Cognizant reports strong revenue growth in 1QFY13; we maintain our "CY13 better than CY12" thesis :JPMorgan

Cognizant (CTSH, US$64.88, rated OW by our US analyst Tien-tsin Huang)
reported a strong revenue quarter with Q/Q revenue growth of 3.7% in 1QCY13
(including revenues from C1 acquisition). The company maintained its CY13
revenue growth guidance of “at least 17%” Y/Y implying “at least 15.8%”
organic Y/Y revenue growth after excluding US$90 mn for C1 acquisition
revenues. The company guided for 2QCY13 revenues of USD 2.13 billion
implying 5.4% Q/Q revenue growth. The company needs to deliver 3.0% Q/Q
revenue growth in the next two quarters (3Q and 4QCY13) to achieve its annual
revenue growth guidance, which seems achievable. We note that gross margins
declined to 40.6% this quarter, the lowest level since CY2000.
 Cognizant reported 1QCY13 revenues of US$2.02 billion (including C1
revenues) meaningfully ahead of guidance of ‘at least US$ 2.00 billion’ and
JPM expectations. The 3.7% Q/Q growth along with 2QFY13 revenue growth
guidance of 5.4% is encouraging in our view. Importantly, 2QFY13 is likely to
benefit from full quarter of C1 revenues as well, but excluding that also, we
believe organic revenue growth guidance of 4%+ Q/Q is healthy. The company
needs to achieve 3.0% Q/Q revenue growth in 3Q and 4QCY13.
 Cognizant maintained its CY13 revenue growth guidance at 17% (~16% on
organic basis). After Cognizant’s experience last year (CY12) when the
company had to bring down its revenue growth guidance from 23% to 20% after
one quarter into the year, we expected Cognizant to be stay extra conservative in
its guidance – likely a case of once-bitten, twice-shy. We believe the company
would naturally want to get back to the “beat-and-raise” earnings pattern,
which has been the hallmark of its performance versus guidance history except
in 2012. Hence, we expect Cognizant to beat its revenue guidance in CY13.
 However, gross margins decreased to 40.6% in 1QCY13, the lowest level in
the last 13 years. Gross margins declined 190 bps Y/Y and 30 bps Q/Q.
Continuous decline in gross margins impacts a company’s ability to invest in
sales and marketing efforts, which impacts revenue growth in medium-to-long
term. Cognizant has an investment-intensive model (high SG&A) that helps its
growth premium and it needs healthy gross margins to sustain this. Management
suggested that pricing remained broadly flat during the quarter.
 Other Details: Financial Services revenues grew 4.9% Q/Q, while
Manufacturing/Retail/Logistics revenues grew 4.2% Q/Q. Healthcare revenue
growth was relatively tepid at 2.0% Q/Q. Rest of Europe (non-UK) delivered
solid growth of 9.7% (thanks to the C1 acquisition), while revenue growth from
UK was also solid at 5.0% Q/Q. Europe (in total) grew 6.7% Q/Q (organic
growth of about 4% Q/Q) meaningfully ahead of company average. North
America reports revenue growth of 3.0% Q/Q.
 Investment view. We continue to think that CY13 will be a reasonably better
growth year for IT Services than CY12. We have OW ratings on Infosys &
HCLT. TCS’s (N) valuations look a tad punchy in the near term, but we see
TCS as a core holding for portfolios as gains from consistent leadership
compound over the long term. The math of compounding tends to be underappreciated – the longer the timeframe, the greater the compounding gains. That
said, the evolution of the immigration bill needs watching (as it relates to visas)

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