CTSH: Don’t Fall into Cognizant’s Value Trap

This article was originally published at RealMoney on November 7, 2007

Don’t Fall Into Cognizant’s Value Trap

Cognizant Technology Solutions (CTSH) is trading down more than 16% after issuing revenue guidance slightly below expectations. Although buying a stock posting 50% earnings growth for a multiple in the 30’s may appear appealing, I think doing so would catch you in a value trap.

As I have noted elsewhere, Cognizant’s labor-intensive business requires adding people in order to add revenue. In fact, the growth in one year’s headcount has generally closely predicted the following year’s growth in revenue. Historically that has not been a problem.

In 2007, however, Cognizant is adding the same absolute number of employees as it did in 2006 – about 15,000. 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 what if the 15,000 employees per year is an upward limit? 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. Then getting a really good return starts to become tough.

PEGging Down the Value

I am no fan of the PEG ratio, which wrongly assumes that growth and valuation have a linear relationship. But many Cognizant investors seem to put some faith in it, arguing that the P/E multiple is low given how much Cognizant is growing. Looking back, Cognizant’s PEG has consistently ranged around 1.0 – which suggests that investors may truly be using it as a gauge. Whatever my own feelings about the PEG’s merits, if it drives the stock price I will pay attention to it.

Sources: Zacks Research Wizard, William A. Trent

So if a PEG of about 1.0 is where the shares will trade, what are the implications of a 15,000 employee per year growth in headcount?

For simplicity’s sake, I am assuming that the employee growth will predict the following year’s revenue growth and that margins will be constant. Increased utilization could make those estimates conservative, while a rising rupee and ongoing wage inflation could make them appear aggressive. For this illustration I’m implicitly assuming those factors will cancel each other out. If you disagree, it is a fairly simple matter to adjust my assumptions to fit your forecast.

Here’s how things would trend using those assumptions for the next five years:

All of the increase in earnings is offset by an equal or greater reduction in the growth rate. Today’s buyer at $33 on the basis of a low PEG ratio should be prepared to sell in five years for a whole $35.

Another Perspective

As I said, I don’t put much faith in the PEG ratio. Therefore I don’t want to draw all my conclusions from it despite its past usefulness in explaining the stock price. For another perspective I turn to my favorite tool, free cash flow yield.

In the last 12 months, Cognizant generated about $138 million in free cash flow (cash from operations less capital expenditures.) With a $9.5 billion market cap after today’s shellacking, the yield is still less than 1.5% – far lower than I could earn on a risk free treasury bond.

On the other hand, Cognizant’s cash flow could grow while the treasury interest payment will not. In the past, cash flow has risen in line with earnings. However, in the last 12 months it has not grown even though EPS have. Still, I will assume that the free cash flow will match the earnings growth over the next five years to reach $326 million in 2012.

By then, the growth will have sufficiently normalized that I would expect at least a treasury-like yield. At 20x the free cash flow, I would only be willing to assign a $6.5 billion valuation in five years. That is nearly a third less than the current valuation.

Either way I cut it, Cognizant is looking to me like a high-growth value trap.

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