Can Cognizant get its act together?

After pushing Samsung Electronics to simplify its complicated ownership structure, improve its corporate governance by adding three independent directors, list itself in the US and pay shareholders a special dividend, activist hedge fund Elliott Management has turned its attention to New Jersey-headquartered IT services major Cognizant Technology Services. After picking up over 4% in the company for $1.4 billion, Jesse Cohn, the head of US activism at Elliott sent a 16-page letter to the Cognizant management drawing out a plan on how it can enhance return to shareholders. Cohn is known to shake up underperforming tech companies ranging from EMC, Citrix to Lifelock. He believes that Cognizant can easily be worth $80-90 per share by the end of 2017, a gain of 45% to 64% in a single year, if the company implements some of the fund’s recommendations. One of its biggest grouse against the IT services major has been the fact that Cognizant continues to swear by a strategy of choosing growth over profitability from nearly two decades since it started out as a contender.

Renewal strategy
While the fund acknowledges that the strategy served the company during its initial growth years, the changing dynamics of the industry calls for a change in strategy. Cohn points in his letter that while revenue has increased by a factor of 140x since the company went public in 1999, the margins have never moved beyond the targeted band of 19-20% which means the company didn’t see any benefits of operating leverage. Elliott points out that despite a similar business mix and gross margin profile to its two closest peers (TCS and Infosys), Cognizant has an operating margin that is 750–850 basis points lower on a comparable basis. The fund believes its value enhancement plan that aims at improving the overall efficiency in the company without sacrificing growth could see the margin move to 23% by 2018. The fund also wants the company to pay out dividends that will give shareholders a yield of 1.5% and make a commitment of returning 75% of its annual free cash flow through share buybacks besides making a stock buyback of $2.5 billion using $1 billion of cash on hand and the rest financed through debt. Currently, the company has $4.9 billion of cash on its books, doesn’t pay its shareholders any dividend and only buys back shares to make up for any equity dilution due to vesting of stock options. The fund also calls up for a shake-up of the company’s board and senior management saying that it was time for directors with some new perspective and skills to come in, given the continued underperformance of its stock. It pointed out that more than half its directors have been on the board for more than nine years and two-thirds of its named executives have been with the company for more than 18 years.

While the company has responded that it will look into all the recommendations, there is a lot of work at hand if the company wants to reclaim some of its lost glory. For Cognizant, the poster child of the IT-services business, 2016 was easily its toughest year in business yet. Its disclosure about an internal investigation regarding certain payments relating to Indian facilities were in possible violation of US corruption laws, the sudden departure of its president Gordon Coburn, who had been the face of the organisation, saw a massive $4.5 billion being wiped off in market capitalisation as the stock fell 13% in a single day on 30^th  September. If that’s not enough, there are a couple of class-action suits filed by some of its shareholders against the company for providing misleading information about its business. All of this comes on the back of the company facing its slowest revenue growth. 

Towards the end of September, Cognizant voluntarily notified the US Department of Justice and SEC that it was conducting an internal investigation whether certain payments relating to its facilities in India possibly violated the US Foreign Corrupt Practices Act. In it’s filing, the company said that the investigation is being conducted under the supervision of the audit committee with the assistance of outside counsel. “The internal investigation is in its early stages, and the company is not able to predict what, if any, action may be taken by the DOJ, SEC or any governmental authority in connection with the investigation or the effect of the matter on the company’s results of operations, cash flows or financial position,” it said.

The disclosure came the same day Gordon Coburn, who was the company’s president then, resigned and IT services head Rajeev Mehta replaced him. Coburn has been with the company since inception and was the company’s CFO before becoming the president in 2012. While the company hasn’t spoken about the two incidents being related, it has taken many by surprise. “Gordon was the face of the company and a lot of credit should go to him for where it is today. He is a great networker and is extremely well-connected with the government. He is a man hugely focused on compliance and maybe that’s why he has taken moral responsibility. The worry is that more heads will roll,” said a former employee of Cognizant. 

And heads have certainly rolled. “We discovered that certain members of senior management may have been aware of or participated in the matters under investigation. Those who may have been involved are no longer with the company or in the senior management position,” said Francisco D’Souza, CEO, Cognizant, during the conference call post the company’s third quarter results. He also added the company has identified approximately $5 million in potential improper payments till date and concluded that it did not have a material impact on its financials or that it requires any restatement of accounts. 

Chasing growth
The company, which has been a trailblazer of sorts, has been grappling with slower growth as clients in two of its major verticals, BFSI and healthcare, have delayed or cancelled projects. Growing more than twice as fast as the industry in the past, Cognizant slashed its full-year revenue guidance not once, but thrice this year making 2016 its lowest year of growth since 1996. The company lowered its revenue guidance from 9.9-14.3% at the beginning of the year to 9.9-12.7% at the end of the first quarter to 8.4-9.5% ($13.47-13.60 billion) at the end of its second quarter and now to 8.4-9% ($13.47 billion to $13.53 billion) to account for the negative impact as a result of the weakening of the pound sterling. 

Clients in the BFSI space are putting off discretionary spend due to uncertainty in the macro environment and are focusing on cost optimisation and improving operational efficiency. “With IT budgets flat to down, customers are deploying less money on running the business and a larger share of their spend is going to change business initiatives,” says Peter Schumacher, CEO, Value Leadership Group. 

With most Indian companies losing out on discretionary spend to competitors like Accenture and Capgemini, there is a fierce battle to bag the ‘Keep the Lights On’ projects. Everest Group’s CEO, Peter Bendor-Samuel feels this intense competition on pricing has just begun due to commoditisation of the legacy business. “Cognizant faces shrinking revenue in its mature applications space because increased competition and automation are shrinking books of businesses already under contract. This phenomenon has just started taking hold, but we expect it to accelerate. This will mean that everyone, including Cognizant, will have to add new clients or scope just to stay still,” says Samuel.  

If the competitive pressure from Indian companies wasn’t enough, increasing offshore presence of multinational companies such as Accenture and Capgemini means they can offer clients the best of transformational consulting and outsourcing at competitive prices. “The traditional business, which represents 50-60% of the overall revenue, is getting commoditised with declining demand for these services and players fighting for the same shrinking pie, thanks to increased automation and the SaaS model which further reduces customisation leading to lower price points. While Cognizant has grown to $12 billion in size, they are no longer immune to the growth challenges that the industry faces,” says V Balakrishnan, chairman, Exfinity Venture Partners, who was also the former CFO of Infosys. 

Market woes
The traditional business is also increasingly being challenged by newer business models such as SaaS, which allow clients to pay-per-use and replaces custom development work. The ERP implementation and maintenance business, which includes implementation, customisation and maintenance costs, were multiple times the license costs. Today, all that can be avoided with implementation costs being much lower and maintenance cost brought down to a fraction of what it was through companies like Salesforce and Workday. Infrastructure management services are also taking a hit with most companies moving to cloud technology, so days of easy money are certainly over for IT service companies. 

There is also a perception that a sense of complacency had crept in. “Past success has led to some complacency. In 2013-2015, Cognizant had the highest mindshare among large customers of IT services. They were enjoying a really strong pull from the market and customers were saying if there was one vendor that they would add it would be Cognizant. This positive customer momentum started slowing in 2015 and eroded further in 2016 — in the USA earlier and stronger than in Europe. Cognizant has always been a company with a finger on the pulse and they seemed have a good sense for anticipating what customers wanted. Unfortunately for Cognizant, customer confidence started waning just as demand was slowing and the market was getting more competitive,” says Schumacher. In fact, according to him, Cognizant lost a major banking client to TCS and one in insurance to Infosys. While the insurance loss was due to aggressive pricing by Infosys, he says TCS won the banking client fair and square by offering a better technology mix that helped them lower overall costs. In the past, Cognizant was known for not yielding on client requests on pricing, but now, they won’t be in a position to do so. With automation, companies will resort to competitive pricing and Cognizant will have to up its game. 

Financial services and healthcare constitute nearly 70% of the company’s revenues. According to Samuel, in both the verticals, they face concentration issues with key clients, where they have significant wallet share, and the clients are reluctant to allow them to grow further. “This is particularly troublesome for Cognizant as a significant part of their growth story is their ability to grow fast in these key accounts,” he says. 

In healthcare, the industry consolidation and the growing trend of DIY strategies of the top five out of 10 companies has only led to a few new projects. “The industry consolidation among several of the largest US players continues to weigh on our healthcare practice,” admitted Rajeev Mehta, president, Cognizant, during the post-results conference call in November.

Sudin Apte, CEO, Offshore Insights, an IT research and advisory firm, feels that the company has not been able to replicate the success it had in other verticals. “They haven’t been able to create the premium positioning in manufacturing, hi-tech retail, energy or utility verticals. They haven’t been able to create the same level of context, relevance and value. When you have grown to the size that Cognizant has, you can’t be dependent on one or two verticals for growth,” he says. 

Bright future?
While Cognizant has been early to identify digital as a future growth area, it hasn’t had the success that Accenture has. For that matter nor has any other Indian IT services provider.  “Accenture is distinct in its ability to focus on transformation and digital, combined with an aggressive M&A program. This has allowed them to build a commanding lead in digital, which is where much of the growth is. The difference between Accenture and the others is the money in M&A that Accenture has deployed to acquire talent and reputation. This has left Cognizant and the rest of the industry in the dust and has allowed Accenture to capture a lion’s share of this high growth segment,” says Samuel. Accenture has spent over $1.7 billion on acquisitions over the past two years, picking up over 30 companies. This has led to the consulting business growing around 30% in FY16 and currently makes up nearly one-third of its overall revenue. In fact during the same period, Accenture’s revenue from outsourcing grew a mere 4%, but the faster growth in consulting and the digital businesses made up for the slower growth in the outsourcing business. 

The shift in discretionary spend is playing to Accenture’s strength. “Customers want to know how digital technologies will impact them and what is the pace of change and a lot of ideas and concepts are being explored and implemented in small steps,” says Schumacher.  “Accenture’s strategy and consulting business has been growing at a significantly higher rate than their IT outsourcing business which caught its offshore competitors off guard.  The view in the market is that Cognizant’s business consulting services are not on par with Accenture’s. Cognizant is still unable to attract the high calibre talent needed to develop deep business connections with customers that Accenture has and deliver a similarly compelling management consulting proposition,” he adds.  

Cognizant is also likely to go down the acquisition route with the company repatriating $2.8 billion sitting in its India entity to both the US and non-US geographies in the June 2016 quarter. The company is likely to go in for more tuck-in acquisitions, particularly to increase its geographical presence and technical capabilities. The company has already acquired around 25 companies in the digital space since 2014.  

What has worked to Cognizant’s advantage is the fact that the company’s sales engine is considered to be one of the best in the industry. “The company is more global in culture and local leaders have been given a lot of freedom to execute,” says Apte. 

Cognizant’s initial success was mainly an outcome of their quick response to changing client requirements after the financial crisis unfolded in 2008. Revenue grew from $2.81 billion in 2008 to $4.59 billion in 2010 when most of the industry was struggling. Then, in the next five years, they built on the lead to close revenue at $12.41 billion in 2015. They understood that customers were looking to cut costs and were open to an outcome-based model. So, it is time for Cognizant to pay closer attention to what clients want. After all, that’s what made it successful in the first place.