Cognizant to Break Through on Economic Improvement

NEW YORK ( TheStreet) -- It takes money to make money. We believe Cognizant Technology Solutions ( CTSH) personifies that idiom. Cognizant is an attractive long-term investment and we recommend investors start a small position at current prices, approximately $72 per share, with an eye on increasing that position on days when there is a general market pullback.

Cognizant is a leading global provider of information technology, consulting, IT infrastructure and business process outsourcing services. The company is well regarded as being run by top-quality management with extraordinary vision.

Cognizant employs more than 150,000 people worldwide. The company has targeted operating margin of 19% to 20%, below its peers, as management has decided to reinvest profits above those levels back into its business. In doing so, Cognizant has seen a growth rate significantly above its peers.

We believe management's focus on the future is what will continue to allow Cognizant to outperform and is a key tenet of our investment thesis. This is what we mean when we use the phrase "it takes money to make money." We believe upside to current expectations lies in management's newer growth opportunities, including expanding its geographic presence (with greater penetration into Europe and Latin America), moving deeper into traditional consulting services and wading into social media, mobile, analytics and cloud services.

Cognizant is often viewed as an Indian IT outsourcer (work done overseas is referred to as "offshoring"), as the bulk of its business is done in India, yet the company is much more than that. In 2011, Cognizant had approximately 15% market share within the global offshore IT services market.

The company derives approximately 49% of its revenue from its application management business, and 51% from its application development business, which is a more discretionary spend by its nature. In periods of economic weakness, these development projects could get pushed out, causing revenue growth to slow.

Business process outsourcing, remote infrastructure management and consulting comprise approximately 15% of Cognizant's sales. We believe Cognizant is beginning to shift itself to a more traditional outsourcer, not just offering offshore services, and will better compete with traditional consulting firms like Accenture ( ACN) and IBM ( IBM).

Interestingly, many make a case that a period of economic weakness creates demand for outsourcing services as many companies seek to cut costs. We see that as being true, but still believe the company does better in an expanding economic climate. However, as we come out of a period of economic weakness, we believe prospective clients may look to increase outsourcing services to remain lean in good times after enduring the brunt of an economic downturn while existing clients ramp up more discretionary IT spending.

Currently, North America accounts for 79.5% of sales, Europe represents 16% and Asia Pacific totals 4.5%. As Europe looks to exit from its economic malaise, we believe the offshoring trend they have long shunned may begin to take hold as they can no longer ignore the economics.

The company has some outsized exposure to a few market verticals. The financial services vertical represents approximately 42% of sales and has been sluggish of late. Health care represents 25.5% of sales, manufacturing, retail and logistics comprise 21% and entertainment and technology total nearly 12% of revenue.

Cognizant stands to benefit from an improvement in the spending environment amongst its financial services customers as we go forward and as Cognizant continues to make inroads into other market verticals including the public sector.

Cognizant had been consistently outperforming Wall Street's expectations until the second quarter of 2012 when the macroeconomic environment caught up with the company and its business was affected and its guidance was revised lower. There had been much consternation about where 2013 guidance would fall out, given the continued economic pressures.

Recently, Cognizant published its 2013 executive compensation plan, which has historically been a good indicator of where its guidance is likely to come out. Wall Street was relieved with Cognizant's 2013 revenue growth goal of 15.9% (this is the level, if achieved, where 100% of executives' "performance units" vest) and the stock rallied, as many had feared worse.

Cognizant has traded with an average 20x price/earnings multiple over the past five years. The stock is currently trading at 18x consensus 2013 EPS of $4.00 a share. Meanwhile the company has a strong balance sheet with over $8.50 per share in cash and investments and no debt. We believe the stock's multiple could increase in a better environment and/or as its newer growth initiatives take hold.

We like the stock as we believe we are seeing signs of economic improvement on a global basis. We are still able to pick up shares while the company's business is being held back by macroeconomic considerations. Upon lifting this weight, we believe the company's business should return to faster growth and may be complimented by better penetration of offshoring in new and existing geographies, growing business in under-penetrated industry verticals and the emergence of a greater variety of offered services (including traditional consulting).

The company has many potential catalysts. Also, historical execution points to the company's ability to achieve greater growth than what the stock is currently discounting. This is why we believe the stock is a buy.

--Written by Bryan Ashenberg in New York City.
In keeping with TSC's editorial policy, Bryan Ashenberg doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.