Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Cognizant Technology Solutions Corp. (CTSH):
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CTSH: Reset Guidance Removes Market Overhang; Target $44
Investment Conclusion. Based on a more cautious but achievable revenue outlook and slightly lower interest income – cushioned by recent rupee depreciation – we are reducing our estimates: 2008 GAAP diluted EPS to $1.44 on revenue of $2.811 billion (32% YoY growth) from $1.50 on revenue of $2.900 billion); 2009 GAAP diluted EPS to $1.80 on revenue of $3.621 billion (29% YoY growth) from $1.92 on revenue of $3.842 billion; and 2010 GAAP diluted EPS to $2.10 on revenue of $4.617 billion (28% YoY growth) from $2.21 on revenue of $4.898 billion. We are also adjusting our target price from $45 to $44. In 12-months, this would correspond to 20-25x forward EPS.
Recent price weakness can be attributed to renewed concern over the U.S. IT spending environment (78% of revenue). Nonetheless, we are reaffirming our Buy rating on the basis of industry-leading 25% compound EPS growth in calendar 2007-09E, backed by substantial margin flexibility (note utilization headroom) and an attractive valuation (17-18x forward EPS).
Due to deterioration in the macroeconomic environment and overall business confidence, Cognizant has assumed a more conservative stance for 2008. Revised revenue guidance includes 5.5% QoQ growth in 3Q08 (vs. our prior 10.0% estimate and 2.0-5.5% at peers) and 5.0% QoQ growth in 4Q08. Near-term revenue should be driven by ramp-up of prior wins and allows for increasing reassessment of spending plans in the Healthcare and European segments. The long-term outlook remains positive given a healthy pipeline, greater emphasis on cost rationalization initiatives and recent competitive wins. Current management priorities focus on the bottom-line, demonstrating offshoring effectiveness to clients and deepening domain capabilities.
2Q08 Results. GAAP diluted EPS of $0.35 vs. $0.27 a year ago on revenue of $685.4 million matched our $0.35 estimate on revenue of $681.7 million. Operating income advanced 32% YoY. Highlights included 33% YoY and 6.6% QoQ revenue growth.
Takeaways. Cognizant posted better-than-expected growth in the Financial Services segment (+29% YoY and +7% QoQ). Areas of strength included the Manufacturing vertical (+38% YoY and +10% QoQ growth) and European region (up 83% YoY and 15% QoQ to 20% of total revenue). The relatively small BPO and Infrastructure Management practices also recorded double-digit QoQ revenue growth. Meanwhile, revenue in the Healthcare segment rose 39% YoY but just 3% QoQ. Management confirmed moderation in annual wage inflation to 10% (effective late-2Q08) vs. 12-16% in recent years. In June, Cognizant acquired Strategic Vision Consulting, a Los Angeles based firm with 60 employees serving the media and entertainment industry. Since 1995, SVC has become trusted advisor to various studio executives and is well positioned to capitalize on the digital transformation of this industry.
Revenue from Application Management services advanced 34% YoY and 8% QoQ to 53% of the total. Revenue from discretionary Application Development & Integration projects rose 32% YoY but only 5% QoQ to 47% of the total. Operating income of $119.7 million (17.5% margin) was in line with our $119.3 million estimate (17.5% margin). Available levers for countering wage and currency pressures comprise offshore utilization 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 $72-73 for onsite work (25% of billable workforce) and $24-25 for offshore (75%). Excluding 7,000 non-billable trainees, offshore utilization stood at 70% vs. 68% a year ago and should rise throughout 2008. Worldwide headcount rose 2.2% QoQ and 30% YoY to 59,300 in June. Attrition improved to 15% from 17% a year ago. Cognizant has elected not to disclose future hiring plans in order to retain flexibility on staffing decisions. In February, it planned to exit 2008 with 72-75K employees, up 30-35% YoY. We now expect less aggressive headcount growth – reflecting a more appropriately sized offshore bench that should neither compromise revenue upside, nor client requirements.
By industry, Financial Services ranked largest (46% of total revenue), followed by Healthcare (24%), Retail/Manufacturing/Logistics (16%) and Technology/Other (15%). Top-10 clients accounted for 31% of revenue, unchanged from the March quarter. Cognizant added 63 new clients compared with 56 in the immediately prior period. It exited the quarter with an active roster of 520, up from 505 in March. Out of 118 strategic clients – those offering annual revenue potential of $5-50 million – most still remain only 20-30% penetrated.
Cognizant posted CFFO of $75 million or $0.25 per share in the quarter. Proceeds from exercise of options amounted to $39 million. Major outflows comprised an acquisition payment ($12 million) and capital expenditures ($32 million), budgeted to climb from $182 million in 2007 to somewhat less than the $250 million previously planned for 2008. To date, Cognizant has repurchased 3.39 million shares of common stock for $105.4 million – or an average price of $31.10 – and has $95 million still available under its current program. Cognizant exited the quarter with net cash of $686.3 million, up from $617.4 million on March 31. Accounts and unbilled receivables slipped to 77 DSOs from 73 in March.
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.
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.