Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Cognizant Technology Solutions Corp. (NASDAQ:CTSH):
Investment Conclusion. Based on slightly lower (but more certain) near-term revenue growth assumptions, a new non-cash/non-deductible Indian Fringe Benefit Tax (NYSEARCA:FBT) expense, lower D&A and higher intermediate-term taxation – we are fine-tuning our estimates: 2008 GAAP diluted EPS is unchanged at $1.50 on revenue of $2.955 billion (38% YoY growth), down from our prior $2.985 billion projection; and 2009 GAAP diluted EPS goes to $1.80 on revenue of $3.988 billion (35% YoY growth) from $1.85 on revenue of $4.036 billion. We are also adjusting our target price from $53 to $50. In 12-months, this would correspond to 25-30x forward GAAP diluted EPS – a premium to the current depressed valuation (18x).
We are enthusiastically reaffirming our recommendation on the basis of industry-leading 25% EPS growth in calendar 2007-09E – including a one-time jump in the tax-rate; substantial margin flexibility (note the low offshore utilization with each 1% improvement = 50 bps impact); and the lowest currency exposure among offshoring majors (1% swing = 20 bps). Recent price weakness is attributed to investor concern over the U.S. IT spending environment (81% of revenue). In our view, initial 2008 revenue/EPS guidance will likely represent a floor. We note that recently filed incentive targets for senior management imply a par performance at 42.5% YoY revenue growth in 2008 (vs. our 38.4% estimate), 37.5% in 2009 (vs. 35.0%) and 32.5% in 2010. Signaling confidence in its future prospects, Cognizant also doubled its share repurchase authorization to $200 million in December.
4Q07 Results. GAAP diluted EPS of $0.32 vs. $0.23 a year ago on revenue of $600.0 million beat our $0.31 estimate on revenue of $595.2 million. EPS were held back by an FBT catch-up provision amounting to $0.02. Still, operating income advanced 39% YoY and matched our estimate. Highlights included 41% YoY and 7.4% QoQ revenue growth; a dramatic improvement in employee turnover to 12.4% from 17.0% in 3Q07; three wins valued at $100+ million each; and reassuring 2008 revenue/EPS guidance.
Takeaways. Areas of strength in 4Q07 included the Financial Services vertical (42% YoY and 9% QoQ growth); and European region (up 89% YoY and 15% QoQ to 18% of total revenue). Revenue included a $5 million contribution from marketRx, acquired in mid-November. Cognizant also credited the 4Q07 performance to an effective sales force and distinctive offerings: 7,500-person Testing practice, industry-specific BPO solutions, and fast-growing Infrastructure Management and SAP implementation services. During the quarter, Merck signed a three-year extension encompassing IT, Infrastructure Management and BPO services. Results have continued to benefit from above-average reinvestment in infrastructure, vertical/horizontal expertise and client partnerships.
A survey of the company's top-50 clients indicates ~80% of 2008 IT budgets have been finalized – consistent with recent years. Most clients expect flat or modest growth in overall IT spending, while increased emphasis on cost rationalization should drive a higher offshore allocation. The 2008 revenue outlook has been drawn from detailed client conversations, a bottom-up field forecast, pipeline review, assessment of the external environment plus some allowance for macroeconomic uncertainty. Separately, Cognizant did not rule out a moderation in annual wage inflation and is monitoring its peers.
Revenue from Application Management services advanced 42% YoY and 6% QoQ to 51% of the total. Revenue from discretionary Application Development & Integration projects rose 41% YoY and 8% QoQ to 49% of the total. Operating income of $106.1 million (17.7% margin) was in line with our $106.5 million estimate (17.9% margin) despite the $5.9 million FBT charge – explained by the revenue overage and control over discretionary expenses. Available levers for countering currency and wage pressures comprise offshore utilization, pricing and scale/SG&A efficiencies, i.e., rental, communications, marketing and back-office savings.
Hourly price realizations appear to have been stable QoQ at approximately $71 for onsite work (25% of billable workforce) and $24-25 for offshore (75%). Excluding 8,700 non-billable trainees, offshore utilization stood at 69% vs. 75% a year ago. Worldwide headcount rose 13.3% QoQ and 43% YoY to 55,400 in December. Attrition improved to 12.4% from 17% a year ago – and stands below a low-teens target. Hiring plans call for exiting 2008 with 72-75K employees, up 30-35% YoY. Less aggressive headcount growth vs. prior periods is a reflection of declining turnover and a more appropriate offshore bench (besides unprecedented rupee appreciation) – and should neither compromise revenue upside, nor client requirements.
By industry, Financial Services ranked largest (47% of total revenue), followed by Healthcare (24%), Retail/Manufacturing/Logistics (15%) and Technology/Others (14%). Top-10 clients accounted for 33% of revenue, down from 34% in the September quarter. Cognizant added 82 new clients – including ~40 that were acquired – compared with 55 in the immediately prior period. It exited the quarter with an active roster of 500, up from 445 in September. Out of 107 strategic clients – those offering annual revenue potential of $5-50 million – most remain only 20-30% penetrated.
Cognizant posted strong CFFO of $150 million or $0.50 per share in the quarter. Proceeds from financing activities (exercise of options and share repurchases) amounted to –$80 million. To date, Cognizant has repurchased 3.39 million shares of common stock for $105.4 million – or an average price of $31.10 per share. Other major outflows comprised an acquisition payment ($135 million) and capital expenditures ($72 million), budgeted to climb from $182 million in 2007 to $250 million in 2008. Cognizant exited the quarter with net cash of $641.0 million, down from $800.1 million on September 30. Accounts and unbilled receivables improved to 65 DSOs from 69 in September.
CTSH shares are suitable for aggressive investors. In our opinion, principal risks include: rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses; correction in the Bombay Stock Exchange and/or U.S. markets; and political opposition.