Cognizant's Growth Is Slowing Slightly More Than Expected

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.”