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Morningstar | Cognizant Reports Reasonable 3Q, but Financial Services Remains a Drag; Shares Modestly Undervalued

Cognizant’s third-quarter results were in line with our expectations with the firm recording solid growth from three of its four industry segments. However, we were looking for a slightly better outlook for Cognizant’s important financial services business (about 38% of total revenue in fiscal 2017), which was the lagging sales performer in the quarter. With peers such as Wipro, TCS, and Infosys reporting before Cognizant (and noting an improved banking and financial services outlook between them), we were expecting a slightly more optimistic position for this segment. Although Cognizant forecasts an improvement in higher value digital services surrounding the banking and financial services sectors, there is still a notable amount of revenue from lower value and lower growth “run the business” spending rather than high growth digital transformation-related services. Management highlighted that companywide digital services grew in the low-20% range during the quarter and constituted over 30% of total revenue. We continue to have a positive outlook for Cognizant’s digital positioning and the ability of this business to drive healthy high-single-digit revenue growth over our explicit forecast period. To that end, our view of Cognizant remains unchanged after the quarter and we reiterate our $80 fair value estimate for this narrow-moat company. With shares falling notably over the past month and approaching 4-star territory, we would recommend the stock to investors looking for a high-quality global IT services firm.

For the quarter, revenue rose 8.3% year over year to $4.08 billion, which included a negative foreign exchange impact of 70 basis points. Financial services revenue grew 2.6% year over year to $1.46 billion and was the underperforming segment, in our view. Meanwhile, other parts of the business performed much better with healthcare, products and resources, and communications, media and technology growing 9.6%, 11.5%, and 17.1%, respectively. Consulting and technology services (57.7% of revenue) increased 6.6% year over year, while outsourcing services (42.3% of total revenue) rose 10.7% year over year. Outsourcing was boosted by acquisitions and large client engagements in the quarter.

Cognizant’s non-GAAP operating margin improved 110 basis points year over year to 21.1% and signifies the company’s ongoing transition to its 22% non-GAAP operating margin target for fiscal 2019. The improvement was attributable to higher utilization, simplification of corporate overhead costs, and more effective spend management. We expect these levers to help over the next year and see some additional improvement for contract management spend and lower employee attrition.