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Cognizant Technology Solutions Corporation (NASDAQ:CTSH) announced financial results for the second quarter ended June 30, 2007. Revenue increased to $516.5 million, up 53% from the year-ago quarter and ahead of the $505 million consensus. Diluted EPS on a GAAP basis was $0.54, compared to $0.37 in the year-ago quarter and a $0.52 consensus estimate. The consensus estimate excludes $0.05 in stock based compensation that it shouldn’t.

The company also raised guidance for the rest of the year. For the third quarter they now expect at least $550 million in sales and $0.56 in GAAP EPS, which is in line with the consensus estimates but includes stock-based compensation. For the full year, the company expects $2.20 in GAAP EPS and $2.40 non-GAAP, compared with a $2.19 consensus.

As I have been saying for some time, it looks like the street is ignoring the good news and focusing on the employee additions:

Total headcount by end of 2007 expected to be approximately 55,000, reflecting the Company’s plan to increase utilization throughout the remainder of the year.

That implies about the same number of new employees as were added last year. But while last years increase amounted to 60% growth in employees, this year’s only amounts to 37.5%. Don’t get me wrong - that is still a very impressive number and the employees have historically been underutilized. Increased utilization can be a good thing.

But many will view this as the signal that there is a 15,000 employee per year limit to growth. Next year that would make for just 27% growth and the year after it would be just 21%. You can see that within a few years the growth rate would look “normal,” and the P/E would have to decline from the current 36x to perhaps half that. Then getting a really good return starts to become tough.

Consider that this year’s earnings growth is similar to last year’s headcount growth. If that continues, and assuming some increases to utilization:

• In 2008 EPS could grow 40% to $3.08.
• In 2009 EPS could grow 30% to $4.00.
• In 2010 EPS could grow 21% to $4.84.
• In 2011 EPS could grow 18% to $5.71.
• In 2012 EPS could grow 15% to $6.56.

I would guess that investors in Cognizant would be hoping for at least a doubling in share price over the next five years. For that to happen it would have to trade at a 25x multiple of my back-of-the-envelope estimate for 2012. While that is certainly possible, it hardly seems like a slam dunk.

CTSH 1-yr chart:

CTSH 1-yr chart

Source: Cognizant's Growth Begins To Tail Off

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