What happened and why Cognizant is a buy
Cognizant Technology Solutions (CTSH) recently reported its 1Q19 results which came below expectations due to softness in its financial services and healthcare segments. As a result, the company made a downward revision in its full-year outlook, which prompted a stock price decline of approx. 20%.
Despite this temporary setback, we believe that the long-term investment case on Cognizant remains largely intact. As a result, we have recently increased our stake in the company, which we have owned since 2016.
This article briefly outlines our investment thesis on Cognizant.
Company background & description
Established in 1994 in New Jersey, Cognizant is a leading provider of professional services aiming to assist clients transforming their business model for the digital era. Its services include digital services & solutions, consulting, application development, systems integration, application testing & maintenance, infrastructure services, and business process services.
In 2018, Cognizant derived some 76% of revenues from North America, 18% from Europe (nearly half of which from the UK), and 6% from the rest of the world. By end markets, the company serves customers in the financial services industry (35% of 2018 sales), healthcare (29%), products & resources (22%), and communications, media & technology (14%).
Source: Cognizant corporate factsheet
Cognizant provides its services to some of the largest corporations worldwide, including 48 of the Fortune 100 companies. In 2018, the company employed close to 282,000 people, of which over 195,000 are located in India.
Cognizant operates in a highly competitive environment. According to the company, key competitors include Accenture (ACN), Atos (OTCPK:OTCPK:AEXAF), Capgemini (OTCPK:OTCPK:CAPMF), Deloitte Digital, DXC Technology (DXC), EPAM Systems (EPAM), Genpact (G), HCL Technologies (OTCPK:OTCPK:HCTHY), IBM Global Services (IBM), Infosys Limited (INFY), Tata Consultancy Services (OTCPK:OTCPK:TTNQY) and Wipro (WIT); as well as a number of smaller local competitors in various markets.
The principal competitive factors affecting the markets for its services include performance and reliability, quality of technical support, training and services; responsiveness to customer needs; reputation and experience; financial stability and corporate governance; as well as pricing.
IT services has been a fast-growing market over the past two decades, and there is little sign that this will change going forward as a result of the accelerating digitalization of the world economy. While historically, this mainly referred to basic IT services (e.g., a company outsourcing its servers), it is now increasingly about an integrated approach bringing together all key aspects of business management, including strategy, technology, data analytics, sales & marketing, etc. A growing number of corporations are recognizing the fact that digital technology is both a potential source of disruption for established business models, as well as a source of opportunity to innovate, be more efficient, and enhance one’s competitive position.
Arguably, this trend of digitalization remains in its infancy, with many more industries and business models yet to be impacted by both the risks and opportunities it presents. Stated differently, IT consultancy and services should continue to experience above-GDP growth going forward. According to Morningstar, market research firm Gartner expects the overall global IT services industry to grow at a CAGR of 4-5% over the next five years. For reasons stated in the next section, we believe that Cognizant can continue to outgrow its underlying market.
Competitive position & barriers to entry
Over the years, Cognizant has built a strong reputation in the marketplace, and is generally considered to be on equal footing with some of its long-established competitors. Perhaps the easiest way to illustrate the highly successful track record that Cognizant has built over its 20+ years of existence is how quickly it has outgrown its competition, albeit from a low base. Most of its growth has been organic in nature, although the company did make a sizable acquisition in 2014, purchasing TriZetto Corporation for USD 2.7 billion. In 2018, the company continued to broaden its range of capabilities, making a total of six smaller acquisitions for USD 1.1 billion.
Why is Cognizant outperforming its peers in this competitive marketplace? If it were to be summed up in two main points, it would be its "client-first attitude" and long-term focus. It appears clear that Cognizant’s management understands that intangible assets such as customer relationships, reputation, and branding are the main source of long-term competitive advantages in this industry, and this is reflected in many aspects of the firm’s strategy and modus operandi. Not only is this evidenced in the firm’s superior organic growth track record, but it is also exemplified by the company’s high client retention rate (of approx. 90%, much higher than peers), as well as its market leader status in terms of client satisfaction, according to studies by third-parties.
Profitability, capital efficiency, and returns on investment:
Source: Thomson Reuters
Cognizant runs a consistently profitable business, which is fairly capital-light, and thus generates very healthy return levels on invested capital of approx. 20%. Note that ROA is burdened by the large amount of cash that is sitting on the balance sheet, representing nearly 30% of total assets as of the end of FY18. Likewise, it is important to note that ROIC has declined from 2014 onwards following the acquisition of TriZetto, which has added a sizable amount of goodwill on the balance sheet.
As shown below, Cognizant has grown at a very rapid pace over the past couple of decades. Over the last 10 years, it has grown sales, operating profits, net income, and EPS at a CAGR in excess of 15%, way faster than the growth of the underlying market.
Source: Thomson Reuters
Please note that a number of extraordinary items blur the picture regarding growth in net income and EPS in the past three years. Specifically, the company paid a high level of income tax in 2016 following the one-time remittance of cash from India to the U.S. in order to fund its plan to return capital to shareholders through dividends and share repurchases. Moreover, in 2017, the company incurred a one-time incremental income tax expense of USD 617 million related to the U.S. Tax Cuts and Jobs Act. Under normal conditions, EPS is expected to grow slightly in excess of top-line growth.
Source: Thomson Reuters
Cognizant runs a fairly cash-generative business despite extending attractive payment terms to its clients, as shown by the average days receivable outstanding of nearly three months. As a service provider, it holds no inventory, which helps minimize the amount of cash that is tied up in the business.
Earnings quality is high, with cash from operations (CFO) systematically higher than net income, averaging nearly 120% over the past decade. Overall, free cash flow (FCF) generation is very strong, with a cash conversion rate of nearly 100%.
The company is in a stellar financial position. Both cash and shareholders’ equity (i.e., retained earnings) increase steadily over the years. Historically, cognizant had no debt until the acquisition of TriZetto in late 2014. Even as it raised over USD 1.5 billion in debt, the balance sheet was hardly levered, and it has steadily paid down its debt ever since. Overall, with a net position of nearly USD 4 billion (13.5% of current market capitalization), Cognizant is in a very strong financial state.
Source: Thomson Reuters
Management team & track record of capital allocation decisions
By and large, Cognizant has had a solid historical track record regarding its managerial capabilities and capital allocation decisions. The only noteworthy hiccup was the unexpected resignation of Gordon Coburn in late 2016, who held the position of president at the time, which seemed to be related to an internal investigation into certain payments in India that may have been made improperly.
For the past 12 years between 2007 and early 2019, Francisco D’Souza has been CEO of Cognizant, overseeing a continuous period of profitable growth, innovation and success. Throughout that time, Cognizant’s revenues increased more than 10x from USD 1.42 billion in 2006 to USD 16.1 billion in 2018.
In February 2019, Cognizant announced that Brian Humphries would be the firm’s next CEO, while Mr. D’Souza would stay on as Vice Chairman of the Board. Mr. Humphries was formerly CEO of Vodafone (NASDAQ:VOD) Business, and also previously held leadership positions at global technology leaders Dell (NYSE:DELL) and Hewlett-Packard (NYSE:HPE).
Despite being the first "outsider" to lead the firm, we don’t expect any meaningful changes in corporate strategy or capital allocation decisions. The firm is still expected to reinvest profits, both internally and via acquisitions, to grow its footprint and capabilities in order to better serve clients in a fast-evolving digital economy. The company will likely continue to focus increasingly on returning excess cash to shareholders via dividends and stock buybacks, helping to alleviate the "growth at any cost" concerns that some investors might have had. This notion is also supported by the fact that the recent U.S. tax reform will make it less burdensome for companies to repatriate cash generated outside of the U.S. for such purposes.
Cognizant only started paying out a quarterly dividend in the second quarter of 2017, and its track record is thus way too short to analyze. As of today, the quarterly dividend stands at USD 0.20 per share, or a dividend yield of 1.4%. The payout ratio was approx. 22% of net income and 18% of cash from operations.
Valuation & risks
Unsurprisingly, the estimated intrinsic value of a high-ROIC company like Cognizant is highly dependent on its growth profile. While it likely won’t maintain its historical growth of 15%+, we believe that Cognizant will continue to outgrow the wider IT services market. We expect the company to grow sales at a CAGR of about 6% over the next 10 years, slightly in excess of the underlying market. We anticipate the company to make steady progress towards its goal of reaching a non-GAAP operating margin of about 22%, as it adjusts its fairly flexible cost base and moderates discretionary spending and investments according to business activity.
Using a terminal growth rate of 2% p.a. and a WACC of 9.0%, our DCF model yields a fair value (FV) of approx. USD 75 per share. Our sensitivity analysis points to a FV range of USD 60-90.
A FV of USD 75 per share represents a multiple of approx. 19x our GAAP EPS estimate of USD 3.80 per share in FY19, which is in line with long-term historical multiples and warranted by the company’s return and growth profile.
Last, the consensus price target and Morningstar FV estimate are USD 69 and USD 79 respectively.
Key risks include increasing competitive rivalry and pricing pressure, attrition rates and ability to attract and maintain IT professionals, unknowns related to cloud computing and the cannibalization of traditional IT outsourcing services, as well as FX risk (exposure to the Indian rupee-USD exchange rate).
Conclusion - Cognizant is a buy
Investing in the technology sector is often a difficult endeavor for conservative, long-term investors due to its inherently fast-moving and ever-changing competitive environment. Having said that, we believe that IT consulting and services firms such as Cognizant deserve some attention, as they stand to benefit from the increasing digitalization of the business world, without bearing the risk of being tied to any specific technology platform.
While the company might not appear as "cheap" at first glance, anyone who understands the drivers of value creation knows it must be looked at through the prism of return on capital and growth. Cognizant’s long-term track record clearly shows that the company consistently earns about twice its cost of capital, with unlevered ROEs of approx. 20%, and grows at a fast rate, in excess of 15% this past decade. We believe it can maintain a high-single-digit earnings growth over the next decade. While a PE multiple in the mid-teens certainly isn't "cheap" on an absolute basis, it is cheap relative to relative to the firm’s potential to compound earnings in the years to come.
We have held a position in the company since 2016, and have recently accumulated more shares.
Source: Thomson Reuters
Disclosure: I am/we are long CTSH. 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.
Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.