Cognizant Technology Solutions (CTSH) gave in rather easily on the demands of Elliott, as "proposed" late November of last year. The company opened up seats on the board, is going to return capital to investors and aims to improve margins, thereby answering positively to all the demands of Elliott. That said, in general the demands of the activist investor were a bit larger than the extent to which Cognizant is now delivering.
Despite this modest disappointment, investors reacted positively to the willingness of Cognizant to engage with Elliott. While I do not share the optimistic scenario of Elliott for next year, I see better days ahead from current levels, making me a buyer on dips.
What Did Elliott Want?
Elliott wrote Cognizant a letter late in November of last year, telling the company that it has become a major shareholder, owning 4% of the shares with a value of $1.4 billion at the time.
Elliott believed that Cognizant is a great investment and company, yet it can be run even better. If Elliott's plans were implemented, the activist projected a valuation of $80-$90 per share by the end of this year. Elliot praised the long-term growth, but notes that shares have underperformed and lost their premium multiple versus other Indian-heritage players and Accenture.
Elliott cited two reasons for the underperformance of the shares in recent years: profitability and capital allocation. Cognizant continues to target operating margins of 20% of sales, something which it started over two decades ago, despite the fact that revenues have increased by a factor of 200 times. This indicates that the company has not benefited from scale, and shows that there is room for improvement, certainly as other players are posting margins in the 25-30% region. Capital allocation has been poor as well as retained earnings are not returned to investors, either in the form of a dividend or share buyback program.
Elliott is essentially demanding better operational results and increased returns of capital. By adopting best practices, Elliott believes that operating margins can improve 3 percentage points by 2018. Adjusted margins should improve to 23% of sales that year, or 21.5% on a GAAP basis. This still marks a 4-5% discount to some peers.
Cognizant's net cash position could furthermore be used to start an accelerated $2.5 billion share buyback program in early 2017 as well as pay a 1.5% dividend yield. Elliott would like to see a bit more aggressive adoption of M&A as well. Another demand is a refreshed board as well as improved incentives for its members.
Using a scenario of 9% revenue CAGR through 2018, adjusted operating margins of 23%, and cumulative buybacks of $4 billion, Elliott came up with a $5 adjusted earnings per share number for 2018, or potentially a bit higher. By applying reasonably conservative multiples to such an outcome, Elliott valued the shares at $80-$90 per share.
Cognizant Is Listening
Little over two months after Elliott's letter, Cognizant is making a move in response to the demand of the activist investor. The company announced that it has reached an agreement with Elliott as the board will be refreshed with three new board members.
The company will furthermore engage on a $1.5 billion buyback program in Q1 of 2017, a billion less which Elliott demanded. Another $1.2 billion in buybacks will be executed from Q2 of this year onwards to 2018. The company furthermore announced a quarterly dividend of $0.15 per share as the 1.1% yield is a bit less than the 1.5% suggested by Elliott. The capital return program is a bit lower than perhaps hoped for, but fortunately the company has committed to pay out 75% of US free cash flows from 2019 onwards, thereby reassuring investors.
While Cognizant has quickly delivered on capital returns and improved board accountability, the hardest step still has to be made, that is achieving margin gains in the actual business.
But What About The Operational Achievements?
For the operations of Cognizant, Elliott guided for a 9% CAGR through 2018 in terms of sales and adjusted operating margins of 23%.
That seems a bit stretched as fourth quarter sales were up by "just" 7.1% to $3.46 billion as full-year growth came in at 8.6% last year. GAAP operating margins for the final quarter came in at 16.2%, down 90 basis points from the year before. Full-year margins came in at 17.0%, down 20 basis points from the year before.
Even if acquisition and stock based compensation expenses are added back, fourth quarter adjusted margins were down 90 basis points to 18.7% of sales, a long way from the 23% goal as suggested by Elliott.
The guidance for 2017 is comforting in terms of sales as revenues are seen at $14.56-$14.84 billion, suggesting that sales are seen up by 8% to 10%. Non-GAAP earnings are seen at least $3.63 per share, which is kind of disappointing as this suggest growth of at least 7% per share. This actually suggests that margins are seen down in the coming year, especially as the earnings guidance takes into account the accretion from the announced share buybacks.
The anticipated margin pressure is attributed to investments to build digital capabilities, which now make up nearly a quarter of total revenues. Cognizant is investing in re-skilling of staff and new technologies. These actions, which are support to ensure revenue growth beyond 2017 as well as a review of the cost structure, should result in non-GAAP margins of 22% by 2019. This target is a percentage point less and a year later as targeted by Elliott.
Agreeing With Elliott, Delivering A Bit Less
Cognizant has in essence given in to all of Elliott's demands as outlined in November of last year, but it has under delivered a bit in relation to the demands of the activist investor. The share buyback program is a bit smaller than demanded, as is the dividend yield. Furthermore, the margin target outlined by Cognizant is achieved a year later and is lower than Elliott demanded for.
Let's however construct the pro-forma picture for 2019 based on the plans, as outlined by Cognizant itself. Based on the midpoint of the guidance of $14.7 billion in sales for 2017 and applying a 7% growth rate through 2019, I see sales of $16.8 billion.
Adjusted margins came in at 19.5% in 2016 as the gap with GAAP margins was 250 basis points, which seems fairly stable driven by amortization charges and stock-based compensation charges. That suggests GAAP margins might come in at 19.5% in 2019, if adjusted margins hit Cognizant's target of 22%. This should boost GAAP operating profits from $2.29 billion in 2016 to $3.28 billion in 2019.
The current share base of 609 million shares can be shrunk given the $2.7 billion share repurchase program, to be executed in 2017 and 2018. That would be sufficient to buy back 48 million shares at current levels, reducing the share base to 561 million shares.
The issuance of debt, as most of the net cash position is held overseas, will involve modest interest charges going forward, despite the fact that Cognizant is remaining net debt free going forward. Using a $3.2 billion earnings before tax number for 2019, and a 25% tax rate, earnings might come in at $2.4 billion on a GAAP basis. That would be equivalent to $4.25 per share in 2019.
Elliott came up with a $4.95 per share number for 2018, but this was a non-GAAP number, as the difference between accounting methods inflates this number by $0.50-$0.60 per share. As such, Elliott is a bit more aggressive, a reason why a $70-$80 valuation seems very reasonable by 2018, instead of the $80-$90 suggested by Elliott.
That being said, it will be challenging to add 2.5% points to margins in a period of little over a year, but Cognizant has reacted positively to Elliott and rather quickly. This is a comforting sign, even as it is not as aggressive as Elliott demands have been.
The $80-$90 fair value assumption of Elliott for the coming 12 months seems too optimistic, as recognized by the market in the sense that shares could rise some 40% in the period of just a year at the normal case outlined by Elliott.
I see potential for $70-$80 valuation if Cognizant delivers on its plants which are a bit less aggressive than Elliott has called for. Even so, achieving a 250 basis point improvement in margins is hard to be achieved by 2019, certainly if the company actually guides for modest margin pressure in the coming year.
That being said current earnings power runs at $3 per share which with a market multiple and net cash could provide a real support to the valuation at these levels. There are some risks however including a potential revoke of the H-1B visa, as Cognizant is the largest "user" of this program. The other concern results from the overhang from a potential violation of the US Foreign Corrupt Practices Act, although Cognizant has voluntarily notified authorities. Given these two overhangs, I subtract $5 per share in the valuation.
If incremental improvements become visible in the coming quarters, a $70 valuation seems fair at this point next year. This makes me a buyer on potential dips which could easily be triggered by political headlines.
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.