Cognizant Rises as Infosys Looks for a Messiah

Sarfaraz is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The co-founder of India’s technology giant Infosys (NYSE: INFY), N.R. Narayana Murthy, has returned to the company amid shareholders’ demand for a turnaround following the poor performance of the business.Starting this month, 67-yeas old Murthy becomes the new executive chairman of Infosys for a period of 5 years.

Murthy, who co-founded the software firm in 1981, was the executive chairman between 2002 and 2006 and during that period, Infosys’s revenues quadrupled to $2.15 billion. Since 2006, he remained with the company as a non-executive chairman, but retired later in 2011 after the business has struggled due to changing market dynamics. The global economic slowdown and the cost cutting initiatives by some of its biggest clients in the U.S. and Europe were cited by the management as the main reasons behind its problems.

Infosys: Challenging business environment and performance

The overall macroeconomic environment for tech-outsourcing firms has been challenging, and very few improvements are expected in the near term. The world’s second-largest technology consulting company, Accenture (NYSE: ACN), and German powerhouse Siemens have also indicated a decline in future IT spending by other firms, particularly in the U.S. and Europe. Infosys gets more than 80% of its revenues from North America and Europe so naturally, it has been struggling.

Accenture is itself moving aggressively in digital marketing services sector through acquisitions, such as those of Fjord and avVenta. More recently, Accenture has agreed to acquire the e-commerce and ad-consultancy firm Acquity for $316 million. I believe that through these measures, Accenture will become more competitive in the industry by offering superior services to CMOs and ad-agencies. However, in the short term, due to the tough economic environment indicated above, shareholders should expect little growth in the current fiscal year. The company believes that it will touch the lower end of its 5%-8% revenue growth guidance; the markets are expecting just 5.1%.

However, despite the challenges, Infosys shareholders aren’t convinced. As Infosys has fallen, its rivals have continued to rise. In fact, Infosys’s growth has lagged behind India’s domestic outsourcing industry average growth. Infosys is targeting a growth of 6%-10% while the Indian IT sector is expected to post an average growth rate of 12%-14%.

In last two years, India’s software outsourcing market leader Tata Consulting Services and nearest rival Cognizant Technology Solutions (NASDAQ: CTSH) have easily outperformed Infosys. In last two years, from India’s IT sector, Infosys’s market share has remained frozen at 6.9%, while TCS now gets 10.7% of the market’s overall revenues, as opposed to 9.3% two years ago.

While Tata Consulting Services, which was already bigger, was getting an even greater share of the market, I believe that a greater symbolic blow came from Cognizant, which is relatively a newer entrant, when last year, it overtook Infosys as the second leading Indian IT firm in terms of revenues.

Infosys vs. Cognizant

Cognizant is the fastest growing firm in India’s IT sector. According the research firm Gartner, the five biggest Indian IT companies posted growth of 13.3% in 2012, with Cognizant at the top with an enviable growth rate of 20.1%, far above the industry’s average.

Earnings

In its most recent quarterly results, Infosys met the earnings but missed the revenue estimates. The company reported 18.1% year-over-year increase in revenues to $1.84 billion while its net income rose 3.4% to $421 million.

Cognizant has also released its quarterly results that topped the estimates. The company’s revenue rose 18% in the quarter, matching Infosys’s growth, to $2.02 billion, below analysts’ expectations of $2.11 billion but its profits rose an impressive 16.6% to $284.2 million. This translates into adjusted earnings of $1.02 per share, above market’s expectations of $0.97. Moreover, the company netted $180 million more in sales than Infosys.

Growth and profitability

Over the years, the revenue growth of both Infosys and Cognizant has fallen due to identical reasons, but over the long run Cognizant, as indicated above, has remained ahead of Infosys. Despite the current increase in Infosys’s sales, which were above market’s expectations, I expect Infosys’ growth to trail behind Cognizant’s in coming quarters.

Infosys is significantly more profitable than Cognizant, as shown in the graph below. But investors should note that Infosys’s profitability has wobbled while overall, in the last two years, its quarterly profit margin has fallen by 2.2 percentage points. On the other hand, Cognizant has been far more consistent in its ability to maintain its profit margin at around 14%.

<img alt="" src="http://g.fool.com/editorial/images/48723/001_large.jpg" />

One of the main reasons behind Cognizant’s growth is its effective reinvestment strategy. As indicated above, Cognizant is not as profitable as Infosys, but this is because the company has been sacrificing its margin for long-term growth by increasing its sales expenditure. Unlike most of its rivals, Cognizant has made market share its top priority; this is how the company has been operating since its inception. Some of its rise can be attributed to inorganic growth through acquisitions. It is currently planning to acquire six companies from Germany’s C1 Group, one of the largest privately owned system integrators in Germany. Like most of its domestic and international rivals, Cognizant is also making significant strides into the more lucrative consultancy and systems integration business.

The increase in market share eventually translates into improvements in earnings per share. As is shown in the picture below, Cognizant has easily outperformed Infosys, which has reported declining earnings per share in its two previous quarters. In the corresponding period, Cognizant has reported more than 17.5% EPS growth.

<img alt="" src="http://g.fool.com/editorial/images/48723/002_large.jpg" />

Conclusion

Cognizant hasn’t been as profitable as Infosys, but it has been growing at an impressive pace and has delivered much better earnings growth. Due to its lower margins, the business is putting good numbers in those markets where others are struggling, such as Europe. Here, Cognizant’s sales in the previous quarter rose 23% from the same quarter last year. When others in the IT outsourcing industry, as indicated by Accenture, are expecting little top-line growth, Cognizant is looking to outperform the market and has reiterated its full year targets. Therefore, I believe that Cognizant is a safer and far more lucrative investment option than Infosys.

Cognizant's shares dropped significantly in April due to a disappointing outlook from Infosys, but that was (and still is) an opportunity to buy the shares. I believe that Cognizant will continue with its robust growth. In the last week of May, analysts at Janney Montgomery Scott and Deutsche Bank have reiterated their Buy ratings with price targets of $90 and $92 respectively. Clearly, big things are expected from Cognizant, and analysts' price targets show significant upside from the current price of $66.58. 

Although the addition of Murthy is a step in the right direction, unlike some of the other analysts, I am not overly optimistic. It is still too early to start predicting a turnaround. Investors’ hopes are higher than ever, but the conditions won’t be the same for Murthy as they were back in 2006 when Infosys was a smaller player on the global scale. Back in 2006, the company had 53,000 employees and recorded annual sales of $2 billion; now it has a 157,000 strong workforce and sales of nearly $7 billion.

Secondly, executives such as Shibulal and Gopalakrishnan, who have been the center of the shareholders' criticism, are still at the helm. With Murthi, there will be three executives at the top position, creating even more confusion.  I hope Murthi will be the one calling the shots.   

Moreover, the company’s original business model of doing back-end work is facing obsolescence, and Infosys isn’t moving quickly enough into the higher margin consultancy operation. The time and effort the company spent on acquiring Lodestone last year has highlighted its slow decision-making process. I believe a large part of Infosys’s problems are associated with management’s risk-averse approach. Unfortunately, the leadership has preferred to sit on large cash reserves instead of distributing them among shareholders or investing in acquisitions to force inorganic growth.

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool recommends Accenture. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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