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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.