RealMoney Silver - Don't Fall Into Cognizant's Value Trap

Don't Fall Into Cognizant's Value Trap
By Bill Trent
RealMoney.com Contributor
11/7/2007 9:51 AM EST

On Tuesday, Cognizant Technology Solutions (CTSH) traded down more than 19% after issuing revenue guidance slightly below expectations. Although buying a stock posting 50% earnings growth for a multiple in the 30s may appear appealing, doing so could catch you in a value trap.

The Employee Factor

As I have noted elsewhere, Cognizant's labor-intensive business requires adding people in order to add revenue. In fact, the growth in one year's head count has generally closely predicted the following year's growth in revenue. Historically that has not been a problem.

In 2007, however, Cognizant is adding the same absolute number of employees as it did in 2006, about 15,000. But while last year's increase amounted to 60% growth in employees, this year's only amounts to 37.5%. Don't get me wrong, that is still a very impressive number, and the employees have historically been underutilized. Increased utilization can be a good thing.

But what if the 15,000 employees per year is an upward limit? Next year, that would make for just 27% growth, and the year after it would be just 21%. You can see that within a few years, the growth rate would look "normal," and the P/E would have to decline. Then getting a really good return starts to become tough.

Square P/E/G, Round Hole?

I am no fan of the P/E/G ratio, which wrongly assumes that growth and valuation have a linear relationship. But many Cognizant investors seem to put some faith in it, arguing that the P/E multiple is low given how much Cognizant is growing. Looking back, Cognizant's P/E/G has consistently ranged around 1.0, which suggests that investors may truly be using it as a gauge. Whatever my own feelings about the P/E/G's merits, if it drives the stock price, I will pay attention to it.

So if a PEG of about 1.0 is where the shares will trade, what are the implications of a 15,000-employee-per-year growth in head count?

For simplicity's sake, I am assuming that the employee growth will predict the following year's revenue growth and that margins will be constant. Increased utilization could make those estimates conservative, while a rising rupee and ongoing wage inflation could make them appear aggressive.

For this illustration, I'm implicitly assuming those factors will cancel each other out. If you disagree, it is a fairly simple matter to adjust my assumptions to fit your forecast.

Here's how things would trend using those assumptions for the next five years:

Year	Employees	Growth	EPS	PE	Price
2007	55,000	37.50%	$1.14	37.5	$42.75
2008	70,000	27.30%	$1.45	27.3	$39.61
2009	85,000	21.40%	$1.76	21.4	$37.70
2010	100,000	17.60%	$2.07	17.6	$36.48
2011	115,000	15.00%	$2.38	15	$35.75
2012	130,000	13.00%	$2.69	13	$35.03

The increase in earnings is offset by an equal or greater reduction in the growth rate. Today's buyer at $33 on the basis of a low P/E/G ratio should be prepared to sell in five years for a whole $35.

Another Perspective

As I said, I don't put much faith in the P/E/G ratio. Therefore, I don't want to draw all my conclusions from it, despite its past usefulness in explaining the stock price. For another perspective, I turn to my favorite tool, free-cash-flow yield.

In the last 12 months, Cognizant generated about $138 million in free cash flow (cash from operations less capital expenditures). With a $9.5 billion market cap after today's shellacking, the yield is still less than 1.5% -- far lower than I could earn on a risk-free Treasury bond.

On the other hand, Cognizant's cash flow could grow, while the Treasury interest payment will not. In the past, cash flow has risen in line with earnings. However, in the last 12 months, it has not grown even though EPS have. Still, I will assume that the free cash flow will match the earnings growth over the next five years to reach $326 million in 2012.

By then, the growth will have sufficiently normalized that I would expect at least a Treasury-like yield. At 20 times the free cash flow, I would only be willing to assign a $6.5 billion valuation in five years. That is nearly a third less than the current valuation.

Either way I cut it, Cognizant is looking to me like a high-growth value trap.