Cognizant: Overblown Immigration Worries

| About: Cognizant Technology (CTSH)

Summary

CTSH is an activist investor target.

The suggested fair value could lead to 25% upside.

But it’s still cheap, but for an overrated reason.

Cognizant Technology Solutions Corporation (NASDAQ:CTSH) is a successful international outsourcing company headquartered in New Jersey. It is managed by 48 year old co-founder Francisco D'Souza, who has guided it through a period of explosive revenue growth - sometimes as much as 30% a year, quadrupling the company's top-line in less than a decade.

While that level of growth is clearly unsustainable after a certain amount of time, a still-impressive 8-10% a year growth rate is not out of the question. The demand for Cognizant's IT and business outsourcing is insatiable - there are simply not enough software engineers and other personnel with relevant skills being trained in the U.S. and other developed countries.

With that, Cognizant has consistently posted gross profit increases in recent years, generating $4.2 billion in 2014, $5 billion in 2015 and then $5.5 billion in 2016. Cognizant is keeping up with demand nicely, being able to hire employees as needed, which also helps keep expenditures lower (using a hire-as-needed model). The company has grown to the point where it has over a quarter of a million full-time employees.

Unfortunately, this is where a potential problem lies.

Recent Developments

Since Cognizant is an outsourcing company, employees are at the very heart of its existence. However, as previously mentioned, the company is based in the U.S. - which continues to lack workers with advanced technology skills. Therefore, much like what Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and every other tech company does, Cognizant brings workers from other countries who have the necessary skills.

These employees are able to work for employers in the U.S. under H-1B visas for up to six years. Unfortunately, there is currently a great deal of upheaval in the country due to President Donald Trump's crackdown on immigration. Many workers who have been working under these visas, but happened to be out of the country at any time of Trump's recent policy changes, have been denied re-entry.

Yet, most companies affected by the new policies seem to be remaining optimistic. While there is no question that these events have caused some disruption, it should be relatively minor. Apparently, a vast majority of the employees working under these visas are from countries considered to be non-threatening. So, despite the media headlines and market jargon, there is a slim chance that Cognizant's operations could be impacted, widespread disruption should not be expected.

A New Perspective

Probably the most important factor driving Cognizant in the short-term is the 4% stake that activist hedge fund Elliot Management has taken in the tech company. With that big of a stake, the fund wants to provide input into how things are run.

In this particular case, Cognizant leadership doesn't seem to have any problem with that. That may have something to do with the fact that Elliot's main representative, Jesse Cohn, says he believes the share price could jump to $80 within the next couple of years - potentially 25% upside from where Cognizant currently trades.

Elliot Management came in with many plans, some of which have already been implemented.

No. 1 - Stock buyback - Cognizant will be using $1 billion of its cash on hand, plus another $1.5 billion in new debt financing, to buy back $2.5 billion of its own stock by the middle of this year - which is over 7% of its current market cap. It has already initiated a buyback of $1.4 billion.

No. 2 - Profit margins - Elliot wants Cognizant to start focusing more on profit margins instead of gross revenue increases. The company's pretax profit margin was 18% when Elliot bought its stake, but the fund believes that Cognizant can up that to 23% with only minor organizational changes.

No. 3 - Board changes - Three of the 13 board members were hired just last month. A refreshed board is expected to breathe new life into the company.

Elliott Management has a very impressive history of success with the companies in which it buys substantial stakes. And Jesse Cohn manages the technology investments for the fund, so he has a great deal of experience in the sector.

The fact that Elliot bought such a big stake in Cognizant - and is advocating for such major changes - is a very clear indication not only that they believe the company to be undervalued, but that they can significantly raise the share price with specific tweaks to operations. Considering the success that Cognizant has already achieved, Elliott has great potential to work with.

All things considered, Cognizant's share price - with help from Elliot - looks poised to take off into heights greater than it has ever seen in the past. Plus, with Cognizant trading at 15 times next year's earnings, it's a relatively cheap stock. You won't find a better value in the business services and outsourcing space. CA Inc. (NASDAQ:CA) comes close but Cognizant's relative stock price underperformance, margin expansion potential and superior balance (i.e. ultra low debt and 13% of its market cap covered by cash on the balance sheet) make it the better bet. And even if it takes two years from now to get to the $80 fair value Elliott put on the stock, that's still a solid 11.8% annualized return - not bad considering the S&P 500 has returned an annualized 5% over the last decade.

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.

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