How many times have you called customer service and been connected to somebody in India or the Philippines? It's common knowledge that many companies have established these call centers in other countries to cut costs. In recent years, companies are not only outsourcing call centers but also data warehousing, software maintenance and information technology infrastructure. With China and India's tech-savvy and low wage workforces, it is no surprise that many companies are outsourcing more and more of their "back office" operations.
When it comes to investing, many use a top-down method to find attractive securities. An investor using the top-down approach looks at the big picture first to find a promising country. The analyst will then look at attractive countries for investment and to determine what the best performing industries are in those countries. Finally, the analyst will determine what the best performing companies in the top industries are. Following that train of thought, since outsourcing is a growth industry, investing in companies which provide these services could prove to be beneficial.
Cognizant Technology Solutions Corporation, which had its initial public offering in 1998 and trades under the ticker CTSH on the NASDAQ, is a leader in this field.
Cognizant is a broad-based firm which provides outsourcing solutions to business. Specific examples of outsourcing include processing business transactions, accounting operations and data management. Company filings report that in 2010, outsourcing made up about 51 percent of Cognizant's total revenues and outsourcing revenues increased 30 percent from 2009. The total market for off-shoring is expected to reach $175 billion in nine years, according to the company's most recent Form 10-K. This secular growth will boost Cognizant's sales.
In addition to outsourcing, the company also provides IT solutions for business. Examples of business IT includes software application design or re-engineering software to suit clients, data warehousing and virtualization. Finally, the company engages in business consulting and uses its IT products to improve operations. What makes Cognizant unique is that it is not just another business IT firm but is able to leverage IT products and services for offshore operations.
Cognizant has a wide range of customers mostly consisting of midsize to large businesses. Financial services companies such as banks and insurance companies are 40 percent of revenues. Health care and life sciences make up 25 percent, and manufacturing and retail makes up 20 percent with other business such as media making up the remainder. In 2010, Cognizant had 712 individual businesses as customers and no single firm made up more than 10 percent of revenues according to company filings. This broad base diffuses the risk that Cognizant might lose a major contract which would materially affect revenue.
With a business model suited to serving customers in two expanding areas, outsourcing and business IT, it comes as no surprise that the company is thriving financially. Earnings before interest, taxes, depreciation and amortization, called EBITDA, have increased from $435 million in 2007 to $972 million for full year 2010. Free cash flow, a measure of raw cash-generating power of a company, has jumped from $161 million in 2007 to $579 million in 2010, according to Bloomberg. The business also has zero debt in addition to stellar net income growth. In fact, for the last three years, Cognizant has beaten Wall Street analysts' earnings expectations.
Despite its incredibly robust financial data and outperformance of many direct rivals such as Wipro and Infosys on a five-year stock value basis, Cognizant's stock only trades at 22 times earnings; the share price divided by the company's earnings per share is 22. On a historical basis, Cognizant is undervalued since it has traded at 28 times earnings since 2009. However, using free cash flow in lieu of earnings in the price to free cash flow ratio, Cognizant is richly valued at 38 times free cash flow while its peers trade for 22 times.
Apart from the fact that Cognizant is a significant player in a growing industry and posts strong financial results, other factors hint at future success. While unemployment remains high, Cognizant is actively hiring new workers. Just from last quarter, hiring increased 6 percent - meaning the company added more than 7,100 employees, as the firm's chief financial officer said in the latest conference call. The fact that Cognizant is hiring strongly, especially compared to its peers, suggests that Cognizant has conviction that its business will continue to expand. Additionally, Cognizant was able to raise prices, indicating healthy demand for its services.
Although the company is doing well at the moment, there are some potential headwinds. First, Cognizant gets 40 percent of revenues from financial services firms, and with banks cutting costs, they might reduce extra IT or outsourcing spending. Second, general economic slowdowns in U.S. or Europe - 96 percent of total revenues - would clearly impact all stocks. However, a weak economic outlook might cause businesses to cut extra spending for outsourcing and IT services, negatively affecting Cognizant. Third, if the United States passes extensive anti-outsourcing legislation to preserve American jobs, those laws could hurt the company.
The market has priced in some risk, as the stock's price has fallen about 20 percent in six months. Yet Cognizant is a significant player in a dynamic industry and since the company continues to do well, this dip might present an attractive buying opportunity.
Harrison's column runs biweekly Tuesdays. He can be reached at h.freund@cavalierdaily.com.
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