Cognizant Likely To Top Newly Raised Guidance

| About: Cognizant Technology (CTSH)

IT outsourcing wonder Cognizant Technology Solutions (NASDAQ:CTSH) reported record fourth quarter results and the market is happy.

Revenue for 2006 increased to $1.424 billion, up 61% from $885.8 million in 2005. GAAP net income was $232.8 million, or $1.55 per diluted share, compared to $166.3 million, or $1.13 per diluted share in 2005. GAAP operating margin was 18.2%. Excluding stock based compensation expense of $29.9 million, non-GAAP operating margin was 20.3%.

Since the revenue and earnings for both the quarter reported and the guidance for next quarter exceeded estimates, the stock is rallying and is already up 5.6% today.

The company also appears to have done a good job managing employee turnover (though that remains our biggest concern). According to the release, the company added a net total of almost 4,500 employees in the fourth quarter and more than 14,500 employees in 2006 overall, bringing their total employee count to more than 40,000. That means that during 2006 the employee count grew by 14,500/(40,000-14,500)=57%. This is important because Cognizant is a consulting firm, and increasing headcount is the primary way such firms can increase future revenues.

While a simplified assumption, we nonetheless believe that the headcount growth is a reasonable starting point for estimating next year’s revenue growth. And taking last year’s 57% growth in employees and applying it to last year’s revenue of $1.424 billion yields an initial guesstimate of $2.24 billion in 2007 revenue, which leaves a substantial cushion for the firm to beat its new revenue guidance of $2.04 billion.

This is not to say that employee attrition is no longer a concern, as a slowdown in employee growth (even to a fairly torrid 30%) would make it difficult to justify today’s multiple. Adding 14,500 employees this year would only make for 37% growth rather than 57%. However, while we believe that ultimately the employee growth will be the factor that stalls Cognizant, as long as the company continues to find staff, the stock can probably continue its steady climb.

CTSH 1-yr. chart:

CTSH 1-yr. chart