Cognizant (NASDAQ:CTSH) is a rapidly growing IT Services provider. Future earnings growth is likely to moderate for a number of reasons: 1) depreciation expense is likely to grow faster than sales; 2) operating margins are higher than the company’s long-term target; 3) the company currently enjoys tax holidays on a large portion of its revenue, and the holidays are set to expire in 2009; 4) revenue growth of 57 per cent annually will likely slow. However, the near-term growth outlook appears undeterred by these concerns. Investors should keep an eye on unbilled receivables and the relationship between cash flow and net income, which are the most significant blemishes on a fairly attractive fundamental picture.
Income statement analysis
Sales growth – overall revenues increased 57.1 per cent. By segment (in order of size), financial services customers grew 51.4 per cent, healthcare grew 77.2 per cent, manufacturing/retail/logistics grew 25.2 per cent and “other” grew 103.0 per cent. The “other” category grew as a result of the Fathom acquisition in Q205 and the addition of new customers, primarily media and new technology customers.
· Revenue recognition – fixed contracts (about 25 per cent of the total) are recognized under the percentage of completion method, which allows for significant management discretion as to the timing of revenues. Unbilled receivables grew 50 per cent sequentially in the first quarter, to more than $33 million, which was faster than either sales or billed receivables. A sharp rise in unbilled receivables sometimes indicates that management’s estimate of the percentage of work completed is too aggressive.
· Other – The top five and top ten customers accounted for approximately 30% and 42%, respectively, of total revenues in Q106 as compared to approximately 35% and 47%, respectively, for Q105. As the company adds new customers and increases penetration at existing customers, the percentage of revenues from top five and top ten customers should continue to trend down over time. However, the loss of one or more major customers could have a significant negative impact. In Q106 no customer accounted for more than 10 per cent of sales, though in Q105 there was one such customer (JPMorgan Chase.)
Seasonality – Rapid growth has obscured any seasonality to the company’s fundamentals. From a trading perspective, the stock tends to do best from September through February.
· Operating margins decreased to 18.6 per cent in Q106 from 20.5 per cent in Q105, due entirely to the requirement to expense stock options. Without that requirement operating margins would have increased to 21.5 per cent, which is above the company’s long-term target range of 19-20 per cent excluding option expense.
· Stock options – reduced earnings per share by $0.04 (11.1 per cent) in the first quarter. Although the company did not record option expense on the income statement in 2005, the valuation assumptions it used for its footnote disclosure changed. In 2006, the company used a lower volatility estimate (which reduced option expense) a longer average expected life for the options (which increased expense) and a higher risk-free interest rate (which increased expense.) Altogether, the changes in assumptions resulted in a 2.5 per cent higher option expense than the previous assumptions would have. (Source: Trading Today Option Calculator)
· Anomalous tax rates – from the 10Q: “Our Indian subsidiary, Cognizant India, is an export-oriented company, which, under the Indian Income Tax Act of 1961, is entitled to claim tax holidays for a period of ten consecutive years…. The majority of the Company’s (operations) in India are currently entitled to a 100% exemption from Indian income tax. Under current law, these tax holidays will be completely phased out by March of 2009. On March 31, 2006, the tax holiday expired for one (facility)…. The effective tax rate of 17.8% for the three months ended March 31, 2005 decreased to 16.6% for the three months ended March 31, 2006 primarily due to the Company’s overall growth, which resulted in a greater percentage of Cognizant India’s revenue falling under the income tax holiday.” By 2009, with the tax holidays expiring, the tax rate should increase toward the Indian statutory rate of 33.6 per cent. This will act as a one-time reduction in earnings growth as the tax rate steps up. (After the change the rate will remain higher but should not get incrementally higher in future years.)
· Other – the majority of Cognizant’s sales are booked in US dollars, but a majority of its expenses are in Indian rupees. Fluctuations in the exchange rate could have a significant impact on operating margins.
Other – diluted share count increased by five million year/year (2.5 per cent.)
Balance sheet analysis
Debt load and maturity schedule – minimal debt.
Value of unexercised options – the intrinsic value of unexercised options is $673 million, which is the minimum value for what some analysts consider to be an off-balance sheet liability.
· Doubtful accounts – allowance for doubtful accounts was flat, despite significant sequential growth of 11.1 per cent in revenues, and 19.7 per cent in accounts receivable. However, the difference in accrual rates was immaterial to EPS and the company beat consensus estimates by $0.03.
Receivables trends (DSO) - Receivables grew faster than sales in Q1.
Long-term or unbilled receivables - $33 million unbilled
Cash flow analysis
Operating cash flow and net income trends – net income increased by $17.2 million year/year to $47 million, while cash from operations was negative in the first quarter of both periods. Cash from operations deteriorated by $3.5 million to a $3.9 million deficit in Q12006. However, the requirement to expense stock options resulted in a reclassification of $9.1 million from operating to financial cash flows. Without this change, cash from operations would have increased $5.6 million year/year and been positive, although both the growth and the total cash provided by operations would have been much smaller than net income. This is part of a longer trend, as cash flow was $22 million higher than net income for FY03 and $27 million higher for FY04, but was $7 million less than net income in 2005. As the relationship of cash flow to net income is considered one of the most important indicators of earnings quality, this is a significant trend to monitor.
Free cash flow and net income trends – free cash flow remains positive but is now trailing net income significantly. This may simply be a function of the company’s rapid growth.
Capital investment relative to depreciation – As befits a rapid growth company, capital expenditures are much higher than depreciation. In 2006 capex was three times the level of depreciation due to aggressive expansion of their facilities in India. The higher spending will increase depreciation in future years, which will act as a headwind for earnings growth, but the facilities will house more consultants who presumably will drive revenue growth.
Legal issues – none disclosed.
Social concerns – immigration and offshoring remain hot-button issues and could expose the company to negative publicity, legislation, or boycotts by certain investor groups.
Guidance - On its May 3, 2006 earnings report, the company provided the following guidance:
* Second quarter 2006 revenue anticipated to be at least $317 million.
* Second quarter 2006 diluted EPS expected to be approximately $0.33 on a GAAP basis, and $0.36 on a non-GAAP basis, which excludes the impact of stock-based compensation expense.
* Fiscal 2006 revenue now anticipated to be at least $1.3 billion.
* Fiscal 2006 diluted EPS expected to be at least $1.37 on a GAAP basis.
* Fiscal 2006 diluted EPS expected to be at least $1.52 on a non-GAAP basis, which excludes the impact of stock-based compensation expense.
* Total headcount by end of 2006 expected to exceed 35,000.
Consensus estimates are currently at the high end to slightly above management’s guidance range.
Backlogs – while the company does not have backlogs per se, it added five strategic clients (clients expected to eventually contribute $5 million per year or more in annual revenue) in the first quarter, ending the period with 72.
Deferred revenue - unknown
Macro-economic factors – For its onsite staff, Cognizant relies primarily on Indian nationals. These employees require visas to work in the customer’s homeland. In the US, where Cognizant currently generates the bulk of its revenue, the award of H-1b and other visas has been restricted significantly since the 9/11/2001 terrorist attacks. A significant disruption to visa issuance could curb growth, at least temporarily.
Industry growth – very rapid
Market share and trends over time – the industry is very competitive but difficult to define narrowly. Cognizant’s nearest competitors, who also employ an onsite/offshore model, are Infosys (NYSE:INFY), Tata Consultancy Services, and WIPRO (NYSE:WIT). In addition, large IT consulting firms such as Accenture (NYSE:ACN), IBM Global Services (NYSE:IBM), and Electronic Data Systems (NASDAQ:EDS) offer offshore services. Finally, many potential customers have in-house IT staffs.