Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Highlights
This piece evaluates Cognizant's Q1:11 earnings report, concluding that Cognizant should be a sound buyon-
the-dip opportunity.
We're revising our CY11 EPS (to $2.82 from $2.84) and CY12 EPS (to $3.52 from $3.55) due to the
following factors: slightly lower revenue growth assumption for CY11, modestly higher non-GAAP
operating margin (due to upside reported in Q1:11), increased assumption for stock compensation expense,
and modest increase in tax rate. Also, we are slightly revising our CTSH target price of $88.00 (vs. prior of
$88.75), derived by applying a 25.0x multiple (unchanged) to our new CY12 EPS estimate of $3.52.
We are disappointed that Cognizant's Q1:11 revenue was below our expectation (i.e., achieved sequential
revenue growth of 4.6%, only in line with consensus and below buy-side expectation of 5.5-7.0%). But we
see six reasons that CTSH's stock should represent a good buy-on-the-dip opportunity:
First, growth drag from Europe should not be lasting: We think Cognizant's less-than-stellar sequential
growth in Q1:11 was due to ramp-downs in post-merger-integration business in the UK. Looking
forward, we think this headwind is prone to subside between now and Q3:11, plus it seems that a strong
pipeline of deals are closing in Europe and should contribute to deal ramp-ups between now and Q3:11.
Meanwhile, it's clear that growth and demand trends in the US remain healthy.
Second, we think Q2:11 (Cognizant's seasonally strongest quarter for sequential growth) is prone to
bring revenue upside: Cognizant's sequential growth guidance for Q2:11 calls for "at least" 5.7% (vs.
consensus of 4.9%), and we think this guidance could prove to be conservative, especially given that
Q2:11 should receive a boost from currency and potentially from pricing. Note that pricing improved
sequentially in Q1:11 by 2%, as new pricing terms likely kicked into gear during Q1:11, with some
incremental potential for continuation into Q2:11, in our view.
Third, we do not think offshore demand is "broken": Investors are asking whether offshore demand is
running into meaningful barriers. We think INFY's weak recent growth results are largely attributable to
company-specific issues (e.g., leadership transition, transition challenges in trying to move up the food
chain), and CTSH's Q1:11 disappointment (vs. high expectations) was largely due to a growth drag from
merger-integration deal ramp-downs. We assert that the "structural" issue involved is that the offshore
market began its growth rebound quite early in the recovery cycle – i.e., in September 2009 – and is no
longer seeing incremental growth boosts now that we've moved into a later-cycle demand phase. Still,
offshore demand is quite healthy, and we think expectations for CTSH to achieve north of 30% revenue
growth in 2011 remain quite feasible (we are now forecasting 32.8% revenue growth for 2011). As an
additional encouraging data point (Exhibit 9), Cognizant's sequential headcount growth has been between
7% and 9% in each of the past three quarters.
Fourth, Cognizant should be helped disproportionately by transformational services demand: Because
of CTSH's distinctive onshore client relationship capabilities and industry vertical focus (as explained in
our past research), we underscore that CTSH should benefit more than other Indian firms in this latercycle
demand phase (which we maintain is lined with strong demand for transformational services, as
opposed to the fast-payback deals that dominated earlier in the recovery cycle).
Fifth, Cognizant's share-gaining prowess (which we think is being extended) is underestimated in
consensus numbers: As shown in our prior research, Cognizant's Y/Y revenue growth results exceeded
the tier-1 Indian firms (TCS, Infosys, and Wipro) as a group by an average of 17.1 percentage points
during 2003 to 2010. Yet, according to consensus estimates, Cognizant's revenue growth is expected to
beat these tier-1 Indian firms by only 5.1 percentage points in 2011, and Cognizant's consensus Y/Y
revenue growth for Q4:11 is only in line with that of the tier-1 Indian firms as a group. We strongly
think Cognizant is likely to achieve materially above-peer growth, thus beating consensus.
Sixth, there's likely conservatism in guidance: Cognizant's practice in setting its fiscal-year guidance in
the first two quarters is to embed conservatism in its growth assumptions particularly for its
"development" category – i.e., to assume demand in the development category may not be as strong in
second half of the year, given that true visibility into discretionary spending is not very strong beyond 6
months. This practice is likely adding conservatism to Cognizant's latest guidance, especially since the
development category should benefit from the healthy environment we see for transformational services
demand. To elaborate:
Cognizant's growth in its application development category (i.e., grew sequentially by 5.4% and Y/Y
by 58.7%, exceeding the application management category's sequential growth of 3.8% and Y/Y
growth of 29.9%) shows that clients have a strong appetite to invest in initiatives such as: software
deployment, integration, technology platform upgrades, business analytics, and business process
change. This higher growth of application development (compared to application maintenance) was
achieved despite the completion of the merger integration work in the UK.
Also, note that the UK and Continental Europe achieved sequential revenue growth of -3.5% and
+11.7%, respectively, in Q1:11,
Investment Conclusion
Ratings across Computer Services stocks: We have outperform ratings on Cognizant, Sapient, Accenture,
and ADP. We have market-perform ratings on Visa, MasterCard, Paychex, and Infosys. And, we have an
underperform rating on CSC
Details
Cognizant's latest results and guidance versus expectations
Exhibit 1 provides a breakdown of Cognizant's latest results and guidance versus expectations.
March 2011 quarter results
March 2011 quarter EPS was $0.67, versus consensus of $0.63.
March 2011 quarter sequential revenue growth was 4.6% (Y/Y growth of 42.9%), versus consensus of
4.3% (Y/Y growth of 42.4%) and our estimate of 6.4% (Y/Y growth of 45.4%).
Note that these consensus figures are as of May 2nd, though we noticed that consensus revenue for the
March 2011 quarter may have crept slightly higher as of May 3rd (i.e., as of Cognizant's earnings release).
June 2011 quarter guidance
Cognizant provided June 2011 quarter EPS guidance of $0.65, which is 1 cent below consensus of $0.66.
Cognizant provided June 2011 quarter revenue guidance of "at least" $1,450 million. This guidance
implies at least a 5.7% sequential increase in revenues (Y/Y growth of at least 31.2%), versus consensus
of 4.9% (Y/Y growth of 29.7%).
Fiscal year 2011 (ending December) guidance
Cognizant revised its 2011 EPS guidance to "at least" $2.72, versus consensus of $2.74.
Cognizant's revised 2011 revenue guidance of "at least" $5,925 million (i.e., 29.0% growth) exceeds
consensus of $5,896.4 million (i.e., 28.4% growth) and the prior revenue guidance of "at least" $5,790
million (i.e., 26.1% growth).
Breakdown of factors causing EPS variance versus consensus
Cognizant's EPS in Q1 exceeded consensus by 3.5 cents, with this upside largely stemming from operating
margin and above-expected non-operating income, partially offset by an above-expected tax rate.
To elaborate, Exhibit 2 analyses the EPS variances (of actual results versus estimates) attributable to
underlying earnings drivers. Cognizant's EPS in Q1 exceeded consensus by 3.5 cents. The following
bullets dissect variances between Cognizant's actual EPS and consensus assumptions:
+0.2 cents was driven by revenues, which were 0.3% higher than consensus.
+1.7 cents stemmed from an operating margin (GAAP), which was 52 basis points higher than the
operating margin implied by consensus (note that we derived consensus margin, assuming consensus was
in line with our estimates for tax rate, share count, and non-operating income). Cognizant's operating
margin (non-GAAP) was 20.50%, above Cognizant's target range of 19-20%.
+2.1 cents stemmed from non-operating income that was above consensus (we assume consensus was in
line with our estimate).
-0.6 cents stemmed from a tax rate, which was 73 basis points higher than consensus (we assume
consensus was in line with our estimate).
Valuation Methodology
Our target prices for IT services stocks are derived by applying multiples to our forward estimates of
earnings and cash flows. Our target multiples are determined based on our assessments of historical priceto-
forward-earnings multiples, after considering each company’s growth prospects relative to historical
levels. Our target multiples are also influenced by the results of our DCF analyses across various financial
scenarios for each company.
More specifically, for IT services firms, offshore services firms, and payroll processors, our target share
prices are derived by applying the following P/E multiples to our calendar 2012 EPS estimates: Accenture
16.0x, Sapient 22.4x, CSC 6.4x, Infosys 21.8x, Cognizant 25.0x, ADP 20.0x, and PAYX 19.4x.
For payment network companies, our target share prices are derived by applying the following P/E
multiples to our calendar 2011 EPS estimates: MA 13.5x, Visa 15.3x.
As an alternative method of calculating our latest $14.75 target share price on Sapient, we apply a target
P/E multiple of 18.4x to our 2012 EPS estimate with a 28% normalized tax rate assumed (i.e., EPS of 71
cents), while also giving Sapient valuation credit for its $1.67 of cash per share. This target multiple is
supported by Sapient's takeover prospects, substantial room for margin expansion, and long-term growth
prospects in attractive segments like multi-channel commerce, Internet advertising, and trading/risk
management.
As alternative method of calculating our target share price on CSC, we apply an EDS-takeover multiple
(i.e., FCF multiple of 12.05x) to our estimate of CSC's "normalized" free cash flow (i.e., FY10 FCF
excluding the impact of lower DSO).
Also, note that, in addition to prospects for stock appreciation, Paychex, ADP, CSC, and Accenture offer
meaningful dividend yields.
Risks
The primary risk to consulting names (Accenture and Sapient) achieving our target share prices is the
potential for pressures on discretionary services spending. In addition, negative economic news flow can
weigh on the sentiment (and valuation multiples) of consulting stocks, and Accenture's stock has a tendency
to be pressured by appreciation of the US dollar (due to Accenture's substantial international exposure).
The primary risks to IT outsourcing companies’ (e.g., CSC, HP/EDS, Perot) fundamentals include contract
restructurings/terminations (a significant risk for CSC) and the shift of IT outsourcing work to offshore
labor centers (a threat to CSC). Further, our research shows the emergence of the offshore/remote
infrastructure outsourcing business, which will enable Indian firms to move into the core market segment of
CSC, and this trend will add pressure to CSC. It is prone to cause some cannibalization of CSC’s existing
infrastructure outsourcing revenues and some share loss to Indian and niche players moving aggressively
into the offshore/remote infrastructure outsourcing business. We also maintain a concern about CSC’s high
balance-sheet accruals. The risk to our underperform rating on CSC is that restructuring efforts and new
strategies could drive EPS improvement and share price appreciation.
Risks facing our target prices on Indian IT services stocks (e.g., Infosys and Cognizant): We still maintain
longer-term concerns about rupee appreciation (see our 10/22/07 research call for an analysis of factors that
could affect future moves in the Indian rupee), margin contraction (due partly to increasing needs,
especially for Infosys, to invest in onshore capabilities and industry-specific solutions), tax rate
normalization (i.e., tax rates for top Indian firms should jump to north of 20% when the STPI tax haven in
India expires), and meaningful hurdles related to supply and competition.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Highlights
This piece evaluates Cognizant's Q1:11 earnings report, concluding that Cognizant should be a sound buyon-
the-dip opportunity.
We're revising our CY11 EPS (to $2.82 from $2.84) and CY12 EPS (to $3.52 from $3.55) due to the
following factors: slightly lower revenue growth assumption for CY11, modestly higher non-GAAP
operating margin (due to upside reported in Q1:11), increased assumption for stock compensation expense,
and modest increase in tax rate. Also, we are slightly revising our CTSH target price of $88.00 (vs. prior of
$88.75), derived by applying a 25.0x multiple (unchanged) to our new CY12 EPS estimate of $3.52.
We are disappointed that Cognizant's Q1:11 revenue was below our expectation (i.e., achieved sequential
revenue growth of 4.6%, only in line with consensus and below buy-side expectation of 5.5-7.0%). But we
see six reasons that CTSH's stock should represent a good buy-on-the-dip opportunity:
First, growth drag from Europe should not be lasting: We think Cognizant's less-than-stellar sequential
growth in Q1:11 was due to ramp-downs in post-merger-integration business in the UK. Looking
forward, we think this headwind is prone to subside between now and Q3:11, plus it seems that a strong
pipeline of deals are closing in Europe and should contribute to deal ramp-ups between now and Q3:11.
Meanwhile, it's clear that growth and demand trends in the US remain healthy.
Second, we think Q2:11 (Cognizant's seasonally strongest quarter for sequential growth) is prone to
bring revenue upside: Cognizant's sequential growth guidance for Q2:11 calls for "at least" 5.7% (vs.
consensus of 4.9%), and we think this guidance could prove to be conservative, especially given that
Q2:11 should receive a boost from currency and potentially from pricing. Note that pricing improved
sequentially in Q1:11 by 2%, as new pricing terms likely kicked into gear during Q1:11, with some
incremental potential for continuation into Q2:11, in our view.
Third, we do not think offshore demand is "broken": Investors are asking whether offshore demand is
running into meaningful barriers. We think INFY's weak recent growth results are largely attributable to
company-specific issues (e.g., leadership transition, transition challenges in trying to move up the food
chain), and CTSH's Q1:11 disappointment (vs. high expectations) was largely due to a growth drag from
merger-integration deal ramp-downs. We assert that the "structural" issue involved is that the offshore
market began its growth rebound quite early in the recovery cycle – i.e., in September 2009 – and is no
longer seeing incremental growth boosts now that we've moved into a later-cycle demand phase. Still,
offshore demand is quite healthy, and we think expectations for CTSH to achieve north of 30% revenue
growth in 2011 remain quite feasible (we are now forecasting 32.8% revenue growth for 2011). As an
additional encouraging data point (Exhibit 9), Cognizant's sequential headcount growth has been between
7% and 9% in each of the past three quarters.
Fourth, Cognizant should be helped disproportionately by transformational services demand: Because
of CTSH's distinctive onshore client relationship capabilities and industry vertical focus (as explained in
our past research), we underscore that CTSH should benefit more than other Indian firms in this latercycle
demand phase (which we maintain is lined with strong demand for transformational services, as
opposed to the fast-payback deals that dominated earlier in the recovery cycle).
Fifth, Cognizant's share-gaining prowess (which we think is being extended) is underestimated in
consensus numbers: As shown in our prior research, Cognizant's Y/Y revenue growth results exceeded
the tier-1 Indian firms (TCS, Infosys, and Wipro) as a group by an average of 17.1 percentage points
during 2003 to 2010. Yet, according to consensus estimates, Cognizant's revenue growth is expected to
beat these tier-1 Indian firms by only 5.1 percentage points in 2011, and Cognizant's consensus Y/Y
revenue growth for Q4:11 is only in line with that of the tier-1 Indian firms as a group. We strongly
think Cognizant is likely to achieve materially above-peer growth, thus beating consensus.
Sixth, there's likely conservatism in guidance: Cognizant's practice in setting its fiscal-year guidance in
the first two quarters is to embed conservatism in its growth assumptions particularly for its
"development" category – i.e., to assume demand in the development category may not be as strong in
second half of the year, given that true visibility into discretionary spending is not very strong beyond 6
months. This practice is likely adding conservatism to Cognizant's latest guidance, especially since the
development category should benefit from the healthy environment we see for transformational services
demand. To elaborate:
Cognizant's growth in its application development category (i.e., grew sequentially by 5.4% and Y/Y
by 58.7%, exceeding the application management category's sequential growth of 3.8% and Y/Y
growth of 29.9%) shows that clients have a strong appetite to invest in initiatives such as: software
deployment, integration, technology platform upgrades, business analytics, and business process
change. This higher growth of application development (compared to application maintenance) was
achieved despite the completion of the merger integration work in the UK.
Also, note that the UK and Continental Europe achieved sequential revenue growth of -3.5% and
+11.7%, respectively, in Q1:11,
Investment Conclusion
Ratings across Computer Services stocks: We have outperform ratings on Cognizant, Sapient, Accenture,
and ADP. We have market-perform ratings on Visa, MasterCard, Paychex, and Infosys. And, we have an
underperform rating on CSC
Details
Cognizant's latest results and guidance versus expectations
Exhibit 1 provides a breakdown of Cognizant's latest results and guidance versus expectations.
March 2011 quarter results
March 2011 quarter EPS was $0.67, versus consensus of $0.63.
March 2011 quarter sequential revenue growth was 4.6% (Y/Y growth of 42.9%), versus consensus of
4.3% (Y/Y growth of 42.4%) and our estimate of 6.4% (Y/Y growth of 45.4%).
Note that these consensus figures are as of May 2nd, though we noticed that consensus revenue for the
March 2011 quarter may have crept slightly higher as of May 3rd (i.e., as of Cognizant's earnings release).
June 2011 quarter guidance
Cognizant provided June 2011 quarter EPS guidance of $0.65, which is 1 cent below consensus of $0.66.
Cognizant provided June 2011 quarter revenue guidance of "at least" $1,450 million. This guidance
implies at least a 5.7% sequential increase in revenues (Y/Y growth of at least 31.2%), versus consensus
of 4.9% (Y/Y growth of 29.7%).
Fiscal year 2011 (ending December) guidance
Cognizant revised its 2011 EPS guidance to "at least" $2.72, versus consensus of $2.74.
Cognizant's revised 2011 revenue guidance of "at least" $5,925 million (i.e., 29.0% growth) exceeds
consensus of $5,896.4 million (i.e., 28.4% growth) and the prior revenue guidance of "at least" $5,790
million (i.e., 26.1% growth).
Breakdown of factors causing EPS variance versus consensus
Cognizant's EPS in Q1 exceeded consensus by 3.5 cents, with this upside largely stemming from operating
margin and above-expected non-operating income, partially offset by an above-expected tax rate.
To elaborate, Exhibit 2 analyses the EPS variances (of actual results versus estimates) attributable to
underlying earnings drivers. Cognizant's EPS in Q1 exceeded consensus by 3.5 cents. The following
bullets dissect variances between Cognizant's actual EPS and consensus assumptions:
+0.2 cents was driven by revenues, which were 0.3% higher than consensus.
+1.7 cents stemmed from an operating margin (GAAP), which was 52 basis points higher than the
operating margin implied by consensus (note that we derived consensus margin, assuming consensus was
in line with our estimates for tax rate, share count, and non-operating income). Cognizant's operating
margin (non-GAAP) was 20.50%, above Cognizant's target range of 19-20%.
+2.1 cents stemmed from non-operating income that was above consensus (we assume consensus was in
line with our estimate).
-0.6 cents stemmed from a tax rate, which was 73 basis points higher than consensus (we assume
consensus was in line with our estimate).
Valuation Methodology
Our target prices for IT services stocks are derived by applying multiples to our forward estimates of
earnings and cash flows. Our target multiples are determined based on our assessments of historical priceto-
forward-earnings multiples, after considering each company’s growth prospects relative to historical
levels. Our target multiples are also influenced by the results of our DCF analyses across various financial
scenarios for each company.
More specifically, for IT services firms, offshore services firms, and payroll processors, our target share
prices are derived by applying the following P/E multiples to our calendar 2012 EPS estimates: Accenture
16.0x, Sapient 22.4x, CSC 6.4x, Infosys 21.8x, Cognizant 25.0x, ADP 20.0x, and PAYX 19.4x.
For payment network companies, our target share prices are derived by applying the following P/E
multiples to our calendar 2011 EPS estimates: MA 13.5x, Visa 15.3x.
As an alternative method of calculating our latest $14.75 target share price on Sapient, we apply a target
P/E multiple of 18.4x to our 2012 EPS estimate with a 28% normalized tax rate assumed (i.e., EPS of 71
cents), while also giving Sapient valuation credit for its $1.67 of cash per share. This target multiple is
supported by Sapient's takeover prospects, substantial room for margin expansion, and long-term growth
prospects in attractive segments like multi-channel commerce, Internet advertising, and trading/risk
management.
As alternative method of calculating our target share price on CSC, we apply an EDS-takeover multiple
(i.e., FCF multiple of 12.05x) to our estimate of CSC's "normalized" free cash flow (i.e., FY10 FCF
excluding the impact of lower DSO).
Also, note that, in addition to prospects for stock appreciation, Paychex, ADP, CSC, and Accenture offer
meaningful dividend yields.
Risks
The primary risk to consulting names (Accenture and Sapient) achieving our target share prices is the
potential for pressures on discretionary services spending. In addition, negative economic news flow can
weigh on the sentiment (and valuation multiples) of consulting stocks, and Accenture's stock has a tendency
to be pressured by appreciation of the US dollar (due to Accenture's substantial international exposure).
The primary risks to IT outsourcing companies’ (e.g., CSC, HP/EDS, Perot) fundamentals include contract
restructurings/terminations (a significant risk for CSC) and the shift of IT outsourcing work to offshore
labor centers (a threat to CSC). Further, our research shows the emergence of the offshore/remote
infrastructure outsourcing business, which will enable Indian firms to move into the core market segment of
CSC, and this trend will add pressure to CSC. It is prone to cause some cannibalization of CSC’s existing
infrastructure outsourcing revenues and some share loss to Indian and niche players moving aggressively
into the offshore/remote infrastructure outsourcing business. We also maintain a concern about CSC’s high
balance-sheet accruals. The risk to our underperform rating on CSC is that restructuring efforts and new
strategies could drive EPS improvement and share price appreciation.
Risks facing our target prices on Indian IT services stocks (e.g., Infosys and Cognizant): We still maintain
longer-term concerns about rupee appreciation (see our 10/22/07 research call for an analysis of factors that
could affect future moves in the Indian rupee), margin contraction (due partly to increasing needs,
especially for Infosys, to invest in onshore capabilities and industry-specific solutions), tax rate
normalization (i.e., tax rates for top Indian firms should jump to north of 20% when the STPI tax haven in
India expires), and meaningful hurdles related to supply and competition.
No comments:
Post a Comment