Phil Town recently asked for my thoughts on Cognizant Technology Solutions (CTSH). I’m always open to researching companies that I am unfamiliar with, so I decided to take some time tonight to research Cognizant.
I discovered that Cognizant Technology Solutions is an offshore IT services provider. Cognizant considers its competencies to include web-centric applications, data warehousing, component-based development, and legacy and client-server systems. They provide IT services using an integrated on-site/offshore business model. Their unique capability involves providing an on-site/offshore business model that combines technical and account management teams located on-site at the customer location and offshore at dedicated development centers located primarily in India. Building strong on-site relationships with their clients while coordinating low cost offshore technical capabilities appears to be their competitive advantage.
Cognizant’s current financial performance has been strong. A quick look at Cognizant Technology Solutions’ financials indicate that they operate a very profitable business. Return on capital is well over 20 percent recently and for the past five years. Revenues and earnings per share have grown over 50 percent per year! That is some major growth.
The big question is whether this growth and profitability is sustainable. It is very difficult of consulting firms, whose main asset walks out the door every day, to maintain a long run sustainable competitive advantage. Cognizant Technology Solutions is focused creating long-term relationships with their clients using their on-site presence while delivering low cost offshore technology savvy manpower. The on-site client managers will provide the main service to their Fortune 1000 clients. There is a significant risk that these managers could leave their positions with Cognizant Technology Solutions and potentially their customers may move with them.
A competitor could make major in roads into Cognizant’s client base if they were able to woo key managers from Cognizant. I do not have direct experience with offshore IT consultants, but my experience with environmental consultants indicates that there is a real danger that clients are more wedded to individual account managers than they are to particular consulting firms. I have seen account managers for consultants retain the same client while moving from one firm to another and then even to a third firm. Each time the account manager moved companies, they took with a large percentage of the clients away from the firms they originally worked for. I am concerned that Cognizant Technology Solutions does not have any significant capabilities of retaining client accounts in addition to their strong local relationships. These relationships may be strong method of retaining clients in the short term, but in the long term people move and personal relationships fray.
The labor cost advatage of Cognizant Technology Solutions is not unique to their company. Infosys (INFY) appears to be the market leader in this sector and they have even better profitability ratios than Cognizant and also use low cost offshore Indian programers. If demand for IT services declines even temporarily, price competition could occur between Cognizant, Infosys, Wipro (WIT), and Tata Consultancy Services. In addition, IT experts from other developing countries with highly educated populations, such as China or Russia, could also provide additional competition in the future.
Given these factors, I believe that Cognizant Technology Solutions only has a shallow price moat. If the price of its shares were low enough, I might still consider this profitable business for my investment portfolio. However, looking at Cognizant’s free cash flow over the past five years, I only roughly estimate an intrinsic value of about $20 per share for CTSH and that doesn’t even take into account stock option expenses which are significant.
This investment could still be profitable if demand for the IT services that Cognizant Technology Solutions remains very strong in the United States and Europe and new competitors from other cheap labor markets don’t come online. Given that I’m not very familiar with the IT outsourcing industry, I think I’ll be passing on this stock.