JPMorgan: India IT Services Cognizant: IR Meeting Takeaways

India IT Services Cognizant: IR Meeting Takeaways – separately, we expect demand in the Indian IT sector to start looking up

Earlier this week, our colleagues Tien-tsin Huang and Puneet Jain met with David Nelson, VP Treasurer and IR at Cognizant. As expected, Mr Nelson did not provide an intra-quarter update, but we did get greater clarity on issues that arose from the 1Q results, such as healthcare, Europe and capital deployment. All told, we remain confident in our growth forecast, which is in-line with guidance for 2Q (at the top end) and FY14, and continue to see a low likelihood of meaningful revenue upside given the slow start to the year due to softness in healthcare witnessed in the 1Q results. We remain Overweight CTSH stock, given premium growth and low PEG ratio relative to ACN. CTSH trades at 17.7x our CY15 GAAP EPS (16.3x non-GAAP) vs ACN at 16.5x, while CTSH is growing EPS ~2x faster than ACN; CTSH has $6 in cash/share (or cash is 13% of market-cap).

· Healthcare. At 25% of revenue (60/40 payer/pharma), CTSH’s healthcare practice started the year softer than expected as demand slowed due to: 1) tough comps after a surge of activity from payers in 2H13 surrounding ACA and 2) pharma patent cliff tightening discretionary spend. CTSH remains bullish on the healthcare outlook longer term as drug pipelines inevitably improve and ACA work builds out to include more users and expands to BPO.

· Europe a bright spot. At 18% of revenue, Europe continues to outperform for CTSH as the continent is embracing offshore at an accelerating pace. This corroborates what Accenture suggested on its last earnings call, which likely had a deflationary effect for ACN given its higher onsite mix (at higher rates than offshore). We believe like-for-like bill rates (pricing) in Europe remain stable. Europe is expected to be a geography of above-firm-average growth over the medium to long term for players such as TCS/CTSH/Tech Mahindra/HCLT – these firms have been investing there for some time now, have customized their go-to-market strategies in the various countries in Europe and are now reaching critical scale.

· Capital deployment. CTSH has $3.9B in cash ($6.3 per share), about 40% of which is in the US and we doubt CTSH would bear the cost of repatriating. That said, we still see room for CTSH to step up its cash returned to shareholders (see our note,Cognizant: Compelling Capital Deployment Potential to Shareholders from 3/25/13), but CTSH has said it prefers to maintain flexibility (e.g. for investments, acquisitions, platforms) so we don’t expect a big capital deployment change in the near term beyond opportunistic share repurchases (and CTSH said it would accelerate its pace of buybacks from the $30M repurchased in 1Q, with ~$500M remaining in its authorization).

· Guidance/growth recap. For 2Q, we see revenue growth of 4.3% qoq (guidance at 3.2-4.4%) – recall CTSH dropped its typical “at least” comment to the upper half of its guidance range, so we don’t think 2Q has the usual firepower to produce big upside as it has in the past. For FY14, we see 17% revenue growth, well above NASSCOM’s industry forecasted growth of 13-15% (NASSCOM’s estimate issued in Feb could be stale given soft 1Q).

· Value relative to ACN. CTSH trades at ~7% premium to ACN on our CY15 GAAP estimates, compared to a YTD average premium of 16% afforded to CTSH. We think a bigger premium is warranted given CTSH’s faster growth (JPMe 17% EPS growth for CTSH in CY14 vs ACN at 7%), acknowledging ACN's total return is enhanced by a dividend yield of 2.25%, which helps offset ACN’s slower growth.

· Investment view in the Indian IT space. Among the Indian IT players, we continue to like Infosys, Tech Mahindra and HCLT – all rated OW. We think TCS’s valuation looks a tad punchy in the near term (at 21x forward P/E), but we see it as a core strategic holding in portfolios as gains from leadership compound over time. Compounding tends to be under-appreciated – the longer the timeframe, the greater the compounding gains thus making TCS a core holding, in our view. The India IT sector has clearly fallen off the radar in the wake of a strong wave of preference for domestic sectors (such as financials and industrials) due to the decisive mandate in the national elections for the BJP-led NDA. Such a theme of vigorous sector rotation is likely to be a temporary phenomenon only, in our view, which might well reverse in the second half of the year as firmer signals about the improving health of demand for Indian IT emerge. INR appreciation remains the key risk to our thesis (we continue to work with INR-USD exchange rate of Rs 59-60 for FY15/FY16).

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