Cognizant Technology Solutions Corp. (CTSH)

http://stockmarketbeat.com/blog1/2008/02/18/ctsh-still-wary-about-cognizant-after-strong-earnings-report/

For 2008, Cognizant is guiding for 17,000 to 20,000 additional net recruits, which amounts to about 33% growth in headcount.

Meanwhile, the company is projecting revenue gains of “at least 38%.” While there is certainly room to increase utilization from the current 56%, there is a limit to how much can be done. What’s more, with the increased productivity I would normally expect an increase in operating profit margins. Yet the company is guiding to the same 19-20% operating margin range that they always have, and that is “assuming no material appreciation in the Rupee” versus the dollar. To me, that implies that the higher productivity is being offset by higher wages for employees.

There’s also room for doubt around whether performance can be sustained in the financial and retail sectors, which both grew about 50% in 2007.

To make things worse, Cognizant has benefited from tax breaks in India, which are set to expire in March 2009. The tax rate is expected to rise from 16.5% this year to about 25% in 2009 as a result. Over time, it is likely to gradually creep toward the statutory 33.66% rate in India. But for 2009 the drag will be significant, keeping the EPS growth rate well below the growth in revenue.

I frequently gauge the quality of reported earnings by measuring the accrual ratio, or the change in operating assets as a percentage of average net operating assets. As a measure of the percentage of earnings explained by accounting choices rather than cash flow, ideally the ratio should hover around zero. After several quarters of improvement or stabilization, Cognizant’s earnings quality deteriorated significantly.