I was scanning through charts this week looking for names with strong runs that have begun to break down. The idea is to catch names where there are momentum players trapped who are likely to sell once they realize a trend has been broken. Obviously, I want to use this screen as an introduction and look more deeply at each company to understand the fundamentals behind the price movement. During this process, I became interested in Satyam (SAY) as a potential short because of they way it was trading, but after more review, I settled on their competitor Cognizant Technology Solutions (CTSH) as a better alternative.

CTSH is a consulting firm that uses an “offshore model” which has become popular with many of its competitors. The offshore model essentially uses cheaper more efficient labor typically from India to service Information Technology projects sold in the US or Europe. A team of US professionals might sit down with a company in Boston and determine the direction they want to go with a particular project. The local team will then communicate with the “worker bees” in India who tie the nuts and bolts together and deliver the working application.

One of the biggest challenges in this business is recruiting and retaining quality professionals in India to process the work. Since the business process is duplicated by a hand full of other consultants, there can be difficulty in finding enough qualified individuals to hire. Currently CTSH is projecting a headcount of 55,000 by the end of the year and this is revised down slightly from earlier forecasts. Management contends that they can continue to service existing clients and new contracts with their current headcount and that hiring is more of a preventative long-term planning issue than a day to day necessity. However, attrition rates picked up the last quarter and while management stated that this was more of a seasonal factor, there is still concern that continued weakness in hiring could put constraints on future revenue growth.

One of the reasons I picked CTSH over SAY was because of the stock valuation. CTSH is trading at a trailing multiple of 36 and a forward multiple of 33x this years expected earnings. While the higher multiple could be justified by the company’s history of growing earnings quickly, Cognizant is now at a size that makes it very difficult to maintain growth percentages while there is little doubt the company will continue to grow in dollar terms. If growth slows to 10-15% per year instead of breakneck 50% plus levels, there will likely be a significant decline in the multiple which could leave the stock at a hefty discount to current prices.

While current analysts are positive on the name, I am concerned that this fosters complacency in the investor base. Sell side research is often slow to recognize and alert investors to changing environments (see Merrill’s downgrade of CFC only AFTER the stock dropped from 40 to 20) and while I’m not anticipating a meltdown in the offshore consulting business, I think people may be surprised to see a decline in the growth rate. It pays to be cautious and hopefully some short ideas give investors a way to hedge positions or profit from these turbulent times. As always, use discipline and exercise stop levels. No need to be a hero in these markets.

CTSH Notes

FD: Author has short position in CTSH

Additional Reading:

Menashi wonders how much longer the offshore cost savings will last.

Stock Market Beat thinks CTSH may be reaching the limit of its growth.