I began expressing concerns about Cognizant Technology Solutions (CTSH) a year ago.  Even when earnings were stronger than expected in February, I stuck to my guns, saying “Cognizant executed so well on so many different metrics this quarter that anything less than perfection in the future is likely to disappoint.”

It didn’t take long. The company’s expectations for the coming quarter are below street estimates, which is very unusual for a company whose typical guidance is for “at least (insert consensus estimate here).” Chief Executive Francisco D’Souza said the company has adopted a more cautious view for the remainder of the year “to reflect the heightened economic challenges over the past two months.”

Since my November RealMoney piece, the stock has lost 6.8%, compared to a 4.0% loss on the S&P 500. I’d call that a push, given that the fundamental thesis appears to be working. Long term, however, I expect the stock price to reflect the fundamentals. While there is still room to grow, I don’t expect returns to be anywhere near the past levels. In fact, the stock is basically at the same price it was two years ago and I expect single-digit returns for the next several years.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this article.

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 India, which are set to expire in March 2009. The tax rate is expected to rise from 16.5% this year to about 25% in 2009 as a result. Over time, it is likely to gradually creep toward the statutory 33.66% rate in India. But for 2009 the drag will be significant, keeping the EPS growth rate well below the growth in revenue.

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.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

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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I recently addressed concerns that Cognizant’s (CTSH) growth - as well as that of other Indian outsourcing firms - may be peaking. Now it seems that those in thee industry may be wondering the same thing.

Is the party over for Indian outsourcers? - Business - News - ZDNet Asia

A confluence of adversities is at play. They include an appreciating rupee that is cutting into earnings, a severe shortage of qualified talent at home, and a cap on H-1B worker visas to the U.S., along with pre-2008 election protectionism threats.

On top of that, there is the end of preferential industry tax benefits at home and the growing success of multinational competitors such as Accenture and IBM on Indian turf. Perhaps most challenging for the Indian players is the pressing need to move up the ladder into business consulting, a domain that companies such as IBM have dominated for decades. Indian outsourcing firms need to invest heavily to secure a position in this arena, and that will erode their fat profits, at least in the short term.For the first time, industry insiders are asking: Is the outsourcing game over for Bangalore? “The Indian IT companies have had an unusually long run in profits and growth,” says Siddharth Pai, partner and managing director of global tech advisory TPI Advisory Services India. But that is “an anomaly”, he adds. “As they mature, they cannot expect the same kinds of returns.”

It is healthy that industry insiders are beginning to worry about the issue. Nothing is more dangerous than cocky management teams. For investors, though, there still needs to be an adjustment to the risks that growth will not be what it used to be.

Cognizant Technology Solutions Corporation (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.

Infosys (INFY) profit rose 34.5% but its full-year outlook was cut due to a rising rupee, according to MarketWatch:

Net profit for India’s second-largest software exporter rose to 10.79 billion rupees ($268.8 million) in the quarter ended June 30, from 8 billion rupees a year earlier. Earnings per share for the quarter rose 31.5% to 18.89 rupees (47 cents).

Infosys said it was reducing its earnings-per-share forecast for the full year, in accordance with Indian accounting standards, to at least 78.20 rupees from its April forecast of at least 80.29 rupees. It made the revision because of a sharp appreciation of the Indian currency against the U.S. dollar.

In dollar terms, the company’s revenue of $928 million and earnings per share of $0.46 were better than the analyst estimates of $909 million and $0.40. However, full-year guidance of $4.0 - $4.05 billion in revenue and $1.92-$1.94 in earnings per share are disappointing. Analysts were expecting $4.07 billion in revenue already, and even though the official estimates were for $1.84 in EPS, $0.06 of upside was provided in the past quarter, and investors were surely hoping for more than another $0.02 for the remainder of the year.

When I previewed earnings on Sunday, I said “The $0.40 consensus estimate factors in slowing growth, but the degree of earnings surprise has been narrowing in recent quarters. Given my own experience with outsourcing recently and the general employee retention issues, I think we’ll see some disappointments in this sector over the next couple of quarters.”

So far, the company is blaming the crunch not on the tight job market but on the rising rupee - but the other factors were not written off entirely:

“The sharp appreciation of the rupee against all major currencies impacted our operating margins during the quarter,” said V. Balakrishnan, Chief Financial Officer. “However, our robust and flexible operating and financial model enabled us to maintain our net margins while absorbing the impact of appreciating currency, higher wages and visa costs.

These are all pressures on an employee-centric enterprise founded on the major wage discrepancies between their home country and those of their customers. If wages and the home currency both rise by 10% annually (in many cases it is even faster) relative to customers, it doesn’t take long for that disparity to reverse. And it takes even less time for the disparity to narrow sufficiently to stall out a 30% growth rate.

Conventional wisdom holds that magazine cover stories are contrarian indicators - by the time a company’s success or failure reaches the cover page of a major publication the story is so well known as to be completely reflected in the stock price. Therefore, all good news is priced in and the stock can only underperform or all bad news is priced in and the stock can only outperform.

While simplistic, the magazine cover indicator now has the support of recent academic research. This research did find that cover story headlines on Business Week, Fortune and Forbes tended to indicate that the mood (bullish or bearish) of the story was about to change in the market.

As a result of this research, we have decided to develop a portfolio of stocks based on using those three magazine’s covers as a contrary indicator. We also track this portfolio on StockPickr. This week’s results:

International Business News : Business News, Technology Industry News

The Real Cost Of Offshoring
U.S. data show that moving jobs overseas hasn’t hurt the economy. Here’s why those stats are wrong

Contrary Pick: Hmm. Is this headline negative about offshoring or the US economy? I’m going with offshoring and saying the contrary pick is to buy the offshore firms like Cognizant (CTSH), Infosys (INFY) and Wipro (WIT).
Forbes and Fortune, being bi-weeklies, were not updated this week.

Cognizant’s recent slowdown in net hiring has taken the wind out of its sails, and we have said several times that the biggest threat to the offshore IT providers is sustaining the employee growth that will be needed to sustain revenue growth - especially given the industry’s high employee turnover rates.

With several of the earnings reports from leading IT outsourcers and offshorers now in, we thought it an opportune time to peruse the conference call transcripts for clues.

First off, it is clear that demand remains strong.

George Price - Stifel Nicolaus

Where are we in terms of headcount in India? And then targets going forward by the end of the fiscal year?

Bill Green

I think I mentioned that we were in the mid-50s, in terms of total numbers. I think we were at 35,000 or targeting 35,000 by the end of the fiscal year. You know, the growth just continues, George, to expand there now with the management consulting expansion. We’re just going to see more substantive growth there. So we’re still on-target to hit the end of the fiscal year number that we’ve been throwing around.

(Excerpt from full ACN conference call transcript)

However, the demand is also putting pressure on wages.

We are increasing the offshore wages by somewhere between 13% to 15% and onsite wages for people outside India by 5% to 6%.

Overall, the impact on the margins because of the wage increases is something around 300 basis points, and we are assuming the rupee/dollar rate at 43.10. The average for fiscal ‘07 was 45. So, that could have an impact of something around 150 to 160 basis points on the margin.

(Excerpt from full INFY conference call transcript)

Margins are under pressure due to a rising rupee as well.

Now, this quarter our operating margin dropped by 100 basis points. This is primarily on account of rupee appreciation. But as we look forward, we have given guidance where we expect the profitability to be maintained at the same percentage level next year.

(Excerpt from full INFY conference call transcript)

Cognizant even claims that the slower hiring pace is just to protect margins:

And in the end, why are we slowing down hiring, because we want to stay within our target margin range, which we feel we can do without disrupting the business at all, because we are running such a low utilization today.

(Excerpt from full CTSH conference call transcript)

This explanation, however, doesn’t hold water with us. For one thing, low utilization has been the norm as the companies bring hires through the training program and prepare for expected turnover. Whether the margin impact is due to rising wages, currency issues or anything else is not the point as they are all symptoms of competition for workers. Instead, the point is whether the employees will add productivity or will allow revenue to grow only in line with employee count. We don’t see why it would be any more important to protect margin now than it would have been a year ago. To some extent it appears Infosys agrees.

S. D. Shibulal

Well, a higher utilization actually creates stress within the system because it’s like having a manufacturing plant and you cannot have people come just in time all the time. So, it made sense for us to have some amount of strategic bench, especially when you are bidding for large deals. And when large deals come into picture, there is one-time investment of people acquired. And today, on an average, every quarter we close some large deals, some multimillion dollar multiyear deal gets closed in every quarter.

So, it was important for us to build a strategic bench. At the same time, at this point in time, we have the fleet transferring too in the bench without impacting the business — including the utilization, without impacting the business.

(Excerpt from full INFY conference call transcript)

One key to continuing growth as the headcount increases is to reduce turnover. Some progress has been made here.

During the quarter, our annualized employee attrition declined to 15% from 17% in Q4. While we are pleased with our sequential progress in this area, attrition remains above historical levels. We continue to monitor employee attrition carefully and take necessary short and long-term steps to manage it.

(Excerpt from full CTSH conference call transcript)

Given Cognizant’s 43,000 employee count, a 2% reduction in annual turnover offers the same benefit as hiring 860 employees in a year. They also seem to be focusing on hiring the real revenue generators:

The increase in cost of revenues was due to additional technical staff for on-site and offshore required to support our revenue growth. We increased our technical staff by over 4,300 during the quarter and ended the quarter with approximately 40,800 technical staffs. This is a net increased of almost 15,750 technical staff from March 31, 2006.

(Excerpt from full CTSH conference call transcript)

Because of the ability to focus the hiring, because of increased productivity as employees gain experience and because of the low current utilization there is certainly some room for the companies to grow faster than they add employees. However, this ability is somewhat temporary. Long term, more sales will require more bodies. The question is whether those bodies can be found and retained.

When we previewed earnings for Cognizant Techonolgy Solutions (CTSH) we said “one of these days the growth will hit a wall, but probably not this day.” Today the company reported earnings:

Revenue for the first quarter increased to $460.3 million, up 8% from $424.4 million in the fourth quarter of 2006, and up 61% from $285.5 million in the first quarter of 2006. GAAP net income was $75.4 million, or $0.50 per diluted share, compared to $47.2 million, or $0.32 per diluted share, in the first quarter of 2006. GAAP operating margin for the quarter was 18.2%. Excluding stock based compensation expense of $7.4 million, non-GAAP operating margin was 19.8%, in-line with the Company’s targeted 19 to 20% range.

So far, so good as the consensus was expecting $0.48 on $451 million in sales. Likewise, next quarter’s consensus target of $0.51 on $496 million in sales appears to be in the bag. However, Cognizant’s full-year “at leasts” don’t quite make the cut of current estimates.

2007 Outlook - Second Quarter & Full Year Based on current visibility, the Company is now providing the following guidance: — Second quarter 2007 revenue anticipated to be at least $500 million.

– Second quarter 2007 diluted EPS expected to be $0.51 on a GAAP basis, and $0.56 on a non-GAAP basis, which excludes the impact of stock- based compensation expense of $0.05.

– Fiscal 2007 revenue now anticipated to be at least $2.07 billion.

– Fiscal 2007 diluted EPS expected to be at least $2.13 on a GAAP basis, and at least $2.34 on a non-GAAP basis, which excludes the impact of stock-based compensation expense of $0.21.

– 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.

Let us first say that it is time for Cognizant to toss aside the “non-GAAP” adjustment for options. It sure looks like the estimates are GAAP-based, so why bother?

The company did not disclose net employee additions in the body of the press release, but the company description at the bottom says “Cognizant has more than 43,000 employees.” This compares to “over 40,000” at year-end. While we remain impressed that a company can add even 3,000 employees in three months, the pace is below the 4,500 added in Q4 and below the run rate to match last year’s 14,500 additions. Further, since the company is now larger the 3,000 additions represent a sequential growth rate of 7.5%, or approximately 33% annualized. This is not only below the current growth rate of 61% but also below the consensus 2008 revenue growth rate of 36.3%.

This is important because Cognizant is a consulting firm, and increasing headcount is the primary way such firms can increase future revenues. While 33% annual growth is indeed good, a trailing P/E multiple of 55x probably requires a bit more. With the growth slowing just a bit faster than expected, however, we still don’t believe that “this day” is “the day.”

The Economic Calendar has three potentially important events this week:

• Personal Income and Outlays on Monday (consensus 0.6% income, 0.5% spending)
• ISM Manufacturing on Tuesday (consensus 51)
• The Employment Situation on Friday (consensus 100,000 jobs added, 4.5% unemployment)

Earnings season continues in full force.

Monday

• Verizon (VZ - Annual Report) - possible upside to sales

Tuesday

• Plantronics (PLT) - anyone’s guess, though our long position gives away our own guess

Wednesday

• Cognizant (CTSH) - one of these days the growth will hit a wall, but probably not this day
• Garmin (GRMN - Annual Report) - shouldn’t need a big surprise to move the stock from this level
• Itron (ITRI) - risk to estimates in both directions due to Actaris acquisition
• Sprint (S - Annual Report) - the worst may be over here
• Symantec (SYMC) - Based on MFE and VDSL should have a big quarter

Thursday

• Ansys (ANSS) - Dassault beat big, and we like Ansys better
• QLogic (QLGC) - too risky for our tastes
• Starbucks (SBUX) - probably no surprise, but risk probably to the downside when they are making this kind of move

Disclosure: Long PLT and ITRI

Disclosure: Author is long Starbucks (SBUX) at time of publication.