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Computing Cognizant’s Potential

Fight Your Conservative Tendencies

 Cy  Lynch A well-balanced portfolio includes rapidly growing, relatively small companies as well as larger, more stable ones. But BetterInvesting members tend to be innately conservative, which coupled with our methodology’s emphasis on strong track records often results in portfolios overly populated with blue chip (and relatively slower growing) companies.


Accordingly, it’s wise to be ever-vigilant in seeking high-quality, smaller companies with exceptional growth records and potential returns. Cognizant Technology Solutions Corp. (ticker: CTSH) may be such a stock. (No investment recommendation is intended for companies mentioned in this article.)
CTSH provides custom information technology, consulting and business-process-outsourcing services worldwide. Cognizant began in 1994 as the in-house IT unit of Dun & Bradstreet (DNB) through a joint venture with India-based Satyam Computer Services (SAY). Its financial results have been consistently outstanding and competitive since being spun off in 1998.
Revenue growth averaged an exceptional 48.4 percent over the last 10 years, the highest rate in the IT services and consulting industry. Its pre-tax profit margin averaged 20.2 percent over the last five years, ranking among the industry’s highest. CTSH’s five-year average net margin of 16.8 percent is more than double the 7.5 percent of its peers.
CTSH is financially strong as well. Cash flows are solid, and as of March 31 it had nearly $450 million in cash and no long-term debt. Value Line gives the company a B++ Financial Strength rating, and Morningstar gives it a Financial Health grade of A. Cognizant clearly meets our quality criteria.
Just as clearly, its explosive growth can’t continue as the company matures. Current U.S. economic conditions are challenging as well, but I find comfort in management’s track record of solid performance during the last business slowdown in the early 2000s. In fact, such macroconditions may cause clients to turn even more to outsourcing solutions such as those offered by Cognizant.
The company anticipates 2008 revenues of almost $3 billion (a 38 percent increase over 2007). Value Line concurs and projects continued growth of 23.1 percent annually over the three to five years after 2008. Morningstar’s projected growth rate is even higher, averaging 32.1 percent annually over the next five years.
These are certainly high rates, but applying arbitrary limits to projected growth in your stock studies under the guise of being conservative can lead to missed opportunities. I find estimated revenue growth of 24 percent to be reasonable.
Increasing efficiencies and spreading fixed costs over a higher revenue base helped CTSH’s historical profit margins. But increased labor costs because of the dollar’s decline against the Indian rupee since early 2006 led to slightly declining margins the last two years. Management also expects much higher tax rates starting next year because some tax benefits under Indian law expire this year.
Value Line and Morningstar both project increasing operating profit margins over the long term as the impact of the rising rupee abates but expect net profit margins to decline because of the anticipated higher tax liability. I chose a projected net margin of 14.3 percent (down from 16.2 percent currently) based on steady pre-tax margins and a higher tax rate of 25 percent. Using Value Line’s projection of 300 million diluted shares (which I find reasonable) results in estimated high earnings per share of $3.26 for CTSH, an average annual increase of 21.4 percent.
A projected high price-earnings ratio of 29 is in line with the current P/E and reasonable in light of my projected strong, albeit slowing, growth rate. Starting with the $34 stock price when this article was written, the resulting potential five-year average annual total return is about 22 percent (CTSH pays no dividend).  
Finally, adding CTSH to our sample portfolio (see table) increases both our portfolio growth rate (to 12.6 percent) and our projected return (to 21.3 percent).

Cy Lynch is a longtime BetterInvesting volunteer educator who runs an investment advisory firm in Atlanta.

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