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Morningstar | Cognizant Reports in Line Quarter; CEO D’Souza to Step Down; Shares Modestly Undervalued

While Cognizant’s fourth-quarter results were mostly in line with our expectations, the quarterly update was anything but boring. Most notably, the firm announced that CEO Francisco D’Souza and President Rajeev Mehta would step down from their respective roles. D’Souza, who co-founded Cognizant and has been CEO for 12 years, will remain on the board as vice chairman, while Mehta will pursue other options outside of the company. Vodafone Business CEO Brian Humphries will replace D’Souza effective April 1, 2019. Despite the managerial change, we don’t expect any drastic transformational approach at Cognizant and believe the firm’s existing competitive position and strategy is well placed versus other large IT services peers. In additional news, Cognizant changed some of its reporting structure, provided some better clarity around operating metrics, and issued full-year revenue guidance that was slightly below our expectations. After digesting the quarter, our long-term competitive view of the company remains unchanged, and we retain our narrow economic moat rating. However, we modestly raise our fair value estimate to $85 from $80 after accounting for the time value of money in our financial model. With shares recently surging back into 3-star territory, we now only view the firm as modestly undervalued. Still, the firm could appeal to investors looking to gain exposure to a high-quality, relatively high-growth IT services leader.

For the quarter, revenue increased 7.9% year over year to $4.13 billion (up 8.8% in constant currency). As we have been calling out for some time, the firm’s expansion into the European market remains a strong growth driver as revenue in the U.K. and Rest of Europe regions surged, 17.9% and 22.3% year over year, respectively. We continue to see these markets as ripe and think Cognizant will look to scale and expand its delivery centers across the continent.

From a segment perspective, Financial Services and Healthcare performed significantly worse than the Products & Resources and Communications, Media & Technology segments. Soft spending from some large banking clients and a ramp down with a large healthcare contract have hampered the results, and while we expect the healthcare market to remain middling in the next year, we do expect a recovery in the financial services business based on Cognizant’s visibility into its deal pipeline.

On the digital transformation front, Cognizant noted that its digital revenue grew in the mid-20% range during the quarter and now constitutes slightly over 30% of total revenue. Margins in this business remain higher than the company average and we expect the digital business to grow at this level for at least the near-term as Cognizant reaps the benefits of being a premier digital transformation provider for existing and new clients.

The company’s operating margins (for which it now provides three varieties of) fell for the quarter on a year-over-year basis. The GAAP operating margin dipped 40 basis points to 16.8%, non-GAAP operating margin slid 20 basis points to 19.5%, and adjusted operating margin (which is new for the quarter and excludes stock-based compensation and acquisition-related adjustments) fell 30 basis points to 17.0%. However, on a full-year basis, margins expanded in line with expectations and followed management’s concerted, multi-year efforts to improve the firm’s profitability. We expect margins to improve over the midterm and cite ongoing initiatives around its employee pyramid, employee utilization, and corporate spending.