Pity the Fool Who Thinks Cognizant (CTSH) is Overvalued?
We have written about both the risks and potential rewards to investors in Cognizant Technology Solutions (CTSH). Weighing in on the bear side is a recent article from Motley Fool, Considering a Costly Cognizant. In it the author lists four reasons it’s overpriced:
* 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 JPMorgan Chase 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.
Valid arguments, all. It is worth noting that Cognizant has chosen to limit margins itself by investing in future growth. When business is strong enough that margins start creeping above their 20 percent target they speed up their hiring process and bring in more college grads. For the first year these new employees are a money-losing proposition as they must receive extensive training. Yet without them there is no potential for future growth due to the nature of the consulting business.
Further, regardless of how much competition there is or how many companies are starting their own IT offices in India, there is no indication that growth will slow any time soon. The Motley Fool author notes that his own IT offshoring business is booked solid through 2009. Some investments are about moats and leverage. Cognizant is about a massive secular shift that will take several years to complete. As this shift winds down it will be important to reconsider the sustainability of Cognizant’s business. In the meantime, there are more pressing concerns.
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