Cognizant Technology: Expecting Growth in 2009

| About: Cognizant Technology (CTSH)

Cognizant Technology Solutions Corp. (NASDAQ:CTSH)

Investment Conclusion

Based on slow IT spending in a deepening global economic downturn – with above-average exposure to the troubled Financial Services segment – we are reducing our estimates as follows: 2009 GAAP diluted EPS to $1.50 on revenue of $2.955 billion (+5% YoY) from $1.60 on $3.103 billion; and 2010 GAAP diluted EPS to $1.60 – including a one-time jump in the tax-rate – on $3.406 billion (+15% YoY) from $1.75 on $3.723 billion. Our current model assumes no sustained upturn in revenue until the December 2009 quarter. In the present environment, any growth in revenue and EPS in 2009 should attest to the durability of a business model.

We are trimming our target price from $30 to $28. In 12-months, this would correspond to 15-20x forward EPS – a premium to the current valuation (14x). Our Buy rating remains in effect on the basis of projected upside, as well as industry-leading revenue and EPS growth in calendar 2008-10E.

4Q08 Results. GAAP diluted EPS of $0.38 on revenue of $753.0 million missed our $0.39 estimate on $747.2 million. Results included a non-operating foreign exchange loss (due to weakening of European currencies vs. the USD) of $11.4 million or $0.03 per share, which was telegraphed in a December 5 filing with the SEC; as well as a slightly higher tax-rate. Operating income advanced 34% YoY and beat our expectation. Highlights included 26% YoY and 2.5% QoQ revenue growth. Also during the quarter, the board authorized a new $50 million stock repurchase over 12 months.

Details. Revenue from ongoing Application Management services rose 5.5% QoQ to 55% of the total. Revenue from discretionary Application Development & Integration projects contracted 1% QoQ to 45% of the total. Areas of relative strength included the Healthcare vertical (+9% QoQ on a reported basis and 25% of total revenue) and Retail, Manufacturing & Logistics (+7% QoQ and 16% of revenue); North American region (+4% QoQ and 80% of revenue); and IT Infrastructure and BPO practices (+16-37% QoQ and 5-6% of revenue). On a constant currency basis, Europe remained resilient (+5% QoQ and 18% of revenue). Meanwhile, weakness was noticeable across the Other/Technology segment (-5% QoQ and 13% of revenue) and Financial Services (flat QoQ and 45% of revenue). Operating income of $142.7 million (18.9% margin) surpassed our $133.0 million estimate (17.8% margin). Profitability benefited from QoQ rupee depreciation and unexpected top-line strength in the second half of the quarter.

Excluding 3,000 unbilled trainees, offshore utilization stood at 70% vs. 69% a year ago. Worldwide headcount rose 3.7% QoQ and 11% YoY to 61,700 in December. Attrition improved to 11.5% from 12.4% a year ago. Cognizant is honoring its prior campus commitments albeit with later start-dates.

Cognizant posted CFFO of $193 million or $0.65 per share in the quarter, aided by strong collection activity. Major outflows comprised capital expenditures ($23 million), budgeted to climb from $169 million in 2008 to $175-200 million in 2009. Cognizant exited the quarter with net cash of $902.9 million ($3.00 per share). Unlike Infosys (NASDAQ:INFY), Wipro (NYSE:WIT) and Patni (NYSE:PTI) – it did not provide a voluntary disclosure of cash balances held at various financial institutions.

Management commentary

  • Guidance includes room for a worsening economic environment but still anticipates a modest pick-up in 2Q09 based on current spending plans. The ~2% sequential drop in 1Q09E revenue is attributed to weakness across core banking clients, budget delays and cutbacks, decommissioning of duplicate systems at recently merged banks, currency headwinds ($4-5 million) and 2% fewer billing days vs. 4Q08. Despite shortcomings in the Financial Services segment, Cognizant expressed longer-term optimism since its clients are reshaping the banking industry. On the pricing front, Cognizant noted some softness in 1Q09. It remains open to pricing concessions that are offset by volume growth. In the absence of widespread irrational behavior, pricing pressure is not likely to be material or come in the way of achieving 2009 revenue guidance.
  • Clients are placing greater emphasis on certain vendor attributes, i.e., a trusted partner with unswerving commitment; deep industry knowledge combined with service innovation; and the highest standards of corporate integrity and ethics.
  • In a difficult environment, Cognizant expects to strengthen its business by taking market share and acquiring companies/talent, catering to demand for cost containment services and focusing on operating discipline. For instance, Cognizant recently acquired a 30-person outfit that specializes in implementation of Oracle (NASDAQ:ORCL) based Retail solutions. In 4Q08, Cognizant also initiated a hedging program ($350 million @ INR 49.44) to shield a portion of its rupee-denominated expenses.
  • Cognizant expects no direct/adverse impact from currently proposed TARP/H-1B legislation.

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.

Disclosure: I, Ashish Thadhani, certify that all the views expressed in this research report accurately reflect my personal views of the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of this report.