Current Price: $77 Price Target: $101
Position Size: 3% TTM Performance: 20%
Cognizant reported 2Q18 revenue up 9% but below the street and at the low end of guidance. This included a $31m rev benefit from the adoption of new accounting rules. Excluding the accounting change, rev was up ~5%. Lower than expected revenue is on weakness in their largest end market, financial services. Higher gross margin, lower OpEx, and a lower tax rate led to EPS that was ahead of consensus, $1.19 vs $1.10. They maintained fully year revenue guidance, but street is well ahead of the midpoint of full year guidance. FY EPS guidance raised and is slightly ahead of consensus. Q3 rev and EPS guidance was below the street.
· Their high exposure to legacy IT, exposure to financials, and a growing war for talent, is leading to concerns that achieving both revenue growth and margin expansion may be difficult for them.
· “The story among large money-centric banking clients remains mixed.” Financials are their largest end market and they continue to see weak spending at banks on legacy IT work. On a positive note, they are seeing some digital work at banks that is offsetting some of this decline – they gave examples of projects related to blockchain implementation, cloud migration and AI related work. “We are optimistic about this shift because banks have realized that they have no choice but to rewrite their futures with digital.”
· Weak guidance for Q3 and high employee attrition (hit 22% this quarter) are also a concern.
· Despite this, Cognizant will continue to benefit from an overall strong IT spending environment and some of their slower growth end markets should improve. Spending from banks should improve as rates rise and healthcare will continue to improve with the transition to value based care. Legacy represents the vast majority of IT spend and it is still early innings of the digital transformation that is occurring across industries.
Similar to last quarter, they expect IT spending to steadily improve through 2018 and continue to see good demand across verticals with the exception of financial end markets. This is their largest end market and continued weakness there was a disappointment especially after they indicated last quarter that they were starting to see an improvement. They remain committed to their 22% operating margin target by 2019, but the concern is whether that may come at the expense of slower top line growth. Weak guidance and high employee attrition continue to be a concern. They again reported employee attrition of over 20%. This higher attrition reflects the war for talent and resultant wage pressure that is occurring in the industry. Salaries make up the majority of their operating costs. Additionally, across the industry there has been pricing pressure on the Legacy IT side where Cognizant (and the other offshore players like Tata and Infosys) has a far greater exposure to than rival Accenture. Accenture’s exposure to digital is 55% vs the 29% Cognizant just reported. Cognizant continues to increase their exposure to digital which is higher growth and higher margin. In terms of capital allocation, they are committed to increasing returns to shareholders via buybacks and dividends and are looking to make additional tuck-in acquisitions.
Interesting example of a bank project: A large multi-national financial services client needed to stem costly credit card fraud losses. That client handles 700 million card transactions a month, of which about 1.3 million turn out to fraudulent. Using machine learning algorithms they built a solution that runs real-time transactions against multiple neural network models. With CTSH’s AI solution, the client was able to understand new fraud patterns, increasing their fraud capture rate by 30% and reducing the rate of false positives (i.e. legitimate transactions wrongly declined) by 100%.
Valuation:
· With a FCF yield of >5%, 1% dividend yield, secular growth tailwinds, strong balance sheet and ROIC running in the mid-20’s, the stock is not expensive.
· Dividend yield is ~1% with plenty of room to grow.
· Strong balance sheet – no net debt.
· On track to complete plan announced in February 2017 to return $3.4B to shareholders by the end of 2018.
Investment Thesis:
· They are well positioned to benefit from the “SMACK” megatrend (Social, Mobile, Analytics, Cloud, and Key disruptors) which is driving corporations to rethink the way they do business.
· Digital readiness and cloud computing are reshaping client demand for IT services. Cognizant is well positioned to benefit from this shift and trades at an attractive valuation.
· Improving capital deployment to shareholders via dividends and buybacks.
$CTSH.US
[tag CTSH]
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109