This article is a reprint of my February 11, 2008 RealMoney column
After Cognizant Technology Systems (CTSH) declined sharply upon reporting its third quarter results, I said the stock was looking like a high-growth value trap. Since that article, the stock has declined 5.3%, though Friday’s 15% rally (spurred by the company’s fourth quarter results) puts it ahead of the 10.1% loss in the S&P 500 over that period.
Jay Somaney outlined a solid case for why he believes Cognizant’s report marked the bottom for Indian tech stocks. While I encourage anyone interested to read his article, when I dug into the report I came away with the opposite conclusion, and remain bearish on Cognizant.
The problem boils down to this: Cognizant executed so well on so many different metrics this quarter that anything less than perfection in the future is likely to disappoint.
To start with, for a consulting business like Cognizant’s revenue growth has to come from either adding more employees or increasing their productivity. Historically Cognizant has done more of the former, but it has now begun shifting to the latter.
Cognizant ended 2007 with 55,400 employees, a 38% increase from year-end 2006. The 16,500 net new employees were slightly above the 15,000 added in 2006, though staff turnover declined for both the quarter and the full year. For 2008, Cognizant is guiding for 17,000 to 20,000 additional net recruits, which amounts to about 33% growth in headcount.
Meanwhile, the company is projecting revenue gains of “at least 38%.” While there is certainly room to increase utilization from the current 56%, there is a limit to how much can be done. What’s more, with the increased productivity I would normally expect an increase in operating profit margins. Yet the company is guiding to the same 19-20% operating margin range that they always have, and that is “assuming no material appreciation in the Rupee” versus the dollar. To me, that implies that the higher productivity is being offset by higher wages for employees.
There’s also room for doubt around whether performance can be sustained in the financial and retail sectors, which both grew about 50% in 2007.
To make things worse, Cognizant has benefited from tax breaks in
I frequently gauge the quality of reported earnings by measuring the accrual ratio, or the change in operating assets as a percentage of average net operating assets. As a measure of the percentage of earnings explained by accounting choices rather than cash flow, ideally the ratio should hover around zero. After several quarters of improvement or stabilization, Cognizant’s earnings quality deteriorated significantly.
Sources: Zacks Research Wizard and company filings, compiled by William A. Trent
On the positive side, the company overcame my concern that headcount growth was stuck at 15,000 per year. Plugging in potential increases in the number of employees added each year improves my five year outlook for the shares, which previously suggested little growth in share price over that time.
Unfortunately, though, it isn’t enough to whet my appetite. After incorporating both the higher head count and the higher tax rate, my new best-guess estimate of the price in five years is about $47 per share. At less than 6.5% per year in expected returns, I see greener pastures elsewhere.
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