company in the industry.
 

In addition to the TIB model, CTSH’s success in outgrowing its peers can be attributed to management’s commitment to reinvest in the business. Management caps EBIT margins ~20% and trades margin expansion for revenue growth. According to an IT services Gartner analyst, CTSH invests ~$200 million of excess profits in sales & marketing (estimate is ~2 years old). For FY 2011, $200 million represented ~3% of total revenue and excluding these reinvestments would have resulted in an adj. EBIT margin of 23% (actual was 20%).

Opportunity to Further Penetrate Key Client Accounts

As illustrated by the recent engagement with Health Net, CTSH has been successful in penetrating and growing key client accounts. According to Gartner, CTSH had 16 of its top clients generate more than $100 million in annual revenue by the end of 2013. Nevertheless, CTSH has a large base of clients (1,197 as of 12/31/13) that it can further expand on its “penetrate and radiate” strategy.

Of the 1,197 clients, CTSH classifies 243 of these as “strategic clients”. Strategic clients are clients that CTSH recognizes as having revenue potential of more than $5-$50 million per year. According to Gartner, CTSH’s focus on cultivating these strategic relationships is one of its greatest strengths.

“For the strategic accounts, Cognizant takes a long-term relationship approach to its client engagements, which translates into a willingness to invest in the relationship, cultivation of customer satisfaction, quick reaction to any issues, and a willingness to work to the intent rather than the letter of a contract. In Gartner research, feedback from Cognizant clients in ERP, CRM and business intelligence (BI) project work has been generally positive, with most indicating high likelihood of recommendation and rehire. The core to this is the relationship and account managers who are recruited from within the targeted industries to drive the relationships with both the IT buyers and business buyers.”

Free Cash Flow Generation and Recent TriZetto Acquisition

CTSH generates significant free cash flow. Between 2010 and 2013, CTSH generated $3.2 billion of cash flow. In Q3’14, CTSH announced the acquisition of TriZetto Corp. for $2.7 billion. TriZetto is a leading software and solutions provider in the healthcare payer (80% of revenue) and provider (20% of revenue) market. CTSH estimates that there will be ~$1.5 billion of revenue synergies and the deal will be immediately accretive to earnings. We believe that the TriZetto acquisition bolsters the existing healthcare practice and provides CTSH with exposure to a high-growing, high-margin and recurring business that will benefit from the constantly evolving and complex healthcare industry.

Valuation and Final Thoughts

We estimate that CTSH could generate ~$3.22/share in 2015 when adding back margin reinvestment of $250 million. That would imply a market-multiple of ~15x P/E for an asset that is growing well above market rates. This is too cheap, given all the business characteristics we discussed above, and we think that many companies with similar strengths and similarly attractive long-term potential trade at 20x+ 2015 P/E. Under a DCF scenario where we project CTSH to grow at a 10% CAGR over the next 10 years, we arrive at a target price of $70, implying ~40% upside.

Given the success that CTSH has already demonstrated, we are confident that management will continue to execute on its strategy to grow and that capital allocation will be properly balanced between share buybacks and accretive M&A – and ultimately will translate to a high return on our investment.

Catalyst

• Large contract wins (similar to HealthNet deal)
• Accretive M&A deals
• TriZetto acquisition providing upside to projected estimates
• Recognition of high-FCF generating business trading at below-market multiples