Cognizant Has Long-Term Potential
2020 will be tough, but margins are set to expand.
We see an attractive long-term investment opportunity in Cognizant Technology Solutions (CTSH). We think the market has overcompensated for the effects of the coronavirus and the recent Maze ransomware attack on the company at the expense of Cognizant’s long-term potential.
We recognize that 2020 will be a tough year for the company, as we expect IT discretionary spending to suffer and Cognizant to see increased costs to mitigate and further secure its systems after the ransomware attack. However, we think the company is well positioned in the long term to benefit from expanding operating margins, as it still has many structural elements to optimize.
Cognizant is one of the leading IT services providers in the world and was known as a growth darling for its revenue growth of 20%-40% during 2010-15. Its double-digit growth days appear over for the near future, but reacceleration in growth is not farfetched. We think Cognizant can deliver this via thoughtful investment in enhancing technical capabilities, more robust strategy consulting operations, and a more diversified client base. With such a focus, we think Cognizant has the potential to strengthen its already moaty business, which benefits from significant switching costs and intangible assets based in its technical expertise.
Cognizant has admitted that it is first and foremost perceived as a back-office enterprise outsourcer, but we think its existing technical capabilities are strong in more nuanced enterprise IT solutions, such as artificial intelligence services, which will help it become better known for digital transformation. While Cognizant has not lagged in its digital capabilities, we think there’s more work to be done for the company to distinguish itself from competitors as a cutting-edge IT service provider. We believe Cognizant is well aware of this potential and has a healthy balance sheet to push forward in its technical capabilities. Still, a pipeline of work from in-house consultants could help bring down the costly activity of highlighting one’s technical capabilities.
For these reasons, we think Cognizant’s slow entrance into traditional consulting will be a worthy cause in the long run. We think these efforts will be more worthwhile if the company can diversify its client base away from healthcare and financial services. With such strategies in motion, we expect Cognizant to pick up the pace on its growth and return to outpacing IT services industry growth by 2022.
Moat Not Under Attack Despite Near-Term Difficulties
We assign Cognizant a narrow economic moat rating stemming from its intangible assets and customer switching costs associated with its services, which we find to be common moat sources across the IT services landscape.
Cognizant operates under two service lines: consulting and technology services, and outsourcing. Under the former, Cognizant offers traditional enterprise consulting as well as application development, system integration, and software and application testing. Under the outsourcing division, Cognizant provides application maintenance and infrastructure and business process services. We think Cognizant exhibits switching costs, particularly in business process as a service. Examples of BPaaS offerings include claims processing and healthcare plan administration. BPaaS is often a hearty extension of a company’s operations that requires significant tailoring to a client’s needs. BPaaS contracts tend to last several years, which we believe to be a function of the significant time it takes to adjust to a client’s wants and needs; these could differ significantly from even a competitor in the same vertical. In addition, we think application maintenance and infrastructure services exhibit high switching costs due to their mission-critical nature. If enterprise software experiences significant downtime or a poor release, or if a company’s servers are not properly maintained or well balanced in terms of loads, a company can bear immense costs. Cognizant ranks highly among competitors when it comes to infrastructure and cloud services offerings; it is number three in HFS Research’s rankings based on execution, innovation, and adapting to customers’ needs. The greater the deal size, the more friction there will be in switching infrastructure service providers. We therefore take Cognizant’s large deal size to be indicative of the high switching costs among the company’s clients.
Cognizant reports that more than 90% of overall revenue each year is derived from existing customers at the beginning of the year. With less than 10% revenue growth in recent years, that leaves dollar renewals each year at least growing minutely, which we think supports our switching cost argument. We think that the costs of even shorter-term projects under Cognizant’s consulting and technology services umbrella bear switching costs because of the high costs of failure if software implementation does not go as planned or if quality assurance testers fail to detect software vulnerabilities. This makes familiarity with Cognizant a friction in switching IT servicers for the next project.
However, we think switching costs are not as high as at some of competitors’ consulting arms, like Accenture (ACN), because very little of Cognizant’s consulting business is traditional consulting, which we think brings the most uncertainty in project outcomes. This makes familiarity with an IT service provider even more important in deciding whom to hire for the next short-term project. We think traditional consulting, which would compete with the likes of Deloitte and Accenture, makes up only a small portion of revenue, given that only about 2% of Cognizant’s employee base works in its traditional consulting arm. On the other hand, larger contributors to consulting revenue, like systems integration, are less ambiguous tasks to contract out, in our opinion.
We think Cognizant benefits from intangible assets as a moat source due to its technical expertise gained from putting enterprise solutions to work across hundreds of companies and refining its solutions with every new deployment--a benefit we find often across the IT services industry. An example of Cognizant’s technical expertise is its strong artificial intelligence services, which are in the leader category, according to IDC and Forrester. We think specialized knowledge is compounded by Cognizant’s vertical focus. For example, Cognizant is considered the top healthcare IT services provider by HFS Research, with Accenture and Optum ranked two and three, respectively. Cognizant has been able to achieve higher revenue growth in the healthcare and communication, media, and telecom verticals compared with some of its other IT services peers due to such specialization.
However, we think Cognizant has lower returns on invested capital than some of its peers, given its greater specialization in industries compared with other IT services companies. For example, Cognizant relies heavily on the healthcare and financial services industries compared with peers. We think this leads to lower returns on invested capital, as we think such specialization results in a mix toward more offerings spread across fewer companies, meaning less scaling effect per offering. This effect is magnified with consolidation in such specialized verticals, especially in healthcare. Despite lower returns on invested capital than peers, we think Cognizant’s still healthy returns due to technical and industry expertise will endure over the next 10 years.
Perception Risk Exists
We think Cognizant is subject to medium fair value uncertainty, given the increasing complexity of enterprise IT and the risks of falling behind in such capabilities, as well as perception risk that could cause distrust in the company’s offerings. Cognizant has been the subject of a bribery investigation in which it bribed officials to receive permits for new offices in India from 2014 to 2016. Given that outsourcing is an act of trust, it’s possible that perceptions cast by such cases could stunt Cognizant’s business. Cognizant is also at risk of an overcast perception in its outsourcing projects that it takes on simply because no one else will. For example, the company was the primary provider of Facebook’s content moderation operations, in which Cognizant employees filtered content coming into Facebook that was flagged as inappropriate. Cognizant announced its departure from the content moderation business after news outlets recounted the conditions that its employees endured as they sifted through extremely unsettling content from Facebook.
We think Cognizant is also subject to risk from vertical specialization. Further consolidation in the industries in which the company operates, such as healthcare, could give Cognizant less leverage in its margins and make the company more vulnerable if a competitor were to suddenly take major share of a vertical.
Like most IT servicers, Cognizant is at risk of attrition. Increased attrition could cause wear on Cognizant’s intangible assets, as less technical and industry expertise would remain in the company. A common risk in the industry is increasing H-1B visa denials for employees whom Cognizant brings on site to client offices outside global delivery centers. Approximately 30% of Cognizant’s employees work on client premises.
We think Cognizant’s balance sheet is well positioned to help the company push its reputation past a back-office outsourcer to higher-value technical offerings--like digital engineering and artificial intelligence solutions--as well as digital transformation consulting. Cognizant has $3.4 billion in cash and cash equivalents and $700 million in long-term debt as of fiscal 2019. We think its financial health will not only help the company outpace IT services industry growth in several years, but also keep its dividend safe, even amid near-term weakness.
Julie Bhusal Sharma does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.