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Cognizant broadly echoes the same tune – digital-ready companies will have the last laugh

The early adopters of digital have had a great run in the stock market, thus rendering their valuations expensive. It remains to be seen how fast the relative laggards catch up.

May 08, 2018 / 06:03 PM IST

Cognizant Technology Solutions (CTS) closed 5 percent lower on the Nasdaq after the company reported its earnings for January-March. The numbers were largely in line with analysts’ expectations, though the full year guidance was a tad lower than expected.

The quarter

For the first quarter of 2018, CTS reported revenue of USD 3.91 billion, which was well within its guided range of USD 3.88-3.92 billion, and marked a sequential growth of 2.1 percent.

Non-GAAP (Generally Accepted Accounting Principles) operating margin, which excludes stock-based compensation expense, acquisition-related expenses, and realignment charges, stood at 20.3 percent, and non-GAAP earnings per share (EPS) was USD 1.06.

The company’s operating margin improved by 60 basis points sequentially. The year-on-year (YoY) growth in revenue for the March quarter was 10.3 percent (10.6 percent in the previous quarter). This included a positive 210-basis-point impact from currency. The growth in constant currency was 8.2 percent.

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In the quarter under review, the company adopted ASC 606, (a new revenue standard) that increased the company’s revenue by USD 21 million, income from operations by USD 29 million and earnings by 4 cents per share.

As for the different segments the company operates in, the growth in the financial services vertical, which includes insurance, banking, and transaction processing, was driven by increased business from insurance companies and mid-tier banks.

This, in turn, helped mitigate the softness arising from legacy businesses. The financial services vertical accounts for 37.3 percent of the company’s revenue.

The growth in the healthcare vertical, which brings in 28.7 percent of Cognizant’s revenue, was attributed to steady demand across payer clients and increasing interest in the company’s digital, analytics, cloud and virtualization solutions.

Products and resources, which accounts for around 21 percent of overall revenue, continued its growth momentum, driven by increased business from manufacturing and logistics clients.

Digital revenues grew 27 percent YoY and were 29 percent of total revenue in the reported quarter.

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The focus is on the forecast

For April-June, the company is expecting revenue of USD 4.00-4.04 billion, which would be 2.3-3.3 percent higher than the revenue earned in the March quarter. For the year 2018, the company raised the low end of its forecast for revenue to USD 16.05 billion from USD 16 billion earlier. The revenue guidance of USD 16.05-16.30 billion implies a YoY growth of 8.4-10 percent.

Of the total, Cognizant expects USD 100 million to come from Bolder Healthcare Solutions, which it bought in April. It revised its expectations of cross-currency benefit to 0.7 percent from 1.0 percent at the beginning of the year. This translates to a revenue loss of USD 50 million. Effectively, the company has revised the lower end of the guidance to account for the two above-mentioned factors but kept the upper end unchanged.

In 2017, the company’s total revenue increased to USD 14.81 billion, up 9.8 percent from USD 13.49 billion in 2016. The non-GAAP operating margin for the year stood at 19.7 percent. For 2018, the company expects non-GAAP operating margin to be around 21 percent and said it expects to achieve a non-GAAP operating margin of 22 percent by 2019.

The guidance for non-GAAP EPS for the full year stands reduced to USD 4.47 (from USD 4.53 in the previous quarter) due to an increase in tax rate from 24 percent to 26 percent.

CTS has so far focused on levers such as sustained higher levels of utilization, an optimal pyramid structure, simplification of business units’ overheads structure, and leveraging corporate function expenses more effectively to improve margin.

With digital bringing in more and more of the company’s revenue, the guided expansion of operating margin is not surprising. CTS is capitalising on this trend with its Digitise, Internationalise and Localise strategy, akin to the top Indian IT companies.

The company has embarked upon a USD 3.4 billion capital return and realignment program, and on a pre-tax basis, the yield works out to 7.5 percent.

The only point of discomfort in the company’s results was the high attrition rate (annualised attrition of 20.3 percent), which could be due to a realignment of the workforce by letting go of people who couldn’t be trained. However, the management attributed it to digital training efforts, which makes the company a poaching ground for competitors.

The key takeaways from CTS management’s reading of the future

The company’s early adoption of digital is the clear differentiator. Over the past 7 years, Cognizant has been investing a lot around digital, especially with SMAC, social, mobility, analytics and cloud initiatives. In addition to that, it has trained many associates around all the digital skills.

While the entire digital business is high growth, the areas which are seeing strong traction are digital engineering, which is the new way of app development, cybersecurity, cloud migration and re-platforming to the cloud, robotic process automation, intelligent process automation and artificial intelligence to automate key business processes.

Like what most Indian peers shared, the growth of the company’s BFSI (banking, financial services, and insurance) portfolio was predominantly led by the insurance segment, as banking continued to remain soft. Cognizant’s banking portfolio is in transition; healthy growth is seen in the mid-tier banks' category, but the challenge is obviously the large "money-center" banks.

The IT major’s legacy work is now getting optimized and its digital business is beginning to pick up. As additional digital spend continues, the company expects to go back to the strong growth it has usually seen in the banking segment.

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In sum, the outlook for Indian IT services doesn’t change much with Cognizant’s slightly soft guidance. The early adopters of digital have had a great run in the stock market, making their valuations expensive. It remains to be seen how fast the relative laggards catch up, as there is a huge gap between the valuations of the two groups, a factor that investors have to watch out for.
Madhuchanda Dey
first published: May 8, 2018 06:03 pm

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