Description

Note: I'm using consensus numbers in the tables at the top of the writeup.

Quick Case

This is a fairly basic pitch, with the idea pretty much being that it is value in plain sight. I think that the earnings growth story will more than likely be dull and unexciting (though there's some chance that the new CEO will be able to reinvigorate growth - not banking on this really for the investment case to work, though), however the more or less constant drumbeat of bad news has, I think, driven valuation and sentiment down to a level where the risk/reward is now quite favourable. I think that if the new CEO can improve the earnings trajectory slightly, there is a shot at a double in the shares, and a realistic chance of 30%-40% upside. If it doesn't work out - I don't see it as that exciting of a case, and US stocks just don't do well with poor earnings momentum, however the low valuation, strong balance sheet, strong cash generation, and decent return on capital and return on equity should mean that you won't lose much money if momentum continues to be poor. The company would probably continue to be very cash generative (prospective FCF yield is about 8%), which will allow the company to both bolster revenue growth inorganically (they will probably spend about $1bn per annum on deals to supplement their digital offering), add a couple of percent to the EPS growth by reducing share count (about $500m should go to buybacks), and add a couple of percent to returns via dividends (yield is currently ~1.9%). The market's reaction to the disappointing revenue growth has driven the 1y forward P/E multiple down from about 16x pre-covid (and ~20x more recently, towards the end of 2021) to about 13x now (with net cash) so I think you have at least some support if the top line momentum doesn't improve. 

Company Description

The company profile was covered in another writeup, but it was many years ago so I'll briefly discuss that. They are an IT and outsourcing business, mostly billing on a time and material basis (as an example, within Financials, time and material is jusy under 60% of revenues) - they would like to increase the share of consulting and "deeper relationship" work that they do, I think because it is lower cyclicality (probably due to more opacity in the pricing) and maybe higher margin, however I'm not modelling any of that happening. An example of what they do would be a cloud consulting project that they recently did for Oxford University Press here in the UK. OUP were spending quite a bit of money spinning up resources in the cloud without a centralised view of who was spending, on what instances, where they were doing it, what the utilisation was, and so on. Cognizant worked with them on suggesting best practices for monitoring the spend (i.e. stopping a situation where some dev person can just spin up a resource costing $10k per month with no sign off, etc), then worked on single view dashboards of spend in order to help guide decisions on consolidating spend, which ended up saving OUP about £1m. Just over half of the business is now Digital services such as this, and in this area, which is higher growth, they've really lagged competitors like Accenture, who got to over 50% Digital (or "The New", as they called it at the time) many years ago. But they are reaching a tipping point now where the mix is more weighted towards Digital, which can't hurt the growth profile. In terms of the verticals they're exposed to, in the previous writeup it was over 40% Financial Services, but due to anaemic growth in that vertical (a little over 1% annualised in the last five years), it's now a bit over 30%, and I think that Healthcare, which has grown at a healthier 6% over the same period, will surpass Financial Services to become the largest single vertical next year. 

The company is led by Ravi Kumar Sigisetti, who moved into the CEO role in January having previously only moved to the company from Infosys in 2022. Prior to this, they were led by Brian Humphries, who joined from Vodafone and only lasted about three years as CEO before parting company with Cognizant, I think reflective of the failure to deliver any improvement in growth momentum (in fact it got worse under him and there was one high profile acquisition, Samlink, which didn't work out and has been a drag on revenue growth in the Financials vertical). You could sense the frustration he increasingly had - UBS did a conference call with him for investors towards the end of 2022 (transcript is on Bloomberg) and you can sense the frustration he was feeling in his response to some of the questions around growth and staff attrition. Prior to Brian Humphires, they were led by Francisco D'Souza, who I think had been with the company since the spin from D&B, and who was well-regarded. He left quite abruptly during the early stages of covid, and I think he now co-runs a venture capital business with a couple of other partners. The focus of the new CEO will be securing large deals and making Cognizant the employer of choice again.

Looking at the financial profile, revenues in 2022 were $19.4bn, with gross profit about $7bn for a GM of ~36%, while operating income was ~$3.0bn (15.3% operating margin) and net income was $2.3bn and FCF was $2.2bn, with conversion almost 100%, and the company previously having guided for 100% conversion over the medium-term. Market cap is $30.5bn and they have a net cash position of about $1bn. 

Considerations

The company had previously been a bit of a market darling. You can pick your own start and end dates to suit any argument I guess, but from the start of the 00's to the high in the shares in Q118, you'd have generated about a 22% CAGR investing in Cognizant. I think the key to that was the very high growth rate, which I lay out in the chart below, together with good profitability on a par with the Indian-listed peers (I'm using names such as TCS, INFO, HCLT, WPRO, among others), which then generated very good return on capital and rapid EPS growth

The revenue growth rate has been monotonically declining, but that's to be expected given the law of large numbers, however somewhere around 2018/19 the growth rate dipped below the Indian peers. In terms of why this happened, there are a few moving pieces, but I think the key parts of it are lack of exposure to Digital, together with high staff attrition.

On the lack of exposure to Digital, the former CEO commented on a conference call right before he left the company that, when he joined in 2017, digital was only 30% of revenues. It's now about 51% of revenues, but if you look at a business like, say, Accenture, they got to over 50% of revenues from Digital many years ago (I think it would have been around 2018/19, possibly even earlier). Just to give a rough sense for the headwind that might have represented, even now, Cognizant's Digital revenues grew 7% in constant currency in the most recent quarter, while the overall business grew at about 4%, implying the business ex-Digital is only growing about 1% in constant currency (and is probably flat to negative excluding structure). Back in 2018/19 when Cognizant top line growth dipped below peers, Digital was a smaller base for everyone and was growing faster due to a lower base effect, so I would imagine that the mix impact was even more pronounced back then. I think that the organic growth they've benefitted from, plus the commitment they have made to be a bit more proactive on deals (similar to something like Accenture) should make this a bit less of a headwind going forward. They called out explicitly on a recent call that they felt that the SaaS mania we saw in markets overall meant that many of the deals they were looking at were being priced at valuations that made no sense to them, which kept them out of the market (for perspective, M&A by year: 2018 $1.1bn, 2019 $0.6bn, 2020 $1.1bn, 2021 $1bn, 2022 $0.4bn) but with valuations having come in a little in the last year or so, they feel comfortable committing once again to spending about 50% of FCF on buying in growth, which I think implies something like $1.2bn-$1.3bn-ish of spend per year, which I think should add something like 2.5% to revenue growth. I don't think the deal aspect of it explains too much of the slowing growth momentum, as that happened way before they eased up on acquisitions, but certainly being a bit more aggressive should accelerate the mix shift to Digital.

On the high staff attrition, it's an issue because lack of availability of staff far enough up the learning curve to contribute leads to delivery delays, reputational risk (note in the prior writeup the company was, back then, pushed as one with a relatively better reputation) and, I think, some margin compression (you have to bring in a replacement and train them up, which takes time, during which time they're less productive). It's an industry with an inherently high staff turnover ratio - I think the model is that you hire developers right out of university in India, and work them extremely hard to extract value out of them, knowing that the chances are they probably quit within 4-5 years, on average. Prior to 2020, the attrition rate was about 20%-25% per year, which is roughly consistent with where someone like Infosys was at the time. It's just a tough industry to hire into, I think, as it's seen as a bit of a dead end job (even if it can be quite well-paid). Since 2020, however, attrition rates have picked up, and peaked at around 37% for Cognizant. It's not a company-specific thing (see here) but Cognizant seemed to get hit especially had. In terms of why it happened, the explanation offered is that it was tied into the general mania we saw in markets for anything tech-related (see ARKK et al, which have been discussed extensively elsewhere) - just as investors were willing to pay up to multiples for loss-making businesses to the point where ever getting a decent return on capital looked unlikely, management observed that when their staff were getting poached, the pay rises they were getting were often in excess of 50%, to the point where it wasn't obvious those staff would ever be able to bill at a level to justify that salary. Nevertheless, Cognizant have been forced to participate in this, which has probably been part of the reason for the drag on gross margins. They've been steadily declining since the start of the last decade, but it accelerated from 2019 onwards, and we've seen GM's decline from about 39% to about 35.5% at the trough. The good news is that 1) obviously a lot of the puff has come out of SaaS et al, which management claim has eased the pressure on them a bit. On top of this, they've ceded a bit on the salary side, and have accelerated the merit round (where the promote people and pay them more) from the end of this year to the beginning of this year (and they'll still do the round at the end of the year, making this year a one-off  (so they claim) double round) and that is having a noticeable impact on attrition rate (see chart below). It will probably mean that GM's continue to be under some pressure, but it will hopefully support revenue growth, which is what people seem to be focused on.

Strategy & Valuation

The strategy of the new CEO (I should also note that they have a new chairman, Stephen Roeder, who spent 35 years at Accenture, latterly as COO) will be to continue the momentum on reducing attrition, and then to go after larger deals, which I understand that he has some track record of doing with Infosys. I should note that, should they be successful with the larger deals, it'll be good for the top line growth, but it's probably going to put further pressure on the margins given the way the larger deals are structured (I think you make more money in the out years as you get up the learning curve) - however we would not be talking in the hundreds of basis points on the group margin, and I think that the multiple rerating you'd see on better top line growth would overwhelm temporarily weaker margins from a shareholder return perspective. Given the new guy has only been in the job a short space of time, there's greater than usual uncertainty in that, when he took over, the usual practice of offering year ahead guidance was temporarily stopped. They gave some limited guidance on Q1 (that revenue would be flat to down 1% in constant currency), but that was it - the new CEO said that he wanted to go visit the teams in Indai, and then meet clients and try to formulate a clearer view, which I think the market perceived as look out below, he's going to kitchen sink it in Q1 to reset expectations lower and set up a beat and raise. They report on 3rd May, so there's more uncertainty than usual related to that release.

In terms of assessing the risk/reward and what to think around valuation. In 2022 they did $19.4bn of sales, $3bn of EBIT, $2.3bn of net income, $4.41 of EPS. Financial Services I think will be down mid-single digit this year, and at the group level I have revenue growth slowing from 5% in 2022 to +1.2% in 2023 before reaccelerating to 7% in 2024 and 8% in 2025. The slowdown this year is reflective of both currency (about 1%) and the slowing momentum the business saw in the back half of 2022, and the results of the regular CTO surveys done by one of the brokers, which indicate concern and an intention to put the brakes on spending (and the result of the last one of these surveys I saw was from before the banking crisis). I think that growth can the reaccelerate beyond that, but I'd note that I'm factoring in acquisitions contributing about 2.5% to growth, which I'm not sure consensus does, so on a LfL basis, these growth estimates are around the order of 4%-5%. It's worth noting that, excluding Financial Services, they've done about double this growth rate over the last 5-6 years, so I don't feel I'm leaning too far into the case, particularly given the greater mix contribution now from Digital, which will only continue to grow. 

I think that gross margins will continue to contract over the next couple of years before holding steady after this. It's as a result of the double merit year filtering through, plus a little bit of the impact of lower margins from bigger deals (but mainly the former). I think that they should continue to get SG&A leverage on sales growth (which was the case even as top line momentum slowed and gross margins compressed), which should see them grow EBIT to just over $3.6bn by 2025. Given the FCF generation and what they've committed to on capital returns, I think that the share count should continue to shrink, and might be down to about 484m in 2025 (which might not be in sell side models), all of which leads me to EPS of ~$5.80.

Given that the historical multiple has been about 16x+, that is potentially about 60% upside with dividends over the next 2-3 years, which I think is quite interesting. I'm not really factoring in heroic assumptions on top line growth or margin recovery, but if even these prove to be far too optimistic, I think that under 14x consensus 2023 EPS for a company with a net cash balance sheet, mid-teens ROIC and strong cash flow generation means that the downside should not be too horrific if the new CEO can't steady the ship.

One other point I should mention is that, as referenced above, the model is to have the majority of the employees in offshore locations (mainly India). About 25% of the cost base is in INR. They have $1.9bn of 2023 exposure hedged at 81.3, and $1bn of 2024 exposure hedged at 84.3, but obviously the continuous depreciation of INR over the years has helped in terms of cushioning the blow from declining revenue momentum. I have no view on INR, but were the momentum to reverse, that would be quite painful and probably negate some of the "downside is protected" argument I'm making.

Catalyst

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