Friday, May 3, 2019

IT Services Major Cognizant Reported Disappointing March 2019 Quarter on All Counts

CTSH delivered weak revenue growth, missed margin targets and reported decline in cash generation in March 2019 quarter. CTSH has cut CY2019 c/c revenue growth guidance to 3.6-5.1%, down from 7-9% at the beginning of the year citing weakness in banking, healthcare and weaker execution. Delivering on medium term goals laid out at the analysts’ day seems challenging. Turnaround themes have their set of challenges; CTSH seems to be going through one with broad-based slippages.

Cognizant misses revenue growth guidance for March 2019 quarter

CTSH reported constant revenue growth of 6.8% in c/c, lower than guidance range of 7.5-8.5% for March 2019 quarter. On organic c/c basis growth was 4.2%. On a sequential basis, CTSH reported revenue decline of 0.5% to US$4.11 bn. Management indicated that revenue growth started weakening towards the second half of the quarter. The magnitude of miss for the quarter was surprising noting that guidance was laid out in the first week of February. The revenue miss was contributed by the slowdown in growth to a trickle in financial services (0.2% yoy c/c growth, 1.5% qoq USD revenue decline) and healthcare (+4.6% yoy in c/c, negligible excluding Bolder acquisition and down 3.1% qoq in USD terms). Other vertical continued robust performance. GAAP EBIT stood at 13.1% and had 290 bps impact from the recent Supreme Court of India ruling on Defined Contribution Obligation; CTSH has accrued impact of the ruling assuming retroactive application. Adjusted EBIT margin of 16% fell short of guidance primarily due to flow through impact of weaker revenue growth.

Steep cut in CY2019 revenue growth guidance, adjusted EBIT margin guidance band cut 17%

CTSH has cut CY2019 revenue growth guidance to 3.6-5.1% in c/c (guidance includes inorganic component), down from 7-9% growth guidance set out at the beginning of the year. Revised guidance bakes in 170 bps contribution from inorganic growth. Cut in guidance captures—(1) slowdown in the financial services vertical (35% of revenues) that was broad-based. Revenue decline from three of the five large banking clients continued. Regional banks are turning more cautious on spending outlook. M&A in regional bank client base also impacted revenue growth outlook. Guidance does not assume any recovery or deterioration in the financial services business and (2) healthcare vertical (28% of revenues) was impacted by M&A in the client base, accelerated movement of work to a captive center at a large North American client. Revised guidance assumes 0.5-2% sequential revenue growth in 3Q-4Q of CY2019. CTSH also cut adjusted EBIT margin guidance to 17% from 19% for CY2019. The company attributed the entire shortfall to weaker revenue growth outlook relative to initial expectations. EBIT margin expectation for 1HCY19 stands at 16% with recovery expectation in 2HCY19 (implied closer to 18%). CTSH cut CY2019 adjusted EPS guidance by 10-12% with a revised number that stands in a range of USD3.87-3.95/ share. CTSH expects to deliver 3.9-4.9% revenue growth in constant currency for June quarter.

Turnaround themes are difficult; CTSH has a few challenges at hand

CTSH’s poor performance surprised us. Weak revenue growth and guidance cut reflects execution challenges at CTSH rather than industry wide growth slowdown. The transition to a profitable growth model initiated a couple of years back had its share of challenges which have been compounded by slippages in execution. The new CEO has a challenge at hand. We would not be surprised with a few leadership changes, common in any turnaround effort. Against this backdrop, ability of the company to deliver board-backed medium term revenue growth target of 7-11% and EBIT margin of 19% with 10 bps expansion every year seems unrealistic to execute in the near term.

Timing the turnaround themes is challenging. CTSH stock may seem inexpensive after the potential correction in stock price but will have its share of bumps in performance and disappointments.

Read through for other IT services companies

Large part of the slippages seems specific to CTSH and not representative of growth across the industry. However the risk to industry growth from the financial services vertical cannot be denied. Clients in the capital market segment of banking have turned a bit more cautious in spending outlook. In addition spending by regional banks in the US is also turning cautious. Other segments of financial services are steady in our view.

Key highlights from earnings call

* Commentary on BFSI: BFSI vertical registered flay yoy growth in constant currency. The vertical is affected by insourcing among CTSH’s BFSI clients. The company reported conservatism in spending among several regional banking clients in North America with some banks impacted by M&A activity. Slowdown in decision making particularly around larger deals in the pipeline due to executive transitions in several clients impacted growth in insurance. Softness in three out of the top five clients is expected to continue in the near term. Management expects pressure on banking spends in 2HCY19 due to moderating growth outlook in the business.

* Life sciences and healthcare. M&A related activity accelerated movement of work to captives in a large client and ramp down of an account in which CTSH is a subcontractor impacted growth in the vertical. The company expects further deterioration in the next quarter and reported sluggish outlook for the full year. Softness was mainly in the healthcare payers business. The company reported strong double-digit growth in life sciences sub-vertical.

* Commentary on products and resources and communication & media verticals. The company reported strong double-digit constant currency growth in retail and consumer goods, travel and hospitality as well as in manufacturing, logistics, energy and utilities. Retail sub-vertical was strong despite bankruptcies in a few smaller clients. Growth in digital services for media and entertainment clients offset slower growth in the communication industry which is affected by consolidation trend.

* Margin levers. The company expects margins to improve in 2HCY19 on the back of procurement optimization, better utilization, improved pricing, simplification of business unit overhead structure, rationalization of delivery costs and shift to higher value services such as digital

* Digital. Digital business now accounts for 33% of overall revenue and is the primary driver of growth. Digital revenue growth in the quarter was strong at 20+%. Core modernization, digital engineering, AI and analytics, intelligent process automation, platform solutions, interactive customer experiences and IoT form the core of Cognizant’s digital strategy

* Senior management. Ex-CEO Frank D’ Souza who is currently in the role of Executive Vice Chairman will transition to Vice Chairman of the Board at the end of June 2019. Raj Mehta has stepped down as president. Malcolm Frank has been appointed as the new President of Cognizant’s digital business. Prasad Chintamaneni, EVP and President of Global Industries and consulting will additionally manage the banking business on an interim basis.

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