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Cognizant's stock has pulled back yesterday and today, and we are seeing a huge volume of questions about
this. We see two concerns, both of which we believe are substantially overblown: 1) concern about
Cognizant being suspended from Business Executive Program (BEP) of the US Embassy in India, a
program that enables expedited or "fast track" applications for US visas, and 2) concern about a call being
made by an analyst in India that CTSH's quarter is progressing somewhat poorly due to issues at Lloyds.
The visa-related concern is overblown because this should not be a material issue, and it seems prone
to get rectified soon:
The suspension of Cognizant from the Business Executive Program does not impact the company's
ability to obtain US visas and to deploy needed employees to the US for customer projects. It simply
closes (likely only temporarily) Cognizant from the "fast track" application process for the time being.
Note: HCL, Accenture, IBM, and TCS were also suspended from this fast-track visa application
program, though IBM and TCS have now been reinstated.
News about the BEP program is hitting the press today. But we think Cognizant's suspension from this
program occurred in March, so Cognizant management would have been aware of this situation prior to
issuing its last guidance.
The reason for the suspensions appears to be paperwork discrepancies in visa applications. And, we
think Cognizant should be positioned to clarify such discrepancies and become reinstated to this BEP
visa program reasonably soon.
We think some investors have equated Cognizant's BEP suspension with Infosys's visa-related subpoena.
But, we think Cognizant's BEP suspension is quite minor compared to Infosys' potential visa issue
(stemming from a whistle-blower case). Note: Infosys received a subpoena from a US court, following
allegations by a former Infosys employee that Infosys was systematically violating US visa regulations.
Concerns about Lloyds (client of Cognizant in the UK) are old news, and more general concerns
about Cognizant's June quarter are likely overblown:
In its Q1:11 earnings report, Cognizant cited a revenue growth headwind stemming from a ramp-down in
merger integration work in the UK. We believe the client involved in this merger-integration work was
Lloyds. As such, we think concerns about Lloyds are essentially old news.
In fact, at our June 1st fireside chat with Cognizant's CFO/COO (at Bernstein's Strategic Decisions
Conference), we asked Cognizant if the growth headwind from merger-integration work was largely
subsided. Cognizant confirmed that this headwind has largely subsided. Again, we think concerns about
Lloyds are old news.
We reiterate six additional reasons to favor Cognizant, especially after its pullback should alleviate
valuation obstacles:
First, growth drag from Europe should not be lasting: We think Cognizant's less-than-stellar sequential
growth in Q1:11 was due to ramp-downs in post-merger-integration business in the UK. Looking
forward, we think this headwind has subsided, plus it seems that a strong pipeline of deals are closing in
Europe and should contribute deal ramp-ups between now and Q3:11. Meanwhile, it's clear that growth
and demand trends in the US remain healthy.
Second, we think Q2:11 (Cognizant's seasonally strongest quarter for sequential growth) is prone to
bring revenue upside: Cognizant's sequential growth guidance for Q2:11 calls for "at least" 5.7% (vs.
consensus of 6.1% and our estimate of 8.5%), and we think this guidance and consensus are likely to be
quite conservative, especially given that Q2:11 should receive a boost from pricing. Note that pricing
improved sequentially in Q1:11 by 2%, as new pricing terms likely kicked into gear during Q1:11, with
some incremental potential for continuation into Q2:11, in our view.
Third, we do not think offshore demand is "broken": Investors are asking whether offshore demand is
running into meaningful barriers. We think INFY's weak recent growth results are largely attributable to
company-specific issues (e.g., leadership transition, transition challenges in trying to move up the food
chain), and CTSH's Q1:11 disappointment (vs. high expectations) was largely due to a growth drag from
merger-integration deal ramp-downs. We assert that the "structural" issue involved is that the offshore
market began its growth rebound quite early in the recovery cycle – i.e., in September 2009 – and is no
longer seeing incremental growth boosts now that we've moved into a later-cycle demand phase. Still,
offshore demand is quite healthy, and we think expectations for CTSH to achieve north of 30% revenue
growth in 2011 remain quite feasible (we are now forecasting 32.8% revenue growth for 2011). As an
additional encouraging data point (Exhibit 1), Cognizant's sequential headcount growth has been
between 7% and 9% in each of the past three quarters.
Fourth, Cognizant should be helped disproportionately by transformational services demand: Because
of CTSH's distinctive onshore client relationship capabilities and industry vertical focus (as explained in
our past research), we underscore that CTSH should benefit more than other Indian firms in this latercycle
demand phase (which we maintain is lined with strong demand for transformational services, as
opposed to the fast-payback deals that dominated earlier in the recovery cycle).
Fifth, Cognizant's share-gaining prowess (which we think is being extended) is underestimated in
consensus numbers: As shown in our prior research, Cognizant's Y/Y revenue growth results exceeded
the tier-1 Indian firms (TCS, Infosys, and Wipro) as a group by an average of 17.1 percentage points
during 2003 to 2010. Yet, according to consensus estimates, Cognizant's revenue growth is expected to
beat these tier-1 Indian firms by only 5.1 percentage points in 2011, and Cognizant's consensus Y/Y
revenue growth for Q4:11 is only in line with that of the tier-1 Indian firms as a group. We strongly
think Cognizant is likely to achieve materially above-peer growth, thus beating consensus.
Sixth, there's likely conservatism in guidance: Cognizant's practice in setting its fiscal-year guidance in
the first two quarters for the year is to embed conservatism in its growth assumptions particularly for its
"development" category – i.e., to assume demand in the development category may not be as strong in
second half of the year, given that true visibility into discretionary spending is not very strong beyond six
months. This practice is likely adding conservatism to Cognizant's latest guidance, especially since the
development category should benefit from the healthy environment we see for transformational services
demand. To elaborate:
Cognizant's revenue growth in its application development category (i.e., grew sequentially by 5.4%
and Y/Y by 58.7% in the March 2011 quarter, exceeding the application management category's
sequential growth of 3.8% and Y/Y growth of 29.9%) shows that clients have a strong appetite to
invest in initiatives such as: software deployment, integration, technology platform upgrades, business
analytics, and business process change. This higher growth of application development (compared to
application maintenance) was achieved despite the completion of the merger integration work in the
UK. See Exhibit 2.
Also, note that the UK and Continental Europe achieved sequential revenue growth of -3.5% and
+11.7%, respectively, in Q1:11. Europe overall (which is 19% of Cognizant's total revenues) grew
sequentially by 1.5% (Exhibit 3).
Investment Conclusion
Ratings across Computer Services stocks: We have outperform ratings on Cognizant, Sapient, Accenture,
and ADP. We have market-perform ratings on Visa, MasterCard, Paychex, and Infosys. And, we have an
underperform rating on CSC.
Valuation Methodology
Our target prices for IT services stocks are derived by applying multiples to our forward estimates of
earnings and cash flows. Our target multiples are determined based on our assessments of historical priceto-
forward-earnings multiples, after considering each company’s growth prospects relative to historical
levels. Our target multiples are also influenced by the results of our DCF analyses across various financial
scenarios for each company.
More specifically, for IT services firms, offshore services firms, and payroll processors, our target share
prices are derived by applying the following P/E multiples to our calendar 2012 EPS estimates: Accenture
16.0x, Sapient 23.0x, CSC 6.4x, Infosys 21.8x, Cognizant 25.0x, ADP 20.0x, and PAYX 19.4x.
For payment network companies, our target share prices are derived by applying the following P/E
multiples to our calendar 2011 EPS estimates: MA 13.5x, Visa 15.3x.
As an alternative method of calculating our latest $14.75 target share price on Sapient, we apply a target
P/E multiple of 18.4x to our 2012 EPS estimate with a 28% normalized tax rate assumed (i.e., EPS of 71
cents), while also giving Sapient valuation credit for its $1.67 of cash per share. This target multiple is
supported by Sapient's takeover prospects, substantial room for margin expansion, and long-term growth
prospects in attractive segments like multi-channel commerce, Internet advertising, and trading/risk
management.
As alternative method of calculating our target share price on CSC, we apply an EDS-takeover multiple
(i.e., FCF multiple of 12.05x) to our estimate of CSC's "normalized" free cash flow (i.e., FY10 FCF
excluding the impact of lower DSO).
Also, note that, in addition to prospects for stock appreciation, Paychex, ADP, CSC, and Accenture offer
meaningful dividend yields.
Risks
The primary risk to consulting names (Accenture and Sapient) achieving our target share prices is the
potential for pressures on discretionary services spending. In addition, negative economic news flow can
weigh on the sentiment (and valuation multiples) of consulting stocks, and Accenture's stock has a tendency
to be pressured by appreciation of the US dollar (due to Accenture's substantial international exposure).
The primary risks to IT outsourcing companies’ (e.g., CSC, HP/EDS, Perot) fundamentals include contract
restructurings/terminations (a significant risk for CSC) and the shift of IT outsourcing work to offshore
labor centers (a threat to CSC). Further, our research shows the emergence of the offshore/remote
infrastructure outsourcing business, which will enable Indian firms to move into the core market segment of
CSC, and this trend will add pressure to CSC. It is prone to cause some cannibalization of CSC’s existing
infrastructure outsourcing revenues and some share loss to Indian and niche players moving aggressively
into the offshore/remote infrastructure outsourcing business. We also maintain a concern about CSC’s high
balance-sheet accruals. The risk to our underperform rating on CSC is that restructuring efforts and new
strategies could drive EPS improvement and share price appreciation.
Risks facing our target prices on Indian IT services stocks (e.g., Infosys and Cognizant): We still maintain
longer-term concerns about rupee appreciation (see our 10/22/07 research call for an analysis of factors that
could affect future moves in the Indian rupee), margin contraction (due partly to increasing needs,
especially for Infosys, to invest in onshore capabilities and industry-specific solutions), tax rate
normalization (i.e., tax rates for top Indian firms should jump to north of 20% when the STPI tax haven in
India expires), and meaningful hurdles related to supply and competition.
An underlying risk to achieving our target prices on Paychex and ADP is cross-selling leverage failing to
materialize, causing expectations of long-term earnings growth to be revised. In addition, weak U.S.
employment growth can hurt the stocks' valuations, present a challenge to their margins, and incrementally
pressure their revenue growth. Downward pressures on interest rates can mar sentiment and reduce ADP’s
investment income from both client funds (float) and corporate investments (note that the yield on
Paychex's float portfolio does not have material room for downside).
A number of risks could prevent our target prices on MA and V from being realized, including:
We see a number of potential competitive threats, which could transpire over the long term, e.g.,
encroachment from mobile payments (e.g., could hurt pricing of V and MA as mobile payments moves to
physical POS in the US) and alternative payment providers (e.g., PayPal), growth of competitive
international networks (e.g., China Union Pay), and some possibility of banks moving into the card
network business.
Regulatory change (e.g., related to interchange) is an ongoing risk, and substantial litigation is pending
against MA and V, with MA more exposed to possible future litigation liabilities since V has an escrow
fund and bank shareholder stock buffering its earnings exposure.
Weakness in consumer spending and any hiccups in the revolving credit market can hurt volume and
transactions growth.
MA and V can lose revenues if a card issuing bank converts to different a debit card brand, or shifts
issuance of credit cards from one brand to another. They can also lose revenues if merchants succeed in
shifting more debit volume from signature debit to PIN debit.
Obstacles to cross-border travel activity can hurt the cross-border revenues earned by MA and V.
Besides being affected by general spending activity, MA's and V's growth rates are materially affected by
moves in gas prices in the United States. For MA and V, gas purchases account for about 6% and 10%,
respectively, of U.S. payment volume (and likely account for higher percentages of U.S. transactions
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cognizant's stock has pulled back yesterday and today, and we are seeing a huge volume of questions about
this. We see two concerns, both of which we believe are substantially overblown: 1) concern about
Cognizant being suspended from Business Executive Program (BEP) of the US Embassy in India, a
program that enables expedited or "fast track" applications for US visas, and 2) concern about a call being
made by an analyst in India that CTSH's quarter is progressing somewhat poorly due to issues at Lloyds.
The visa-related concern is overblown because this should not be a material issue, and it seems prone
to get rectified soon:
The suspension of Cognizant from the Business Executive Program does not impact the company's
ability to obtain US visas and to deploy needed employees to the US for customer projects. It simply
closes (likely only temporarily) Cognizant from the "fast track" application process for the time being.
Note: HCL, Accenture, IBM, and TCS were also suspended from this fast-track visa application
program, though IBM and TCS have now been reinstated.
News about the BEP program is hitting the press today. But we think Cognizant's suspension from this
program occurred in March, so Cognizant management would have been aware of this situation prior to
issuing its last guidance.
The reason for the suspensions appears to be paperwork discrepancies in visa applications. And, we
think Cognizant should be positioned to clarify such discrepancies and become reinstated to this BEP
visa program reasonably soon.
We think some investors have equated Cognizant's BEP suspension with Infosys's visa-related subpoena.
But, we think Cognizant's BEP suspension is quite minor compared to Infosys' potential visa issue
(stemming from a whistle-blower case). Note: Infosys received a subpoena from a US court, following
allegations by a former Infosys employee that Infosys was systematically violating US visa regulations.
Concerns about Lloyds (client of Cognizant in the UK) are old news, and more general concerns
about Cognizant's June quarter are likely overblown:
In its Q1:11 earnings report, Cognizant cited a revenue growth headwind stemming from a ramp-down in
merger integration work in the UK. We believe the client involved in this merger-integration work was
Lloyds. As such, we think concerns about Lloyds are essentially old news.
In fact, at our June 1st fireside chat with Cognizant's CFO/COO (at Bernstein's Strategic Decisions
Conference), we asked Cognizant if the growth headwind from merger-integration work was largely
subsided. Cognizant confirmed that this headwind has largely subsided. Again, we think concerns about
Lloyds are old news.
We reiterate six additional reasons to favor Cognizant, especially after its pullback should alleviate
valuation obstacles:
First, growth drag from Europe should not be lasting: We think Cognizant's less-than-stellar sequential
growth in Q1:11 was due to ramp-downs in post-merger-integration business in the UK. Looking
forward, we think this headwind has subsided, plus it seems that a strong pipeline of deals are closing in
Europe and should contribute deal ramp-ups between now and Q3:11. Meanwhile, it's clear that growth
and demand trends in the US remain healthy.
Second, we think Q2:11 (Cognizant's seasonally strongest quarter for sequential growth) is prone to
bring revenue upside: Cognizant's sequential growth guidance for Q2:11 calls for "at least" 5.7% (vs.
consensus of 6.1% and our estimate of 8.5%), and we think this guidance and consensus are likely to be
quite conservative, especially given that Q2:11 should receive a boost from pricing. Note that pricing
improved sequentially in Q1:11 by 2%, as new pricing terms likely kicked into gear during Q1:11, with
some incremental potential for continuation into Q2:11, in our view.
Third, we do not think offshore demand is "broken": Investors are asking whether offshore demand is
running into meaningful barriers. We think INFY's weak recent growth results are largely attributable to
company-specific issues (e.g., leadership transition, transition challenges in trying to move up the food
chain), and CTSH's Q1:11 disappointment (vs. high expectations) was largely due to a growth drag from
merger-integration deal ramp-downs. We assert that the "structural" issue involved is that the offshore
market began its growth rebound quite early in the recovery cycle – i.e., in September 2009 – and is no
longer seeing incremental growth boosts now that we've moved into a later-cycle demand phase. Still,
offshore demand is quite healthy, and we think expectations for CTSH to achieve north of 30% revenue
growth in 2011 remain quite feasible (we are now forecasting 32.8% revenue growth for 2011). As an
additional encouraging data point (Exhibit 1), Cognizant's sequential headcount growth has been
between 7% and 9% in each of the past three quarters.
Fourth, Cognizant should be helped disproportionately by transformational services demand: Because
of CTSH's distinctive onshore client relationship capabilities and industry vertical focus (as explained in
our past research), we underscore that CTSH should benefit more than other Indian firms in this latercycle
demand phase (which we maintain is lined with strong demand for transformational services, as
opposed to the fast-payback deals that dominated earlier in the recovery cycle).
Fifth, Cognizant's share-gaining prowess (which we think is being extended) is underestimated in
consensus numbers: As shown in our prior research, Cognizant's Y/Y revenue growth results exceeded
the tier-1 Indian firms (TCS, Infosys, and Wipro) as a group by an average of 17.1 percentage points
during 2003 to 2010. Yet, according to consensus estimates, Cognizant's revenue growth is expected to
beat these tier-1 Indian firms by only 5.1 percentage points in 2011, and Cognizant's consensus Y/Y
revenue growth for Q4:11 is only in line with that of the tier-1 Indian firms as a group. We strongly
think Cognizant is likely to achieve materially above-peer growth, thus beating consensus.
Sixth, there's likely conservatism in guidance: Cognizant's practice in setting its fiscal-year guidance in
the first two quarters for the year is to embed conservatism in its growth assumptions particularly for its
"development" category – i.e., to assume demand in the development category may not be as strong in
second half of the year, given that true visibility into discretionary spending is not very strong beyond six
months. This practice is likely adding conservatism to Cognizant's latest guidance, especially since the
development category should benefit from the healthy environment we see for transformational services
demand. To elaborate:
Cognizant's revenue growth in its application development category (i.e., grew sequentially by 5.4%
and Y/Y by 58.7% in the March 2011 quarter, exceeding the application management category's
sequential growth of 3.8% and Y/Y growth of 29.9%) shows that clients have a strong appetite to
invest in initiatives such as: software deployment, integration, technology platform upgrades, business
analytics, and business process change. This higher growth of application development (compared to
application maintenance) was achieved despite the completion of the merger integration work in the
UK. See Exhibit 2.
Also, note that the UK and Continental Europe achieved sequential revenue growth of -3.5% and
+11.7%, respectively, in Q1:11. Europe overall (which is 19% of Cognizant's total revenues) grew
sequentially by 1.5% (Exhibit 3).
Investment Conclusion
Ratings across Computer Services stocks: We have outperform ratings on Cognizant, Sapient, Accenture,
and ADP. We have market-perform ratings on Visa, MasterCard, Paychex, and Infosys. And, we have an
underperform rating on CSC.
Valuation Methodology
Our target prices for IT services stocks are derived by applying multiples to our forward estimates of
earnings and cash flows. Our target multiples are determined based on our assessments of historical priceto-
forward-earnings multiples, after considering each company’s growth prospects relative to historical
levels. Our target multiples are also influenced by the results of our DCF analyses across various financial
scenarios for each company.
More specifically, for IT services firms, offshore services firms, and payroll processors, our target share
prices are derived by applying the following P/E multiples to our calendar 2012 EPS estimates: Accenture
16.0x, Sapient 23.0x, CSC 6.4x, Infosys 21.8x, Cognizant 25.0x, ADP 20.0x, and PAYX 19.4x.
For payment network companies, our target share prices are derived by applying the following P/E
multiples to our calendar 2011 EPS estimates: MA 13.5x, Visa 15.3x.
As an alternative method of calculating our latest $14.75 target share price on Sapient, we apply a target
P/E multiple of 18.4x to our 2012 EPS estimate with a 28% normalized tax rate assumed (i.e., EPS of 71
cents), while also giving Sapient valuation credit for its $1.67 of cash per share. This target multiple is
supported by Sapient's takeover prospects, substantial room for margin expansion, and long-term growth
prospects in attractive segments like multi-channel commerce, Internet advertising, and trading/risk
management.
As alternative method of calculating our target share price on CSC, we apply an EDS-takeover multiple
(i.e., FCF multiple of 12.05x) to our estimate of CSC's "normalized" free cash flow (i.e., FY10 FCF
excluding the impact of lower DSO).
Also, note that, in addition to prospects for stock appreciation, Paychex, ADP, CSC, and Accenture offer
meaningful dividend yields.
Risks
The primary risk to consulting names (Accenture and Sapient) achieving our target share prices is the
potential for pressures on discretionary services spending. In addition, negative economic news flow can
weigh on the sentiment (and valuation multiples) of consulting stocks, and Accenture's stock has a tendency
to be pressured by appreciation of the US dollar (due to Accenture's substantial international exposure).
The primary risks to IT outsourcing companies’ (e.g., CSC, HP/EDS, Perot) fundamentals include contract
restructurings/terminations (a significant risk for CSC) and the shift of IT outsourcing work to offshore
labor centers (a threat to CSC). Further, our research shows the emergence of the offshore/remote
infrastructure outsourcing business, which will enable Indian firms to move into the core market segment of
CSC, and this trend will add pressure to CSC. It is prone to cause some cannibalization of CSC’s existing
infrastructure outsourcing revenues and some share loss to Indian and niche players moving aggressively
into the offshore/remote infrastructure outsourcing business. We also maintain a concern about CSC’s high
balance-sheet accruals. The risk to our underperform rating on CSC is that restructuring efforts and new
strategies could drive EPS improvement and share price appreciation.
Risks facing our target prices on Indian IT services stocks (e.g., Infosys and Cognizant): We still maintain
longer-term concerns about rupee appreciation (see our 10/22/07 research call for an analysis of factors that
could affect future moves in the Indian rupee), margin contraction (due partly to increasing needs,
especially for Infosys, to invest in onshore capabilities and industry-specific solutions), tax rate
normalization (i.e., tax rates for top Indian firms should jump to north of 20% when the STPI tax haven in
India expires), and meaningful hurdles related to supply and competition.
An underlying risk to achieving our target prices on Paychex and ADP is cross-selling leverage failing to
materialize, causing expectations of long-term earnings growth to be revised. In addition, weak U.S.
employment growth can hurt the stocks' valuations, present a challenge to their margins, and incrementally
pressure their revenue growth. Downward pressures on interest rates can mar sentiment and reduce ADP’s
investment income from both client funds (float) and corporate investments (note that the yield on
Paychex's float portfolio does not have material room for downside).
A number of risks could prevent our target prices on MA and V from being realized, including:
We see a number of potential competitive threats, which could transpire over the long term, e.g.,
encroachment from mobile payments (e.g., could hurt pricing of V and MA as mobile payments moves to
physical POS in the US) and alternative payment providers (e.g., PayPal), growth of competitive
international networks (e.g., China Union Pay), and some possibility of banks moving into the card
network business.
Regulatory change (e.g., related to interchange) is an ongoing risk, and substantial litigation is pending
against MA and V, with MA more exposed to possible future litigation liabilities since V has an escrow
fund and bank shareholder stock buffering its earnings exposure.
Weakness in consumer spending and any hiccups in the revolving credit market can hurt volume and
transactions growth.
MA and V can lose revenues if a card issuing bank converts to different a debit card brand, or shifts
issuance of credit cards from one brand to another. They can also lose revenues if merchants succeed in
shifting more debit volume from signature debit to PIN debit.
Obstacles to cross-border travel activity can hurt the cross-border revenues earned by MA and V.
Besides being affected by general spending activity, MA's and V's growth rates are materially affected by
moves in gas prices in the United States. For MA and V, gas purchases account for about 6% and 10%,
respectively, of U.S. payment volume (and likely account for higher percentages of U.S. transactions
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