Cognizant’s Growth Will Come From Europe

Cognizant’s (CTSH) 45,500 employees provide global IT and business process outsourcing services, including in financial services (up 49% YoY), healthcare (up 62% YoY), and retail/manufacturing/logistics (48% YoY). With a 62% YoY growth, the question is will Cognizant maintain its speed into Q4, especially with the current market jitters?

Q2 revenue posted at $516.5 million, up 53% YoY to Q2 in 2006, and up 12.2% quarterly ($460.3 million in Q1). Top 10 client revenue grew 11%, and total clients reached 430 (97 strategic). US revenue equals 84%, Europe is 15%, and 1% from Asia. Based on the above, Q3 guidance is $550 million (45% YoY). Cognizant will hit the $2 Billion annual revenue mark this year.

The Indian IT outsourcer reported third quarter revenue of $558.8 million, and with EPS of 32 cents GAAP, 34 cents non-GAAP. The Street had expected $556.4 million, 29 cents and 34 cents. But for the fourth quarter, the company sees revenue of $590 million to $595 million, which is below the consensus of $597.6 million. Cognizant sees EPS for the quarter of 31 cents GAAP, 34 cents non-GAAP, in line with expectations. The softer Q4 guidance has sent the stock tumbling down almost 20%, offering an excellent buying opportunity.

Company cash is approximately $750 million. And Cognizant has already authorized a $100 million buyback of shares. At the same time, the company is sinking another $100 million into its domestic infrastructure.

Operating margins are at 18% versus Infosys’ 27%. But this is attributed to funneling more dollars into marketing and growth initiatives. Cognizant can later improve profits by bringing down spending to equal competitors’. Employee attrition equaled 17% and utilization was 85% onshore and 56% offshore due to a large number of trainees, increasing operating costs.

2006 investment in global expansion has paid off and sustains Cognizant so far. Demand was diversified with Europe growing the fastest. Representing a 15% share, Europe grew 84% in Q2 versus Q1 in 2006. Expansion also included new centers in South America and China.

Cognizant is trying to develop new service areas to hedge against sole reliance on finance and healthcare, announcing in October it would be acquiring MarketRX, Inc., for $135 million to obtain analytics and related software for life sciences markets and customers. Cognizant already had a leadership position in supporting pharmaceuticals, with life science revenues growing 88% in 2006. MarketRX adds 75 life science clients, including all of the 20 top pharmaceuticals and 4 of the 5 top biotech companies pushing Cognizant further ahead in the vertical.

Previous acquisitions included Fathom Solutions to strengthen telecommunications capabilities. The gambit paid off with a 73% revenue increase YoY versus 2006. The integration of Fathom gave Cognizant a full-service approach in telecommunications that starts with evaluation consulting and ends with providing outsourced BPO services.

The stock trades at about 40 times its earnings estimate with a $9.5 billion market cap. However, the company is exposed to the current credit worries given its financial services business concentration (47% of revenues). This panic dropped the share price by 19% at the time it had hit the market.

Proponents argue that companies will always seek outsourcing support, as evidenced by the spike in European business for Cognizant. Meanwhile, Cognizant needs to keep buying those Rosetta Stone licenses, to churn out multi-lingual magicians if major bets continue to be on Europe to sustain rapid growth. Latin America would be another strong opportunity to pursue.

The stock is a reasonable growth buy at $30-32/share. What brought Cognizant’s shares down again is a lackluster Q4 guidance which doesn’t seem tragic at all.