Indian IT stocks hit yearly lows last week, on news that Cognizant Technology Solutions ’ revenue and earnings outlook was below street expectations.
How serious is Cognizant’s outlook on outsourcing and do its recent statements warrant a fresh round of selling in Indian IT stocks? Cognizant is the fourth largest outsourcing firm which uses India as an offshore base. Its September quarter revenues were about 10% higher than those of Satyam Computer Services Ltd.
Besides, Cognizant’s September quarter results announcement comes nearly four weeks after that of Infosys, which essentially means it has a better handle on how the December quarter results will turn out. The company also has the added advantage of information from its annual customer conference, Cognizant Community, during which it conducts a survey of clients’ outlook on IT budgets and outsourcing trends.
This is how Gordon Coburn, chief financial and operating officer at Cognizant, summarized the findings of the annual survey: “We are seeing very positive comments from our clients regarding the planned 2008 spend on offshore outsourcing.”
He added: “However, we are not seeing a year-end budget flush as we experienced in the prior few years.” This statement coupled with the muted guidance for the December quarter is what spooked the markets. Although Cognizant beat its earnings guidance for the September quarter by a handsome margin (14%), its revised guidance was far from upbeat.
Instead, the earnings outlook for the December quarter was maintained at the level the company had foreseen back in July. This went against the experience in earlier years.
In the past few years, Cognizant reported strong results in the December quarter, because of what it calls a “budget flush”. This is essentially when clients underspend in the earlier part of the year and bunch up IT spend towards the end of the year to make full use of their annual budget. In some earlier cases, clients even began projects in the December quarter using the budget meant for the next year.
This phenomenon isn’t repeating itself this year. Cognizant points out that discretionary IT spend such as that on application development outpaced maintenance work in the earlier part of 2007, leaving little extra room in clients’ budgets to spend in the December quarter. In essence, it’s not that budgets are being cut; it’s just that there isn’t any extra budget to spend.
Based on Cognizant’s hiring plans till the end of the year, its employee strength would increase about 42% over the previous year. Besides, the company plans to increase utilization rates from current levels. If both these factors hold true, revenue growth in 2008 shouldn’t be much lower than the 49% rate it will achieve this year.
Also, as Coburn said during a call with analysts: “We had a couple of analysts who were getting fairly aggressive, so we wanted to make sure that people didn’t have unrealistic expectations for Q4 (fourth quarter).” To be sure, Cognizant shares were trading at a trailing multiple of more than 35 times, and at a premium of about 35% to Infy on the Nasdaq. Thanks to the post-results correction, its valuation has fallen to less than 30 times.
As far as the takeaways for other Indian IT firms is concerned, the positives outweigh the negatives, especially going by the optimism of the Cognizant management after its client survey. The fact that the budget flush isn’t happening this year could impact growth of other firms this quarter, but then the top firms have given a muted guidance citing holidays in the US. What’s more, at current price levels, top firms such as Infosys are available at their cheapest valuations in the past three years, if one were to exclude the crash in May-June 2006.
That doesn’t necessarily mean investors are going to flock to IT counters, since the rupee scare remains and the incremental news from the US financial services sector is grim. But since the outlook on overall demand continues to be strong, it could well be a good time to accumulate quality IT stocks.
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