Cognizant: Inexpensive, Even in a Pessimistic Scenario

| About: Cognizant Technology (CTSH)

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Cognizant Technology Solutions (NASDAQ:CTSH):

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Investment Conclusion. Based on reassessment of IT spending plans amid the ongoing global financial crisis and economic downturn – cushioned by recent rupee depreciation – we are revising our estimates as follows: 2008 GAAP diluted EPS to $1.45 on revenue of $2.811 billion (32% YoY growth) from $1.44 also on revenue of $2.811 billion); 2009 GAAP diluted EPS to $1.60 on revenue of $3.103 billion (10% YoY growth) from $1.80 on revenue of $3.621 billion; and 2010 GAAP diluted EPS to $1.75 on revenue of $3.723 billion (20% YoY growth) from $2.10 on revenue of $4.617 billion. Our model conservatively assumes subdued or no QoQ revenue growth in the next three quarters.

To reflect prevailing sentiment, we are also resetting our target price from $44 to $30. In 12-months, this would correspond to 15-20x forward EPS – a premium to the current depressed valuation.

These aggressive cuts enable us to accentuate 1) an upward bias to our estimates; and 2) inexpensive valuation of 13x forward EPS. We are reaffirming our Buy rating on the basis of industry-leading revenue and EPS growth in calendar 2007-09E, backed by substantial margin flexibility. The long-term outlook remains encouraging given recent competitive wins and a healthy pipeline. Cognizant is well positioned to participate in M&A integration, risk management, regulatory compliance and cost reduction initiatives in the Financial Services segment.

3Q08 Results.
GAAP diluted EPS of $0.38 vs. $0.32 a year ago on revenue of $734.7 million beat our $0.37 estimate on revenue of $723.1 million. Results included a non-operating foreign exchange loss ($14.8 million or -4.2 cent EPS impact) – offset by recent rupee depreciation (+2.1 cents) and a lower-than-projected stock-based payout (+1.9 cents). Operating income advanced 41% YoY. Highlights included 31% YoY and 7.2% QoQ revenue growth. In recent weeks, Cognizant has announced new/expanded client agreements with Deutsche Telekom, AstraZeneca and Health Net ($100 million TCV).

Takeaways. Revenue outpaced peers but was adversely impacted by weak European currencies and a lower contribution from a top-5 Healthcare client. For the second straight quarter, Cognizant posted better-than-overall growth in the Financial Services segment (+31% YoY and +8% QoQ). Areas of strength included the Healthcare vertical (+34% YoY and +6% QoQ growth) and European region (up 54% YoY and 4% QoQ to 20% of total revenue). Meanwhile, revenue in the U.S. region rose 26% YoY and 8% QoQ. Operating profitability benefited from 5.1% QoQ rupee depreciation and higher utilization – mitigated by an annual salary increase for offshore employees (effective July). Management noted:

- The 4Q revenue outlook incorporates fewer working days and slow project starts in anticipation of late budget approvals in 2009, i.e., potentially in March vs. January usually.

- Direct exposure to impacted Financial Services clients – IndyMac, Lehman, WaMu, Wachovia, Bear Stearns and HBOS – is limited to 5% of total revenue with work ongoing and not likely to end abruptly.

- Shifting demand toward Application Management, BPO and Infrastructure Management services.

- The latter two recorded double-digit QoQ growth but still account for only 5-10% of total revenue.

- Good price discipline by all major players.

- Client engagement at a more strategic level, i.e., in the role of a trusted partner vs. mere vendor. Investments in relationship management that hold particular relevance in the current environment, e.g., Cognizant boasts 700 client partners, 70+ executives focused on strategic opportunities, an advanced solutions practice and 1,700 business consultants.

Revenue from Application Management services advanced 36% YoY and 8% QoQ to 53% of the total. Revenue from discretionary Application Development & Integration projects rose 26% YoY and 6% QoQ to 47% of the total. Operating income of $142.6 million (19.4% margin) surpassed our $126.5 million estimate (17.5% margin). Available levers for countering wage and currency pressures comprise offshore utilization and scale/SG&A efficiencies, i.e., rental, communications, marketing and back-office savings.

Hourly price realizations appear to have been stable QoQ at approximately $72-73 for onsite work (25% of billable workforce) and $24-25 for offshore (75%). Excluding 4,400 non-billable trainees, offshore utilization stood at 72% vs. 68% a year ago and should rise throughout 2008. Worldwide headcount rose just 0.3% QoQ and 22% YoY to 59,500 in September. Attrition deteriorated to 17.6% from 17.0% a year ago and is attributed to the spike that usually follows annual salary hikes. Cognizant has elected not to disclose hiring plans in order to retain flexibility on such decisions. In the short term, we do not expect significant headcount growth – reflecting a more appropriately sized offshore bench that should neither compromise revenue upside, nor client requirements.

By industry, Financial Services ranked largest (46% of total revenue), followed by Healthcare (24%), Retail/Manufacturing/Logistics (16%) and Technology/Other (14%). Top-10 clients accounted for 29.7% of revenue, down from 31.0% in the June quarter. Cognizant added 63 new clients compared with 63 in the immediately prior period. It exited the quarter with an active roster of 550, up from 520 in June. Out of 124 strategic clients – those offering annual revenue potential of $5-50+ million – most still remain only 20-30% penetrated.

Cognizant posted CFFO of $140 million or $0.47 per share in the quarter. Proceeds from exercise of options amounted to $10 million. Major outflows comprised stock repurchases ($28 million) and capital expenditures ($61 million), budgeted to climb from $182 million in 2007 to somewhat less than the $250 million originally planned for 2008. Cognizant exited the quarter with net cash of $734.2 million, up from $686.3 million on June 30. Accounts and unbilled receivables improved to 73 DSOs from 77 in June.

CTSH shares are suitable for aggressive investors.
In our opinion, principal risks include: U.S. slowdown; rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses; correction in the Indian and/or U.S. markets; and political opposition.