Researching software companies can be a great sleep aid. Within the first two pages of their 10-Ks, you come across such sleep-inducing doozies as "business and IT alignment and optimization" or "middleware, service-oriented architectures." Today, refreshed and well-rested, I want to analyze fast-growing Cognizant Technology Solutions
What's software outsourcing, you ask? Well, suppose a bank wants to change its software for the way it records and processes your checks and deposits. Typically, that bank won't hire its own software programmers to do so. Instead, it will "outsource" the work as a contract, insisting that vendors like Cognizant do 10% to 20% of the work in the U.S. (mostly supervision and consultation with the bank) and get the rest of the work done in India (analyzing, writing the code, testing, debugging, and so on).
Too pricey
Without a moat, I can't digest what I see as a sky-high valuation. Cognizant, which rubs shoulders with stronger competitors such as Wipro
|
Company, year ending |
Forward P/E |
Forward P/S |
|---|---|---|
|
Cognizant (Dec. '06) |
49.2 |
7.3 |
|
Infosys (March '07) |
31.1 |
7.7 |
|
Wipro (March '07) |
34.5 |
6.4 |
|
Adobe (Dec. ' 06) |
25.3 |
7.3 |
I believe that the headlong rush to get a toehold in India, and the dearth of large companies to acquire there, is driving up valuations. In the long run, prices should come down to more reasonable levels for both Cognizant and the sector.
Riding the boom and building the brand
Cognizant's had an excellent five years riding the outsourcing boom, with 49% average annual revenue and earnings growth from 2001 to 2005. It's also built up a good brand within the software outsourcing industry.
Gartner, in a recent publication on offshore service providers, rated Cognizant on par with WIPRO and just below the top two, Tata Consultancy and Infosys. That's no mean feat, since this group included IBM
Clients such as banks, investment banks, brokerages, have gotten used to the "global delivery model" -- a team of techies working at the clients' site in the U.S. to oversee the bulk of the work done abroad at local wage rates. While there is no lack of software companies outsourcing work, few command good prices to do so on a large scale.
Besides, clients now want vendors to know their business, build an application that saves them time and money, and proactively suggest ways to shorten processes. Infosys, Wipro, and Tata Consultancy have usually done that well; now, Cognizant is getting a look in. The ability to fulfill these client demands should lend Cognizant a higher-than-average value -- but not its current stratospheric levels.
Four reasons it's overpriced
Here's why I think Cognizant's too richly valued:
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No moats. Forty-nine percent of Cognizant's revenues comes from financial applications, where a large number of providers -- global, U.S., or Indian -- jostle for space. Research indicates that no single vendor has more than 5% market share. Without an easily distinguishable product, or a large market share, I don't see any significant barriers to entry, nor much scope for price increases. The rest of Cognizant's business consists of the health care, manufacturing, and "others" segments. Again, in my opinion, those sectors have plentiful competition.
-
Can't leverage fixed costs. Cognizant, like many rivals, customizes solutions for clients such as banks, brokerages, and insurance companies. Solutions and services are not products that can be sold, so revenues are contract-driven. Historically, outsourcing companies like Cognizant have trouble leveraging the fixed costs that come with any price increases they manage to gain from customers. Any gains are usually consumed by higher marketing expenses or passed along to employees.
-
More competition. Global giants such as Accenture are scaling up in India, and financial-sector giants such as JPMorganChase are setting up their own captive centers there. This March, EDS's headcount in India after its Mphasis acquisition shot up from 3,000 to 14,000. Accenture wants to go from 24,000 in India, China, and the Philippines today to 50,000 in the next three years. Lehman, which used to outsource work to Wipro and TCS, now wants to run its own India operations, as does MetLife. If everybody's in India, what happens to the cost advantage?
- Unimpressive margins. Historically, Cognizant's margins of 20% have been lower than market leader Infosys' 28%. Its 2005 average revenue per employee, $36,420, was also much lower than Infosys' $54,674 and Wipro's $46,882. Critically, Infosys has always managed to price its services higher than its competitors. Cognizant hasn't.
These wares should get softer
Since I represent an outsourcing company from India in New York, I can anecdotally vouch for growth in the sector -- we're booked solid until 2009! But, internally, I'd be surprised if we could forecast anything beyond 20% revenue and 30% earnings growth for the next three years. While we get 80% to 90% of our business from repeat customers, this business tends to get lumpy.
Infosys boasts operating margins of 27.8 %, compared to 19.5% for Cognizant. Yet it sells for just 10.5 times last year's sales. If I would hesitate to buy the strongest player, with almost 50% better margins -- a player that's been hugely successful in getting better pricing -- I could never recommend Cognizant at its own current valuation.
Even the recent acquisitions in India have been at lower valuations. EDS's takeover of a 52% stake in Mphasis was priced at four times revenues, while Infosys paid 5.8 times sales for a 20% stake in Progeon. Two years back, these acquisitions were being made at two and three times sales! Bulls would argue that with roughly 50% earnings growth, a forward P/E of 49 is reasonable. But without a moat, or any conceivable chance of one in its existing business model, I couldn't justify any investment expecting 50% growth unless it came at a much more reasonable price. Cognizant is an excellent company, but Mr. Market is asking way too much.
Further homegrown Foolishness:
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Fool contributor Bobby Shethia owns shares of Adobe, but no other company mentioned in this article. He had the best night's sleep of his life after reading the IBM 10-K, and he still doesn't understand what middleware is. The Motley Fool is investors writing for investors.
