Investors Should Be Cognizant of This Undervalued IT Services Stock

IT services firm  Cognizant (CTSH) announced on Sept. 15 that it has entered into a definitive agreement to acquire TriZetto, a privately held health-care IT provider, for $2.7 billion. Strategically, the combined health-care unit is expected to add value for Cognizant given integrated end-to-end service capabilities. Cognizant already has a good position in the health-care industry--health care constitutes approximately 26% of the company’s revenue--and we think the acquisition will further cement the firm in the market. Importantly, we believe the combined business will enhance Cognizant’s ability to compete for larger integrated deals. The acquisition is expected to be neutral to positive to growth and margins in fiscal 2015 and gradually contribute roughly $1.5 billion in revenue over the next five years. Still, we retain our $55 fair value estimate and narrow economic moat rating.

Cognizant and TriZetto have a long-standing relationship. The companies have significant overlap of clients, and Cognizant has the substantial experience of providing systems integration services for TriZetto. As a result, we think the acquisition will be fairly seamless. Cognizant will finance the deal with cash and debt, and the company has secured a $1 billion bridge loan. Long-term financing is expected to be in place around the close of the deal in the fourth quarter of the financial year. Cognizant does not expect any additional large-scale M&A in the foreseeable future, and the firm’s existing share repurchase plan will be unaffected. With the company trading at a 20% discount to our $55 fair value estimate, we think the firm offers the most attractive upside within the IT services industry. For investors looking for a growth stock within the IT services market, we believe Cognizant is an appropriate holding.

A Focus on Client Engagement Has Created Success for Cognizant
Cognizant has exemplified industry-leading growth for many years. With revenue growing at a compound annual rate of approximately 26% over the past five years, for an industry incumbent, Cognizant has become a notable competitor. Though we do not forecast such a high revenue growth rate over the next five years, we think the firm can significantly outperform the overall global IT services industry, which is projected to grow at a 4.5% CAGR, according to Gartner. Further investments in key industries, new geographies, global delivery, and social, mobile, analytics, and cloud technologies are expected to underlie such growth.

Cognizant’s client-first attitude has been the primary reason for its success. A differentiated Two-in-a-Box operating model--whereby a senior leader in the United States manages the client relationship while another senior manager oversees service delivery from India--has built greater client engagement and enduring relationships. Furthermore, a three-horizon investment framework--which expands Cognizant’s core capabilities, builds critical mass in newer services, and invests in emerging SMAC technologies--provides clients with the appropriate tools and business partner to build out their long-term IT road maps. We think this translates into significant customer switching costs.

Our Fair Value Estimate Is $55 per Share
Our fair value estimate for Cognizant is $55 per share, which implies forward fiscal-year price/earnings of 21 times, an enterprise value/EBITDA of 14 times, and a free cash flow yield of 4%. Cognizant’s full year earnings revision (which was announced during its second-quarter fiscal 2014 results) represents short-term, nonfundamental issues, and does not underline any longer-term trend for the company. We believe the firm’s competitive position remains attractive. We think the company has a number of growth drivers and expect it to generate a top-line CAGR in the midteens over the next five years. However, we expect revenue growth to moderate from lofty levels as Cognizant becomes more mature and the law of larger numbers becomes apparent.

Growing demand from clients for cost rationalization, regulation and compliance (particularly in the health care and financial services segments), and SMAC-related services will underlie healthy long-term growth. Additionally, Cognizant will push further into markets such as Latin America, Continental Europe, and the public sector through both organic and acquisition-led endeavors. The company is looking to be more aggressive in terms of its M&A to build out its capabilities.

We expect non-GAAP operating margins to hover around 20% as the company has a mandate to keep margins in the 19%-20% range and reinvest all excess profits back into client-facing capabilities such as onshore and offshore senior leaders, industry experts, MBAs, and flexible resource allocation. Such reinvestment is seen as a critical factor in building better client relationships, and to that end, Cognizant has been recognized as a market leader in client satisfaction studies from third parties. The company has no debt, and we use a 10% cost of capital to discount our projected future cash flows.

Cognizant is in a very secure financial position. As of June 2014 the company had approximately $4.1 billion in cash, cash equivalents, and short-term investments and carried no debt. We do not expect the company to face any liquidity concerns for the foreseeable future. The firm has never declared a dividend and intends to retain its earnings for future growth opportunities. However, it does have an opportunistic share repurchase program of roughly $2 billion (which was recently raised from $1.5 billion) to counter stock option dilution. The firm’s ample free cash flow allows it to actively pursue M&A opportunities.

Switching Costs Lead to a Narrow Economic Moat
We believe Cognizant has a narrow economic moat given customer switching costs. The firm’s commitment to client satisfaction (through its Two-in-a-Box operating model) has led to the formation of critical long-term relationships and an intimate knowledge of customer business processes (we estimate the company’s strategic client retention ratio to be in the high 90s). Notably, about 30% of a Cognizant project team resides at a client’s site, which differentiates the company from other offshore outsourcers. The larger onshore presence exemplifies Cognizant’s dedication to building stronger client relationships and better local business understanding. Compared with competitors, Cognizant sacrifices some margin due to significant reinvestment into client-facing competencies such as onshore and offshore senior leaders, industry experts, MBAs, and flexible resource allocation. We think Cognizant’s client engagement creates a deep understanding of critical business systems, which leads to client reluctance to switch service providers.

Management Understands Need for Ambitious Innovation
The number-one risk for Cognizant is the highly competitive marketplace. To maintain its position and fend off marketplace irrelevance, the company must continue to develop innovative solutions that keep it one step ahead of the competition, execute on contracts to maintain its reputation, and attract (and retain) the right IT professionals to the organization. Additionally, with approximately 77% of revenue generated in North America, Cognizant is highly exposed to the economic well-being of the region. Finally, the firm faces earnings volatility due to foreign exchange movements such as the Indian rupee versus the U.S. dollar.

We view Cognizant’s stewardship of capital as standard. Francisco D’Souza was appointed group CEO on Jan. 1, 2007, and Gordon Coburn was appointed president on Feb. 6, 2012. Both men have a wealth of experience at Cognizant, having been with the company for approximately 20 years each. Collectively, all key insiders own roughly 1% of Cognizant’s outstanding shares, which isn’t particularly high. Nevertheless, we think management has worked in shareholders’ best interest by generating excess economic returns.

The company’s accelerated reinvestment strategy has been critical in growing its footprint and building a high-quality client experience. Management’s paranoia over complacency has been vital to its success and has fueled the firm’s high-growth trajectory. Cognizant is well aware that if it does not continue to innovate it will become irrelevant. We think this shrewd approach will maintain the firm’s competitive advantage in the market.

Over the past 10 years Cognizant has proved its ability to build depth in key industries--business consulting, global delivery, and SMAC services. We think the company’s three-horizon investment framework appropriately identifies opportunities in the market and allows Cognizant to allocate capital resources in the most effective manner. Cognizant typically acquires about two to five companies per year but is looking to be more aggressive going forward in order to build out its geographic capabilities, industry depth, intellectual property, and SaaS platforms. As a result, the company is not expected to pay out a dividend in the near term as it will retain its earnings for future growth.