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IT Companies in an Environment of Increasing IT Spending

August 30, 2013 | About:
Outsourcing processes helps companies save money, not only by avoiding hefty investments on infrastructure, but also by providing quick and easy solutions to complex problems that would require plenty of labor. As the demand for IT services increases and corporate spending in this area accompanies, some companies seem particularly well positioned to make a profit. In this article we will look into three of them, Rackspace Hosting (RAX), Xerox (XRX) and Syntel (SYNT), in order to elucidate which ones stand as the most attractive investment opportunities.

Customer Service Is the Key

Rackspace Hosting is the world’s leader in hosting services. By offering data center and server management, the company allows its customers to avoid hefty investments in IT infrastructure and running expenses. Its product portfolio includes managed, email and cloud hosting. This last one has been the fastest-growing market segment and, as such, is expected to drive revenue growth over the upcoming years.

As IT spending continues to grow despite declining PC sales, Rackspace seems to be particularly well positioned to benefit from it. In addition, managed hosting spending is expected to deliver average annual growth rates above 10% over the next four years (Morningstar).

However, the company´s differentiator, in my view, has been its customer service, which has helped keep its clients´ security and technical concerns under control. Many of these contempt customers represent great cross-selling opportunities for the firm. Once managed hosting customers, they now seem bound to acquire cloud computing services.

But, given Rackspace’s growth prospects and above-average EPS growth expectations for the years to come, why have investment gurus kept away from this stock? Why did Renaissance's Jim Simmons and Sac Capital's Steve Cohen sell out most of its shares? What kept the firm´s largest shareholder, Capital World Investors, from purchasing more stock?

Well, I believe that the answer lies on its overvaluation. Trading at $44 per share, or 58 times its earnings, its valuation quadruples the industry average. Something similar can be said about its 4.4x P/S ratio, compared to the 1.7x industry mean.

The Verb Brand

Xerox does a lot more than just manufacturing photocopying (or, as many of you might know them, Xerox) machines. In fact, it is the world's leading company for business process and document management. Its wide product portfolio comprises services from data processing and healthcare solutions to transportation solutions.

Although this established company is not a growth investment, it is certainly a safe one. And both State Street and the Vanguard Group, major shareholders, seem to notice this, since they have been buying substantial amounts of stock over the last quarter. Its strong cash flow generation capabilities provide it with the necessary stability to fund growth initiatives going forward while maintaining its generous dividend policy. As a bonus, Xerox´s stock trades at 11 times its earnings, at more than a 30% discount to the industry average.

What makes me believe in the firm’s future is its transformation program, which provides plenty of upside potential (over 50%). Over the next few years, the firm’s focus will be shifted away from the declining printer and copier industry, and into the outsourcing services segment. With this change in focus, the company will not only benefit from long-term sticky contracts, but also from increased cross-selling capabilities. To fully focus on its service segment, the firm has also been divesting its less profitable businesses, ameliorating its margin profile and freeing up capital (Morningstar).

Xerox is especially strong within the healthcare segment, serving two-thirds of all U.S.-insured patients. As the healthcare industry continues to seek to cut costs, the company seems poised to see its demand for IT solutions increase considerably.

The Advantages of Being Indian

Syntel is an IT and Knowledge Process Outsourcing (KPO) services provider. Although focused on the health care and financial segments, it serves all kinds of companies and government agencies. Despite the fact that its stock price has been up over 30% year-to-date, it still trades at a reasonable valuation — 15x P/E — given its industry leading margins and (revenue and income) growth histories. This might be one of the main reasons behind Jim Simons' and Joel Greenblatt´s decision to add more of these shares to their portfolios lately.

One of the pillars of Syntel’s success seems to be its global delivery model, which helps link its service centers around the world in an efficient manner. Bound to open centers in Tamil Nadu, India and Manila, Philippines, while expanding existing ones, the company is certainly headed in the right direction.

In the short and mid-term, this Indian company will benefit from a weak Rupee coupled with a recovering U.S. economy, a situation that encourages business process outsourcing to India. And, although other Indian firms like Infosys (INFY), and Wipro (WIT) will also make profit out of this situation, their valuations, margins and returns are not as attractive as Syntel's. Furthermore, increasing regulations in the healthcare and financial segments, in which the company specializes, will lead to increased IT spending and, consequently, revenue for the firm.

Going forward, diversified revenue streams, a wide international presence and a focus put on servicing big-cap firms (usually among the Fortune 100) should continue to help Syntel beat analyst estimates, as it has in the past few quarters. Moreover, a wide product pipeline should drive revenue growth even further by helping acquire new customers and start new projects with old clients.

Bottom Line

Although all three of the above described companies offer compelling growth prospects and promising EPS growth estimates for the years to come, Rackspace’s valuation makes of it the least appealing option. On the other hand, a recovering economic environment and an increasing demand for outsourcing services make of Xerox and Syntel great long-term investment options at their current valuations. I say buy and hold.

Disclosure: DamianIllia has no position in any stocks mentioned

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


Rating: 3.8/5 (8 votes)

Comments

federicof1982
Federicof1982 premium member - 1 year ago
Nice contribution. The addition of Syntel makes it particularly interesting
damianillia
Damianillia premium member - 1 year ago
Thanks Federicof1982. I will be posting new articles every day. Hope they come in handy

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