Cognizant delivered strong results during the third quarter, posting revenue in line with expectations and broad based growth across segments and geography. Three of the four business segments were strong growth contributors. CTSH is focused on enhancing its digital capabilities and working to improve margins moving forward. Operating margin for the quarter was 20% and they are committed to a target of 22% in 2019 by balancing growth and profitability. CTSH has continued its momentum throughout 2017 and expects to close the year with solid revenue and earnings growth. Thesis intact. Price target unchanged.
Current Price: $73
Price Target: $76
Position Size: 2.3%
TTM Performance: +42.3% (purchased mid-December 2016)
1. Consulting and technology services revenue grew 11.3% (59% revenue) and outsourcing services (41%) revenue grew 6.1% – outsourcing improving in back half of year as predicted
a. Q3 revenue was on the high-end of guidance and they are raising low end of guidance for 2017 total revenue ($14.78 – $14.84 billion)
b. Banking and financial services – grew 3.8% yoy but came in below expectations. A recent win in the segment was Voya Financial which engaged CTSH for an end-to-end transformation
c. Health care – revenues grew 9.3% yoy. The Q3 acquisition of TMG Health extends their leadership as the leading software services health care partner
d. Products and resources – grew 14% yoy. Strong growth from manufacturing and logistics clients offsets the sluggish growth in retail
e. Communications media and technology – grew 18.2% yoy. Growth across the segment with expansion in areas like creating and curating content
2. CTSH is focused on several value-enhancing initiatives: incremental growth in digital, significant margin expansion, and returning capital to shareholders
a. Initial dividend yield 1%. In Q3 CTSH completed its $1.5 billion accelerated share repurchase program and declared a quarterly cash dividend of $0.15 for November
b. CTSH is looking to improve operating margins (which have been fixed) by 200 – 300 bps over the next few years with a goal of 22% by 2019
c. Expected real yield in 2018 of 4-5% (~4% buyback + 1% dividend yield). The goal is to repurchase an additional $1.2 billion by the end of 2018 (additional details on the program at a later date)
Driving Digital at Scale Through Transformation of Clients’ Enterprise Models (3 Practice Areas)
Investment Thesis:
1. The IT services market is expected to grow ~5% per year over the next 5 years. I expect CTSH to grow earnings and revenues ahead of the industry due to their digital capabilities. 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.
2. 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. Recent headwinds have created an opportunity to take an initial position in CTSH. The company currently trades at a 6% FCF yield and 15x forward earnings.
3. CTSH has grown FCF at a healthy 25% CAGR over the past 5 years and maintains a strong balance sheet. I expect that over time they will increase returns to shareholders via buybacks and eventually a dividend; boosting EPS growth and transitioning the narrative from a revenue growth to a total return story. In the near term growth is a bigger priority than initiating a dividend.