WNS Holdings: Generating Attractive Returns Amid Brexit Uncertainty
As intrinsic value investors, we seek to identify opportunities to purchase an ownership stake in a business for meaningfully less than the present value of the company’s anticipated future cash flows. We are often asked how macroeconomic forecasts factor into our investment process. While we spend very little time attempting to make better macroeconomic forecasts than other investors, occasionally macroeconomic events result in businesses that have limited macroeconomic exposure being priced by the market as if they are quite economically sensitive.
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As of December 31, 2019 Diamond Hill owned WNS Holdings Ltd. (equity) and Cognizant Technology Solutions Corp. – Class A (equity).
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This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Reliance upon this information is at the sole discretion of the listener. Investing involves risk including the possible loss of principal.
WNS Holdings (WNS) is an example of an investment opportunity that arose as a result of fears around Brexit and the impact it could have on businesses with significant exposure to the economy of the United Kingdom (U.K.). In late 2016 and early 2017, WNS was added to multiple Diamond Hill strategies on the heels of the Brexit vote in June 2016. During the company’s 2016 fiscal year, over 40% of revenue was generated from clients in the U.K. Given the uncertainty associated with Brexit, many market participants found that geographic revenue composition to be unappealing. However, after thoroughly researching WNS, we believed it was a business that presented a strong value proposition to current and prospective clients in a variety of macroeconomic scenarios. Based on our estimates of the company’s future fundamentals, we believed WNS was trading at a discount to intrinsic value and was an attractive investment opportunity.
WNS is a business process management (BPM) services company that uses expertise of specific business processes and industry verticals to allow clients to achieve improved efficiency and operational flexibility. An emphasis is also placed on providing analytical insights into key processes and business drivers. It is a recurring revenue business with over 95% renewal rates, and in most cases, WNS is engaged to work with clients on core business processes with the objective of making the organization more efficient, insightful, and competitive. Due to the non discretionary nature of the services it is providing, we believed that Brexit would not meaningfully impact the ability of WNS to grow its revenue base, earnings power, and the intrinsic value of its business. While we did not claim to have unique insights into how Brexit might play out, Brexit presented an opportunity to establish an ownership stake in a business at a discount to intrinsic value despite the operations of the business having limited exposure to potentially negative Brexit scenarios.
With most of our long-term investments, the investment return is a combination of the narrowing or closing of the initial gap between price and intrinsic value and the growth of the intrinsic value of the business over the holding period. In the case of WNS, the initial discount to intrinsic value was important because we would not have made the investment unless we were able to purchase shares at a discount to our estimate of intrinsic value. However, growth in the intrinsic value of the business over the holding period has been the more significant driver of the investment return realized by Diamond Hill strategies. WNS shares have more than doubled in the approximately three years since our initial investments, and our estimate of intrinsic value has slightly more than doubled over that time period. The company’s revenue base is approximately 50% larger than when we initially valued the business, and management has been disciplined in achieving operating margin expansion and prudently allocating capital. While the discount to intrinsic value has narrowed significantly over the holding period, we continue to believe that an ownership stake in WNS is likely to produce favorable risk-adjusted returns for Diamond Hill clients.
Understanding Industry Dynamics
The ability to successfully value businesses is crucial to Diamond Hill’s investment process. In order to value a business, we need to have a thorough understanding of how the business operates and what the value proposition is for clients of the business. In the case of WNS, it was important to understand that client relationships typically progress as follows:
- A one- to two-year sales cycle as potential clients become knowledgeable of and comfortable with the business process management offerings.
- The first contract is three to seven years in length, and is often priced based on “full-time equivalent” positions.
- The second contract (and each additional contract) is three to five years in length and is typically the point at which WNS truly “owns” the process, resulting in higher profit margins and very high customer retention. This contract is often priced based on metrics associated with volume (number of items processed, etc.) rather than “full-time equivalent” people.
Once WNS, or any BPM provider, wins a second contract with a client, it is rare that the client terminates the relationship, since changing BPM providers or bringing a business process back in-house involves meaningful switching costs. In the rare instances in which a client does switch BPM providers, it is often due to poor service by the incumbent provider.
BPM companies typically focus on specific industry verticals and end up with deep knowledge and expertise in these industries. In the case of WNS, the insurance and travel industries collectively represent over 40% of revenue. Having teams of industry-specific process experts allows WNS to very efficiently manage core business processes and work with clients to implement analytic solutions, automation, and other technology. Because of the value proposition that BPM companies provide to clients from both a cost and quality of service standpoint, we have a favorable view of the growth profile of the BPM market. Within the market, we believe that the deep industry expertise WNS possesses will continue to allow it to compete successfully against other providers.
Capital structure is always a consideration when evaluating a potential investment. Earlier in the life of the business, WNS operated with significant leverage. However, in recent years the company has operated with cash and investments in excess of debt, and WNS clients seem to have a favorable view of the stability that this capital structure provides. While we will consider investments in companies with a variety of capital structures if we believe we are more than adequately compensated for risk, we believe WNS having a clean balance sheet is a modest positive from a competitive standpoint.
Diamond Hill’s investment philosophy places heavy emphasis on valuing businesses and little emphasis on macroeconomic forecasts, but a crucial factor is considering how the company’s operations are likely to fare in a variety of economic environments. At times, excessive focus on macroeconomic events by other market participants may create opportunities for us to invest in businesses at a discount to intrinsic value. Our investment in WNS Holdings is an example of a favorable investment return being generated from a focus on identifying an individual business mispriced by the market.
As of December 31, 2019, Diamond Hill owned WNS Holdings Ltd. (equity).
Originally published on January 28, 2020.
The views expressed are those of the research analyst as of January 2020, are subject to change, and may differ from the views of other research analysts, portfolio
managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.