Cognizant (NASDAQ:CTSH) released results for its fiscal Q4 on February 8th, 2016. As I expected in a report I published on the Seeking Alpha site, the company reported decent numbers for the quarter but was forced to guide down significantly, particularly for Q1 2016. The results themselves were pretty typical of Cognizant quarters. EPS was a couple of pennies above investor expectations, with revenue being just a bit below the consensus forecast. Operating margins at 19.6% were in the middle of the company's long-time range of 19%-20%. The company had a significantly stronger quarter in both Europe and particularly Asia/Pac than was the case in the US. Although revenue growth came in at planned levels, sequential growth at just 1.4% was not particularly ebullient even in the wake of the Diwali holidays in India, the Christmas/New Year's holidays in the US and Europe and whatever impact there may have been from the floods in Chennai. For the first time in many years - and perhaps longer than that - sequential growth for Cognizant was below that of its core competitors including IBM (NYSE:IBM), Accenture (NYSE:ACN) and of course Infosys (NYSE:INFY) and Wipro (NYSE:WIT). I think that this is a remarkable turn of events and one that bears some further consideration on the part of investors. For as long as this writer can remember CTSH has enjoyed a premium valuation in its space because it was taking market share from its competitors at a steady pace. Over the years it grew to become the second largest company in the space after TCS. There has been an aura and mystique surrounding CTSH that remained un-dented even during the hard times of the financial crisis and its impact on both CTSH and the industry as a whole. And now, to some extent unheralded, CTSH finds itself growing at average rates. Indeed, in this past quarter, sequential revenue growth was the lowest - although not by that much - of the large names in the space.
The share price action in the wake of the earnings release was relatively muted - certainly by the standards of Tableau (NYSE:DATA) or LinikedIn (NYSE:LNKD). The shares fell by less than 8% which has to be considered a muted move in the recent environment. Cognizant is comfortably profitable, it has a pristine balance sheet and its valuation wasn't particularly crazy before the disappointing guidance - the stock market is still able to discriminate to a degree between risky and less risky bets.
Guidance for both the company's Q1 and for the full year is somewhat below prior expectations but perhaps of equal significance the kind of growth being forecasted would be a material slowdown in terms of revenue performance vis-a-vis the company's principal competitors. Cognizant introduced a new style of giving guidance on its call on February 8th - it will now use ranges when providing guidance whereas heretofore it had used a single point minimum. Because we haven't any experience with Cognizant and the ranges it is now providing for guidance, it seems prudent to use the midpoint of those ranges although based on how Cognizant guided heretofore one might be justified in saying the low point of guidance is equivalent to the "at least" caption of prior earnings releases.
But the fact is that Cognizant is now guiding to negative revenue growth in Q1 vs. a prior expectation that was 7% greater. Earnings, too, are below prior expectations. They are now forecasted to be $.78-$.80 for the period compared to a prior consensus of $.81. Full-year guidance represents 10%-14% growth. Prior expectations were about 280 basis points greater. The EPS mid-point also is a couple of percent below prior expectations.
Explanations, Thoughts and Musings
The company called out macro weakness and uncertainty as hobbling its forecast in the company's financial sector which is the company's second largest vertical after healthcare. Interestingly, financial services were not particularly slow for CTSH in Q4 and its competitors mainly cited financial services as a demand driver. Given the turmoil in the financial services world, my guess is that CTSH is far more likely to have been both correct and prudent in opining that its growth will be hobbled because of a slowdown in financial services.
It also suggested that the uncertainties surrounding potential mergers in the healthcare space had lead and would continue to lead to some weakness in the outlook for the healthcare vertical at least during this quarter and perhaps Q2. Healthcare is now the company's largest vertical by a significant amount in the wake of the Trizetto acquisition. Management felt that the recovery of the healthcare vertical was quite likely as industry consolidation came to pass and transactions in which Cognizant has already been selected as the vendor of choice came to be executed. On the other hand, it suggested that it did not really see a material recovery in its financial services vertical for the balance of the year.
Cognizant has always been a company that has forecast conservatively and I have no reason to believe that it has shed that conservatism in the new year. That being said, however, the math suggests that management is looking to see a quite extraordinary pickup in growth in the healthcare vertical, even just to achieve the mid-point of the revenue growth guidance. Without going through the math at a detailed level, if Cognizant starts the year off with no growth in Q1 but expects to end the year with 12% growth overall, while 25%-plus of the company's revenues remain flat at best, then the other 75% of revenues of which healthcare is more than half would have to grow by something like 20% or more in the last three quarters of 2016. The growth would actually have to be closer to 25% in healthcare depending on the exact results that are likely for Q2.
Excluding the Trizetto merger, that is a level of growth that the company hasn't seen for at least the last 5-6 quarters and it certainly is a more aggressive forecast than that which Cognizant typically chooses to make.
Cognizant is still having a difficult time in managing turnover which came to an annualized rate of 19% last quarter, down marginally from Q3 but still quite elevated. Again, if turnover remains elevated, it is going to be very hard for Cognizant to staff those whale size consulting jobs that it is forecasting if it's going to be able to close in the health are vertical later this year. Cognizant has made a point for many years of staffing its jobs with consultants with deep industry domain expertise. That expertise is typically a product of spending some time at the company's "universities." Hiring is expected to be muted in Q1 after hiring was barely positive rates in Q4. I just have to wonder how the company is going to staff what it describes as complex jobs in its healthcare vertical without more rapid hiring and training that will apparently take place over the next 120-plus days.
Further it is going to be interesting for me to see if Cognizant manages to maintain its market share against newly revivified Infosys and a host of other competitors. The aura of invincibility that Cognizant once enjoyed seems to be tarnished these days and its competitive positioning no longer seems quite as invincible as had heretofore been the case. There is a certain disconnect, I believe, between the CEO's commentary at how new Cognizant hires marvel at their sense of freedom and autonomy, and the company's attrition rate, which continues to hold at close to 20%. It is hard for me to attempt to figure out why Cognizant's aura, or its mojo if you prefer, seems to be tattering at the edges, although it does seem likely that there has been a convergence between Cognizant and its competitors in terms of how industry participants price their jobs and manage their projects. Management made its characteristic comment that Cognizant competitors are being very aggressive in terms of pricing - there really are no signs of gross margin attrition among any of the major industry competitors that suggest any undue aggressive pricing.
Cognizant has made a habit of attempting to guide conservatively and then raising its expectations as the quarters unfolded. There are doubtless going to be many observers who feel that this is exactly what is happening this time around. At this point, none of the analysts who cover the name have chosen to change their rating for the shares which remain at a highly bullish 1.7 with a mean price target of just below $75, or almost 40% above current prices. At the least, I think, it is inevitable that with the current guidance, there will be loads of price target changes, and it is possible that some analysts may temper their long standing love affair with this company in the wake of what is the slowest revenue growth guidance in 14 years which came during the trough of the dot com implosion.
Cognizant shares are notionally not particularly expensive. They are just around 16X expected earnings for 2016 and the company. But for the first time in many years I think that the construction of the company's forecast is significantly riskier than has heretofore been the case and I think it is a leap of faith to believe that the non-financial services components of the company's business can achieve the 20%-plus growth targets that have animated the company's current forecast and will shortly be integral to the published earnings consensus. I think that the company's shares are more likely than not to be in the "show me" category until at least the end of Q2 when there might be some visibility as to the snap back the company is forecasting in its healthcare vertical.
This company continues to generate lots of cash, almost $700 million last quarter which compares to about $500 million of non-GAAP net income. Running a profitable professional services business of some maturity is simply not very capital intensive. Capital expenditures for the quarter were only $74 million which will allow the company to repurchase shares at a good clip or consider paying a dividend. Overall, the company grew its cash balances by $1.5 billion last year and the company now has more than $4.5 billion in cash and equivalents, net of its revolving line of credit, far more than is necessary to operate the business from a day-to-day standpoint. That being said, however, in the short term, I expect that the company is going to try to use its surplus cash to make an acquisition such as Trizetto which was self-described by management as being "more than expected." If the company hopes to resume a strong growth pattern and to start to grow at above industry average growth rates, it is almost certainly most likely to achieve such a goal by buying specialized vendors that either expand the company's geographic footprint or more importantly allow the company to deepen its domain expertise in its leading verticals. I think one of the keys to potential stock performance going forward will be the company's ability to start to acquire significant pieces of technology that will enhance the competitive position of its intellectual property.
Cognizant reported its earnings and while not a huge disappointment, certainly represented some disturbing trends in terms of the guidance it gave and the outlook for some of the company's verticals. Whatever else seems true, it does seem quite evident to this observer that the years stretching back a decade and more during which company regularly gained market share against its leading competitor have drawn to a close and may not return any time in the near future. That alone would be alarming to me as it suggests that over time there is likely to be a change in perception regarding the company that will lead to multiple compression.
I think that for the first time in years the company has a forecast that is riskier than is likely to be perceived by many investors. I'm quite dubious that some of the whale size deals in the company's healthcare pipeline will get closed in time or staffed soon enough to produce the revenue growth snapback that the company is forecasting for the second half of 2016. This may be a year in which Cognizant simply struggles to achieve its mid-point goals and is unable to raise guidance. I think current analyst price targets are going to have to be substantially revised which is not going to set a favorable backdrop for share price appreciation. Given the company's relatively modest valuation and its pristine financial condition that is not likely to change any time soon, I think the shares have limited downside at this point. But I think investors might do better than to complacently buy this dip. There are names within the IT space with far greater snap back capability than CTSH - that is whenever we finally actually see a snapback that lasts more than a few hours.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.