CTSH -- Ride the Outsourcing wave

This is continuation of the series in which I introduce some of my favorite names in technology. The major themes were discussed in the It's a tough market- pick your stocks wisely. In the first part we discussed JNPR and FFIV. Another theme that I like is Outsourcing, Lou Dobbs can say what he wants but it's happening and we all benefit from it. Competition in outsourcing is good for all including Philippines, China, Russia and other countries as they become alternative to India.

Some of the companies that are leaders in outsourcing are: INFY, WIT,SAY, CTSH. According to India's software exporting association, (NASSCOM) exports of software and services from India are expected to grow 34% in 2004-05 or about $18 billion. So its more than a fad and it is still early to invest in this trend. Europe is just opening up to outsourcing and could become bigger customer for these companies than US market.

CTSH is based in U.S unlike many of its competitors was spun out of Dun & Bradstreet. Like its competitors, CTSH has majority (73%) of its employees outside of U.S. I want to focus on CTSH since I believe it has one of the fastest growth prospects of ~40% revenue growth and has a healthy 20% operating margins (intentionally capped by management). CTSH is avoiding fighting the pricing war by expanding into offering services such as R&D for pharmas, testing services, high-end business process outsourcing (BPO). The outsourcing model hinges on not only providing cheaper software (approx 25%-30% cheaper) but also providing quality product. CTSH is considered to be one of the top-tier company in the business, such that CTSH turns away business it considers not to be strategic. CTSH started off in the Financial vertical but has been growing its footprint in other verticals such as retailing and healthcare.

Some important material from CTSH 10K just filed:

• Core competencies include web-centric applications, data warehousing, component-based development and legacy and client-server systems.
• Have proprietary methodologies for integrating on-site and offshore teams to facilitate cost-effective, on-time delivery of high-quality projects. These methodologies comprise our proprietary Q*VIEW software engineering process, which is available to all on-site and offshore programmers.
• We have over 1,000 project managers and senior technical personnel around the world, many of whom have significant work experience in the United States and Europe.
• Over 90% of our revenues in the year ended December 31, 2004, were derived from customers who had been using our services for one year or more.
• Our senior project managers are hired from leading consulting firms in the United States and India. Our senior management and most of our project managers have experience working in the United States and Europe

And then there are risks, including intensive competition. I believe risks are even more important when dealing with something so political like outsourcing.

• Our most direct competitors include, among others, Infosys Technologies (INFY), Tata Consultancy Services and WIPRO (WIT), which utilize an integrated on-site/offshore business model comparable to that used by us. I would include SAY in this list also.
• We also compete with large IT service providers with greater resources, such as Accenture (ACN), Electronic Data Systems (EDS) and IBM Global Services (IBM)
• A substantial portion of our assets and operations are located in India and we are subject to regulatory, economic and political uncertainties in India.
• While wage costs are lower in India than in the United States and other developed countries for comparably skilled professionals, wages in India are increasing at a faster rate than in the United States, which could result in our incurring increased costs for technical professionals and reduced operating margins.
• There is intense competition in India for skilled technical professionals and we expect that competition to increase.
• The issue of outsourcing of services abroad by American companies is a topic of political discussion in the United States. Measures aimed at limiting or restricting outsourcing by U.S. companies are under discussion in Congress and in as many as one-half of the state legislatures.
• A significant portion of our projects are on a fixed-price basis, subjecting us to the risks associated with cost over-runs and operating cost inflation.

CTSH has a hefty valuation (32X '06 EPS; but below PEG of 1) to go with its break-neck growth rate. I believe in paying up for quality and growth. Management has guided to 44% revenue growth for 2005 and I (and the market) would be disappointed if CTSH did not beat that guidance. Plus with stock trading close to 52-week high is evident of strong investor interest in CTSH. Its always nice to row with the flow.

Full Disclosure: At time of publishing the author owned shares of CTSH, which could change at any time without public notice.