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We have written several times on Cognizant Technology Systems (CTSH). The IT outsourcing firm has been growing rapidly and gaining market share, and trades at a price/earnings multiple in line with its growth rate, which is to say uncommonly low compared to other high-growth technology names.

We noted before our belief that the greatest risk for Cognizant is managing its growth. We still believe that, although recently the stock is trading down due to some of the other risks it faces.

For one, Cognizant is a high-growth, high-beta Nasdaq name, and when the Nasdaq rises or falls one might expect Cognizant to do the same, in spades. However, due to its exposure to India, Cognizant also tends to trade in line with that market. As the chart below demonstrates, over time Cognizant tends to perform somewhere in between the Nasdaq markets and the Indian market (we use The India Fund (IFN) as a proxy for that market.)

CTSH, IFN, and IXIC comparative performance, last 2 months:

CTSH 1

Both Bloomberg and the New York Times highlighted yesterday’s 10 per cent drop in Indian markets. They make Cognizant’s 3.5 per cent drop look tame. Seeking Alpha has charts of the weekly performance of US-traded Indian stocks that highlights just how well Cognizant has reacted (it had the third-best performance).

CTSH # 2

Bloomberg pinned the blame for falling India shares on Japanese investors taking money off the table. Alternatively, it could be one of a host of other risk factors, including political risks, perceived risks in the Indian rupee/US dollar exchange rate, etc. It doesn’t much matter while the shares are falling.

Cognizant is the type of high-quality company that is worth buying when the market turns sour. However, it is also worth waiting until the bottom has been put in. No sense trying to catch a falling knife, as they say.

Still, while we continue to believe that Cognizant is a good value, there are certainly a fair share of naysayers who believe the company is still overpriced at current levels.

Weighing in on the bear side is a recent article from Motley Fool, "Considering a Costly Cognizant." In it the author lists four reasons why it’s overpriced:

* No moats. Forty-nine percent of Cognizant’s revenues comes from financial applications, where a large number of providers — global, U.S., or Indian — jostle for space. Research indicates that no single vendor has more than 5% market share. Without an easily distinguishable product, or a large market share, I don’t see any significant barriers to entry, nor much scope for price increases. The rest of Cognizant’s business consists of the health care, manufacturing, and “others” segments. Again, in my opinion, those sectors have plentiful competition.

* Can’t leverage fixed costs. Cognizant, like many rivals, customizes solutions for clients such as banks, brokerages, and insurance companies. Solutions and services are not products that can be sold, so revenues are contract-driven. Historically, outsourcing companies like Cognizant have trouble leveraging the fixed costs that come with any price increases they manage to gain from customers. Any gains are usually consumed by higher marketing expenses or passed along to employees.

* More competition. Global giants such as Accenture are scaling up in India, and financial-sector giants such as JPMorgan Chase are setting up their own captive centers there. This March, EDS’s headcount in India after its Mphasis acquisition shot up from 3,000 to 14,000. Accenture wants to go from 24,000 in India, China, and the Philippines today to 50,000 in the next three years. Lehman, which used to outsource work to Wipro and TCS, now wants to run its own India operations, as does MetLife. If everybody’s in India, what happens to the cost advantage?

* Unimpressive margins. Historically, Cognizant’s margins of 20% have been lower than market leader Infosys’ 28%. Its 2005 average revenue per employee, $36,420, was also much lower than Infosys’ $54,674 and Wipro’s $46,882. Critically, Infosys has always managed to price its services higher than its competitors. Cognizant hasn’t.

Valid arguments, all.

It is worth noting that Cognizant has chosen to limit margins itself by investing in future growth. When business is strong enough that margins start creeping above their 20 percent target, they speed up their hiring process and bring in more college grads.

For the first year these new employees are a money-losing proposition as they must receive extensive training. Yet without them there is no potential for future growth due to the nature of the consulting business.

Furthermore, regardless of how much competition there is or how many companies are starting their own IT offices in India, there is no indication that growth will slow any time soon. The Motley Fool author notes that his own IT offshoring business is booked solid through 2009. Some investments are about moats and leverage. Cognizant is about a massive secular shift that will take several years to complete.

As this shift winds down it will be important to reconsider the sustainability of Cognizant’s business. In the meantime, there are more pressing concerns.

CTSH 1-yr chart:

CTSH 1 yr

Source: Cognizant of the Risks (CTSH)