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Morningstar | Cognizant Reports Surprisingly Weak 1Q; Banking & Healthcare Drag; Shares Mildly Undervalued

Cognizant reported a surprisingly weak start to fiscal 2019 and, with only one quarter in the books, materially lowered its full-year guidance. Notably, the firm almost halved its full-year revenue growth outlook from a midpoint of 8.0% in constant currency terms to 4.4% and reduced its adjusted diluted EPS expectations from over $4.40 to a midpoint of $3.91. The soured outlook comes fresh on the heels of prior CEO Francisco D’Souza’s departure and places new CEO Brian Humphries (who has been in the role for approximately 5 weeks) in a less than ideal starting position. We think Humphries will have his hands full over the coming quarters in order to gain confidence in his leadership and Cognizant’s ability to regain momentum in its two most important segments of financial services and healthcare. With the firm signaling ongoing weakness in both of these segments, we have lowered our midterm expectations. We think there will be a consequential impact on margins too.

As a result, we are lowering our fair value estimate to $79 from $85 for this narrow-moat IT services leader. With shares heading into 4-star territory, we think the bad news is an opportune time to add a leading global IT services leader to holdings.

For the quarter, revenue rose 5% year over year to $4.11 billion (increased 6.8% in constant currency). Much like the fourth quarter of last year, it was a tale of two businesses where the financial services and healthcare segments performed poorly, whereas the products & resources and communications, media & technology segments both posted double-digit year-over-year revenue growth. Financial services are being plagued by general softness in a handful of key clients and some in-sourcing, while the healthcare segments in seeing reduced spending due to industry merger integration and Cognizant specific execution issues. We don’t see any overnight remedy for these segments and believe it’s going to take at least 12-18 months to rebuild momentum.

Despite the near-term weakness, we still think momentum can be built around the firm’s provision of, and its clients’ need for, end-to-end digital capabilities. The market opportunity is vast (estimated to be in the hundreds of billions of dollars by Cognizant) and we think Cognizant remains a premier provider of these digital-related services globally. A focus on core modernization, digital engineering, AI and analytics, intelligent process automation, industry and platform solutions, and interactive customer experiences should stand the firm in a good position to take advantage of the growing market.

On the margin front, Cognizant’s adjusted operating margin fell 170 basis points year over year to 16.0%. The margin was below our expectations as revenue was below our forecast. Meanwhile, headcount costs outpaced management’s forecast and bad debt expenses related to client bankruptcies were elevated. Management expects margins to improve in the back half of the year as they align their cost structure to the revised growth outlook and, over the long-term, we think the firm can incrementally improve margins due to ongoing initiatives around its employee pyramid, employee utilization, and corporate spending.