Undervalued by 20%, This Stock Is a Rare Buy in Its Sector

Cognizant Technology Solutions CTSH is a leading IT-services provider, and clients are embracing its Neuro AI offerings. Nevertheless, its stock looks undervalued compared with its immediate competitors in particular and the technology sector in general. Morningstar chief U.S. market strategist Dave Sekera lists Cognizant as one of his attractive derivative plays on the artificial intelligence theme in Where Are the Growth Opportunities in AI Investing? Cognizant is also among our analysts’ top 33 undervalued stocks for the fourth quarter.

Cognizant is one of the leading IT-services providers in the world and was known as a growth darling for its revenue increases of 20%-40% during 2010-15. While we don’t see the company returning to that level in the near future, a reacceleration in growth is not far-fetched. 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 the company has the potential to strengthen its already moaty business. We believe Cognizant is on sound footing to benefit from strong digital transformation trends.

Key Morningstar Metrics for Cognizant

• Fair Value Estimate: $94
• Star Rating: 4 Stars
• Economic Moat Rating: Narrow
• Uncertainty Rating: Medium

Economic Moat Rating

We think Cognizant exhibits switching costs, particularly in business process outsourcing as a service, which often requires significant tailoring to a client’s needs. These contracts tend to last several years. In addition, we think application maintenance and infrastructure services exhibit high switching costs due to their mission-critical nature. 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 an indication of high switching costs. 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. Although Cognizant’s returns on invested capital are lower than peers’, they are still healthy, and we expect they will endure over the next 10 years.

Read more about Cognizant’s moat rating.

Fair Value Estimate for Cognizant Stock

Our fair value estimate implies fiscal 2023 enterprise value/adjusted EBITDA of 14 times. Given Cognizant’s increased investments in the cutting edge of enterprise digital IT and gradual expansion of its strategic consulting business, we expect a five-year compound annual revenue growth rate of 9%. We expect gross margin to stay flat over the next five years as the company’s overhaul of its pricing structure is offset by wage inflation in India. As the company becomes less dependent on headcount with more automatized solutions, we believe operating margin will increase from 15% in 2022 to 16% by 2027, predominantly driven by selling, general, and administrative expense leverage.

Read more about Cognizant’s fair value estimate.

Risk and Uncertainty

We assign Cognizant a Morningstar Uncertainty Rating of Medium, 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. We think Cognizant is also subject to specialization risk. Further consolidation in the industries in which the company operates, such as healthcare, could give Cognizant less leverage in its margins and make it more vulnerable if a competitor were to suddenly take major share. Like most IT-services companies, Cognizant is at risk of employee attrition.

Read more about Cognizant’s risk and uncertainty.

Cognizant Bulls Say

• Enterprise spending with Cognizant should increase as the technical landscape gets more difficult to navigate and increasingly important in staying competitive.
• Cognizant will rely more on automation to handle some of its business process outsourcing, allowing for margin expansion.
• Cognizant’s traditional consulting business should become a greater portion of overall revenue, strengthening the company’s authority in digital IT and expanding profit margins.

Cognizant Bears Say

• Growth could become increasingly limited, given Cognizant’s specialization and ongoing consolidation.
• Cognizant’s switching costs could erode if clients are more inclined to bring application testing and maintenance in-house.
• As cloud-native software improves its capabilities, Cognizant’s custom application layers for even the most complex enterprises could become less necessary.

This article was compiled by Susan Dziubinski and Sylvia Hauser.