We are selling Cognizant and adding 75bps to Apple and 175 bps to IVV.
Rationale for selling Cognizant:
· Labor arbitrage model of offshore outsourcing is becoming less attractive.
o Offshore wages are rising, narrowing the wage gap.
o While digital is driving growth, it only accounts for 29% of revenues. Growing at over 20%, this accounts for basically all their organic growth. Other 70%, legacy business has challenges and some negative impact from digital trends.
o The cloud is leading to lower labor intensity in some of CTSH’s key areas. This is also leading to less attractive contract terms and a loss of pricing power.
o Much of their India labor base (70% of their labor force) needs to be re-skilled – shortage of relevant skills is driving attrition and wages, which means CTSH is paying to train a labor force they are having a hard time keeping.
o Attrition and data security concerns (especially in data sensitive industries) is driving some insourcing, where companies hire their own teams offshore.
o Barriers to entry are eroding – customers are increasingly using smaller competitors with niche technology expertise.
Rationale for adding to Apple:
· Attractive valuation underpinned by high loyalty installed base and recurring revenue of services.
o A conservative DCF with low-single digit top line growth and slightly eroding FCF margins gives a >$200 PT. Current price is $168.
o As an alternate sum-of-the-parts view:
§ Subscription model companies trade at around an average multiple of 8x EV/annual recurring revenue (ARR). The multiple varies depending on growth.
§ 8X Apple’s very high-growth Services business ($40B annual run rate) contributes $320B in enterprise value.
§ Apples total EV is $677B (mkt cap is ~$800 less about $123B in cash). That means the rest of the business underpins the remaining $357B.
§ An LTV analysis of Apple’s high-loyalty installed base of iPhones already supports most of their valuation. LTV analysis is basically the net present value of a subscriber.
§ LTV can vary a lot depending on assumptions, so I use this as more of a scenario analysis: Apple has a 1.4B installed base of devices. Assuming an average of 1.5 devices per user and 90% iPhone penetration, that gives an installed base of about 840m (estimates vary, but this is slightly conservative). ASP’s are about $800, which can loosely be translated to an ARPU of about $215 using a 3.5-4 yr replacement cycle (again conservative). Further assuming a mid-30% contribution margin (or around $75/sub), no attrition, no growth, and an 8% discount rate this can be viewed as a perpetuity. These assumptions basically support Apple’s entire enterprise value. No attrition is the only non-conservative assumption. They actually don’t need to maintain ASP’s to make this math work either, they just need to maintain the recurring $75/head.
§ So, clearly, backing into an LTV based on a $357B enterprise value bakes in some bearish assumptions for what is the world’s most valuable consumer franchise. Moreover, this assigns no value to sales of iPads, Macs, Apple Watch etc.
§ While smartphones are maturing, Apple has a record of successfully transitioning from one product to the next…Mac to iPod to iPhone. They have done this with the assistance of multiple bolt-on acquisitions and have a lot of cash to do the same with Services. They also have had massive success without being first to the game…Blackberry, for example, led in smartphones before them. There are massive opportunities with Apple Music, Apple Pay, potential print & video subscription model, health wearables, CarPlay etc.
§ Including cash on the balance sheet and annual FCF production, they have >$300B in cash to deploy over the next 3 years to be net cash neutral (which is a stated goal). That’s over a third of their market cap.
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109
www.crestwoodadvisors.com
