Contemplating Cognizant (CTSH)

Cognizant Technology Solutions (CTSH) is a worldwide provider of Information Technology services.  The company has over 100,000 employees based mostly in India, but is incorporated and headquartered in the U.S.

CTSH was named to the 2010 Fortune 100 Fastest Growing Companes list ranking 37^th with 55% EPS and 30% Sales growth.  Wikipedia reported that Cognizant has made Fortune’s Fastest Growing list for eight consecutive years.

CTSH was the subject of the September 2011 Online Stock Study at the Better Investing website.  It was led by Carol Clemens and Christi Powell, two members of BI’s Heart of Oklahoma chapter.  Handouts available to BI members include the CTSH Value Line and Morningstar reports as well as the audio presentation and power point slides.

Sadly, and once again, no completed SSG is available even though the purpose of the monthly Stock Study is to generate a SSG in about one hour using consensus decision-making by the online participants.  I’ve complained, but these omissions month after month must be deliberate and seem foolish to me.

 Company Background:

– According to Cognizant’s 2010 Annual Report, revenues increased an impressive 40% last year and the company added more than 120 new clients, most ever in its history.

** Revenue growth in Europe was especially noteworthy: sales in the United Kingdom increased 58%; the company began operations in Spain, expanded offices in Stockholm, Paris, Zurich, and Amsterdam, and opened office in Geneva.

– Most of CTSH’s revenues are generated in the  U.S. and Wikipedia reported that 2010 revenues by geography were: 77% from North America; 19% Europe; other 4%.

– According to Value Line, 2010 revenues by segment were: 42% financial related services; 26% health care services; 18% retail-logistics-manufacturing; 14% other.

** IT Services are provided by an on-site technical and account management team supported by development centers located primarily in India.

– To distinguish itself from competitors, Morningstar observed, Cognizant chose to build a U.S.-based management team in order to gain the trust of U.S. customers and, at the same time, delivering the cost savings of offshore outsourcing. 

 ** This model has provided CTSH with a “significant” competitive advantage;

 ** Like other IT providers, Cognizant’s clients are highly concentrated: CTSH’s top 5 and top 10 customers accounted for 20% and 30% of revenues;

 ** Mstar thought it was unlikely that clients would change their IT provider given the high costs of switching and the sticky nature of these relationships.

– The Indian government is ending its tax subsidies on software exports in 2011 and Cognizant’s low tax rates are xpected to rise.

– After the following table comparing four SSGs on Cognizant, I discuss key issues about CTSH’s future growth, its downtrending Return on Equity, its Competitors, and its Financial Condition.

Cognizant                  Technology Solutions (CTSH)	CarolC	ChristiP	Armin	AnnC             (from BI’s First Cut)
SSG Date &                    Study Date	7/27/11 & 9/7/11	Unknown & Same	8/15/11	7/8/11
Data	Mstar via SC	Same	Mstar via BI	Same
Price	$60.84	$72.95	$63.93	$76.40
52 week High &              Low Price	$83.84 & $53.59	Same&        Same	Same &        Same	Same & $52.10
Last Quarter of     Reported Data	Q2 ending 6/30/11	Same	Same	Q1 ending 3/31/11
Software Used	TK6 &     Online SSG	Same &       Same	TK6	Online SSG
Project Growth              From End of	Last Q	Same	Same	Unknown
Future Sales Growth	21.4%	Unknown	20.0%	17.0%
Future EPS Growth	18.9%	19.0%	16.0%	16.0%
High P/E	20.0	31.3	27.9                  (last 3 yr ave)	27.0
High EPS	$6.32	$6.35	$5.59	$5.36
High Price next 5 yrs	$126.40	$198.80 (37% > VL)	$156.00           (5.5% > VL)	$144.72
Value Line Estimated High Price = $95-145 as of 8/19/11and 5/2011
Low P/E	15.50	Unknown	12.5	15.0
Low EPS	$2.66	Unknown	$2.66	$2.55
Low Price next 5 yrs	$41.23	$39.60	$33.30	$38.25
Upside/Downside Ratio	3.34	3.80	3.00	1.79
Total Return	15.75%	22.20%	19.50%	13.63%
SSG Buy Under	Unknown	Unknown	$63.98	Not Used
RV/PRV                         (outliers eliminated)	Unknown	Unknown	118.8/102.6     (06 & 07 out)	Not Used
RV/PRV                           (no outliers)	Unknown	Unknown	87.9/75.9	Not Used
Quality	Not Used	Not Used	S&P = B+	Not Used
PTPM – 5 yr ave	Unknown	Unknown	19.2%          Trend even	19.15% Trend N/A
ROE – 5 yr ave              Ending Yr Equity	Unknown	Unknown	20.9%              Trend down	20.92% Trend N/A
ROE – 5 yr ave         Beginning Yr Equity	Unknown	Unknown	28.4%          Trend down	Not Used
Debt to Equity –               5 yr ave	Unknown	Unknown	-0-                  Trend even	Not Used

 Estimating CTSH’s future growth: the Online Stock Study

(A) Carol&Christi gave participants 5 choices to estimate future Sales growth for the next 5 years: 31.9%, the company’s last 5 year average; 22.0%, Value Line’s estimate; 19.7%, average BI member sentiment; 20.1%, estimate from Manifest Investing, a pay site; and  None of the Above.

** Value Line’s 22.0% estimate was for Sales per Share, not Sales, and VL makes no Sales estimate;

** BI’s 19.7% average member sentiment was based on some 78 Online SSGs made in the last 90 days which ranged from an estimated 39.4% high to a low of 7.5%;

** “None of the Above” is not a meaningful choice and I will not report it again;

** The Consensus (35% of the votes) chose 19.7%, BI’s average member sentiment; second place (30%) was for VL’s 22.0% estimate.

 (B) Participants were given 4 (meaningful) choices to estimate future EPS growth for the next 5 years: 30.6%, the company’s last 5 year average; 20.5%, VL’s estimate; 17.6%, average BI Member sentiment; 18.5%, Morningstar’s estimate.

** The Consensus (35% of the votes) chose 17.6%, BI’s average member sentiment; 32% voted for Mstar’s 18.5% estimate.

(C) Carol&Christi then used BI’s Preferred Procedure to estimate CTSH’s future EPS growth.  The PP involves making 4 estimates for the next 5 years: Sales growth (less) Pre-Tax Profit Margin (less) Taxes (divided by) Shares Outstanding (equals) EPS growth.

** Instead of using 19.7%, the Consensus choice for future Sales growth, Carol&Christi used 21.4% and offered no explanation; see Presentation Slide #40.

** For PTPM, they used the Online SSG’s default value (19.2%, last 5 year average); they substantially increased Taxes to 28.0% (up from the 16.6% default); and they increased Shares Outstanding  to 310.0 M (up from 304.0 M).

### Their estimated Tax increase is likely due to the 2011 end of India’s tax subsidies, but a major weakness of the PP is that there is little or no guidance regarding the amount of any such a change.

** The PP result was 18.9% EPS which they used instead of the Consensus pick (17.6%), again without explanation.  Carol used 18.9% while Christi rounded up to 19.0%.

** I no longer use the PP because it involves making too many estimates and too much guesswork; see: Pondering the Preferred Procedure,  March 28, 2009

Estimating Future Growth: Armin and Ann’s SSGs:

(A)  I found that CTSH’s historical growth over the last 5 years had been around 33% Sales & 31% EPS, both slowing to 28% during the last 3, and increasing to 40% Sales & 33% EPS over the last 2.

** When I did my SSG, the 7 analysts I ALWAYS check were closely estimating long-term EPS at an average of 21.12% with Mstar high at 21.9% and Zacks.com low at 18.5%.

** If you don’t check all 7, you can’t learn which is high, low or goofy.  For how I estimate EPS for all my SSGs, see: Estimating EPS, March 5, 2009

** I lowered my EPS estimate to 16.0% because I did not want to substantially exceed VL’s High Price estimate which I add as a SSG criteria.

(B) Ann wrote that CTSH’s growth had been stready and strong with Sales and EPS growing at around 45% during the last 10 years and slowing to about 27% over the last few.

** Ann found that analysts (unidentified) were estimating lon-term EPS at 20.0%, but lowered her EPS choice to 16.0%, slightly less than her Sales estimate, to reflect lower profit margins in the next 5 years due in part to wage inflation in India.

(C) SSG Final Results:

	CarolC	ChristiP	Armin	AnnC
Estimated EPS	18.90%	19.00%	16.00%	16.00%
Forecast High P/E	20.0	31.3	27.9	27.0
Forecast High Price	$126.40	$198.80	$156.00	$144.72
Forecast Low Price	$  41.23	$  39.60	$  33.30	$  38.25
Upside/Downside	3.34	3.80	3.00	1.79
Total Return	15.75%	22.20%	19.50%	13.63%
Overall Result	SSG BUY	SSG BUY	SSG BUY	SSG Don’t Buy

–  All of the judgments by the 4 SSGs are similar except for their Forecast High P/Es with Christi high at 31.3 and Carol low at 20.0. 

– Ann’s  was the only SSG that got a Don’t Buy.

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– Cognizant’s 5 year average PTPM is trending even and its ROE is trending down.  Any downtrend could be a red-flag warning sign of deteriorating fundamentals or, on the other hand, a sign of an unsustainably high level.

– The way I evaluate this is to compare the company to its Industry Averages.

– I use the Industry data at Stock Central.com which is the only website I know of that lists six metrics for all companies in each industry and which is the only way to identify whether the 5 year industry average is distorted by outliers.

(A) PTPM:

– Even though Cognizant’s PTPM is trending even, which is not a troublesome sign, I ALWAYS want to know how each company compares to its industry average.

– Morningstar places CTSH in the Information Technology Services Industry which consists of 65 companies total.

– CTSH is substantially better than its Industry Average (19.2% vs 9.8%) and ranks 7^th out of 65;

** Infosys (INFY), a direct competitor, ranks 2^nd with a PTPM of 32.5%.

(B) ROE:

– The Industry data only uses Ending Equity and CTSH is slightly worse than its Industry Average (20.9% vs 21.2%),  and ranks 10^th. 

– However, the Industry Average is distorted by three companies with unusually high ROEs (RSY @ 200%, UIS @ 77.9%, and IPXFF @ 75.1%);

** If these three are eliminated as outliers, CTSH looks substantially better (20.9% vs 13.4% Adjusted Industry Average).

(C) Conclusion:

– I am not troubled by Cognizant’s PTPM or ROE as they are substantially better than its PTPM Industry Average and its ROE Adjusted Industry Average;

– To learn how easy it is to adjust any Industry Average in order to remove distorting outliers, see: Investigating Industry Info, May 8, 2009

– The Online Stock Study did not discuss Cognizant’s PTPM and ROE which is a serious omission in my opinion.

Competitors:

– Competitors can be a confusing issue and easily get mixed up with peers, ordinary competitors, and direct or close competitors.

– BI reports only peer group members which are not necessarily competitors and which I never use.

– Some websites claim to show competitors, but may list a mishmash/hodgepodge: Bloomberg Business Week, for example, shows 5 so-called competitors for CTSH in 4 different industries.

– I most often rely on YahooFinance and Morningstar:

** YahooFinace lists CTSH’s direct competitors as: Infosys (INFY), Wipro (WIT), and Tata Consultancy (private);

** Morningstar, which I get on-line and free from my library, lists CTSH close competitors as: INFY, WIT, Accenture PLC (ACN), and ComputerSciences Corp (CSC).

CTSH’s Financial Condition:

(A) Value Line:

 – VL gave Cognizant an A++, its highest grade, for Financial Strength;

– VL also reported that CTSH had no debt and $2.27 B in Cash as of 7/1/11.

(B) Morningstar:

– Mstar observed that CTSH had a strong balance sheet with more that $2.2 B in cash and no debt.

– Mstar also reported that Cognizant had a strong cash flow averaging in the low teens of revenue in the last 5 years, and expects the company to remain debt-free for the foressable future.

(C) S&P Stock Report:

– S&P found that CTSH had a strong balance sheet, steady cash flows, and rapid revenue growth;

– S&P also reported that Cognizant had a compound annual growth rate (CAGR) in free cash flow of 40% over the past 5 years which, it thought, might decline to 30% in the next 5.

 (D) Bob Adams’ One-Click, Annual Report Spreadsheet:

– This easy-to-use spreadsheet gave CTSH’s 2010 Annual Report a 43 out of 100 with 5 Bullish and 8 Bearish results:

** The Bullish good things included: no debt; sales increased; ROE was adequate; free cash flow margin of 13% was good;

** The Bearish not-so-goods included: accounts receivable increased as did shares outstanding; cost of sales grew faster than sales and got a red-flag warning sign; sales grew slower than cash flow.

Armin