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Stock Strategist

Three Top Value-Creating Stocks

Our profitability study highlights three top-performing IT services firms.

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First and foremost, smart long-term investing requires determining which companies create economic value for their shareholders over the long run. Return on invested capital (ROIC) is a method favored here at Morningstar to gauge how much economic value a firm can generate. However, some businesses (consulting, information technology services, various advisory firms) have little invested capital, so their ROICs can be distorted to the upside or be so high as to make them meaningless: Is a firm generating 60% ROIC significantly better than one generating "only" 55%? On the other hand, these same businesses tend to derive most of their economic value through human capital--that is, the employees who create the ideas, the institutionalized skill sets, the intellectual capital, and other intangibles that generate revenue and profits for a company and cash for shareholders.

We recently measured the performance of the IT services firms that we cover based on revenue, costs, and operating profit on a per-average-employee basis. Because the fiscal years of these firms differ, we used data from their most recently finished fiscal years--but results would not be materially different if we used other years. Given how quickly some of these firms are adding employees, we decided to use average employees in an attempt to remove distortion. Some firms were excluded from our study due to various, firm-specific circumstances: For instance,  BearingPoint (BE) has incurred increased costs rectifying its financial controls problem, so its results were not comparable, in our opinion.

 Per-Average-Employee Metrics
 

Revenue
( $ )

Costs
( $ )
Operating
Profit ( $ )
Avg # of
Employees
Accenture (ACN) 127,071 110,820 16,251 155,000
Infosys (INFY) 49,457 35,821 13,637 62,478
Computer Sciences (CSC) 188,058 174,782 13,276 79,000
Wipro's Global IT Svcs Group (WIT) 42,157 32,224 10,082 67,800
Stanley (SXE) 163,764 153,934 9,831 2,500
Affiliated (ACS) 97,839 88,573 9,265 59,000
Satyam (SAY) 43,210 34,588 8,622 33,821
Cognizant (CTSH) 45,143 36,936 8,207 31,550
Patni (PTI) 47,050 39,371 7,679 12,303
EDS (EDS) 171,516 164,935 6,581 124,000
Perot Systems (PER) 116,947 111,196 5,751 19,650
Ness Technologies (NSTC) 70,478 65,484 4,994 6,730
WNS (WNS) 27,612 25,515 2,097 12,759
ExlService Holdings (EXLS) 15,712 13,767 1,945 7,750

While our study yielded many insights, the most important thing for shareholders, in our opinion, is how much economic value--operating profit, in this case--each employee contributes. Here, we found that the 14 companies analyzed split into three camps. First, the clear leaders are  Accenture (ACN),  Infosys (INFY), and  Computer Sciences (CSC). All three demonstrate higher operating profit per average employee than the rest of the pack. Perhaps most amazing is Infosys; with only a fraction of the revenue per employee, Infosys places itself in the same league as two industry titans. Importantly, this isn't solely because of its labor arbitrage capabilities; in fact, it outperforms other India-based firms. Clearly, all three of these firms are outperforming their rivals in turning human capital into economic value. Both Accenture and Computer Sciences are currently 5-star stocks, and Infosys recently traded in 5-star territory.

Second, most IT services firms generate $5,000 to $10,000 in operating profit per average employee. Even within this grouping, though, we noticed a few interesting points. While  Stanley (SXE) stands out as having the fewest employees of any firm studied, it still manages to wring $9,800 in operating profit from each of them. We believe this reflects how scale alone does not trump skill in the IT services sector.  Electronic Data Systems (EDS) is near the bottom of the profitability pack despite having tremendous scale, a truly global delivery network, and the second-highest number of employees of any IT services firm studied. This is largely because EDS has high depreciation and amortization expenses (which lower reported operating profits) and because of the relatively capital-intensive nature of its infrastructure outsourcing business.

Another interesting point is the similarity in revenue, costs, and profit for  Satyam (SAY) and  Cognizant (CTSH), two firms once joined at the hip. (Cognizant was originally set up as a joint venture between its then-parent  Dun & Bradstreet (DNB) and Satyam.) This underscores for us that operating structures and cultures can trump broader industry characteristics when it comes to firm performance.

Third, solidifying our belief that business process outsourcing (BPO) firms are the weakest economic value creators among IT services firms,  WNS Holdings (WNS) and  ExlService Holdings (EXLS) are at the bottom of the list. This is not to say that they are bad firms: They are good investments currently, and they do create shareholder value. However, we believe our study reflects that few BPO processes and people can create significant, durable intangible assets that will drive economic results. Instead, we believe that most BPO services are lower-level, noncore capabilities, for which corporations are loath to pay a premium. Our study also bolsters our long-term view that neither WNS nor ExlService has an economic moat.

Overall, our study shows that there are ways to look at a firm's economic value creation other than return on invested capital. When a business operates and competes in a knowledge-based industry, intangible assets and skills embodied in employees are what matter. And one way to determine the value they create for shareholders is to look at how much profit the firm generates through their services.

Mike Taggart does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.