Cognizant (CTSH, Financial) announced last Friday that it is conducting an internal investigation into whether it violated the U.S. Foreign Corrupt Practices Act (FCPA) in relation to improper payments made for Indian facilities.
The company also announced that its president was resigning on the same day. The stock immediately fell from $55 per share to less than $48 per share but has since regained some of the loss to $50.90 per share.
Cognizant is an IT consulting company headquartered out of New Jersey. The company uses a global delivery model where it has offices around the world. Cognizant had 221,700 employees at the end of 2015, with approximately 40,800 people in North America, 8,600 people in Europe and 162,500 people in India.
It offers services in two main categories –Â consulting and technology services and outsourcing services. Projects in consulting and technology services may include business process re-engineering, operations consulting, application development, systems integration, enterprise information management, application testing, digital services and software-related services. Clients will hire teams from Cognizant to complete projects. The teams usually have lead staff on the client’s site and supporting staff offshore.
Typically, the lead staff will manage the projects, and the staff in lower-cost regions such as India handle tasks such as data extraction, data porting, application development, etc. Outsourcing services may include handling a specific function on behalf of a customer such as call centers, accounts payable, billing, internal IT maintenance, etc. Clients may outsource these functions instead of hiring their own employees. They save money as Cognizant staffs from lower cost regions.
The bull thesis for IT consulting companies is straightforward. Digital disruption will only accelerate with trends such as mobility, big data, the cloud (IaaS, PaaS, SaaS) and the increasing need for cyber security. The accelerating pace of change also comes with new laws and regulations that also create a ton of work. Most companies don’t have the internal resources to constantly stay on top of every new technological or regulatory development.
For instance, a bank may urgently need to match its competitors' offerings with a mobile app, but that mobile app requires specific encryption protocols. Rather than going through the time-consuming and expensive process of hiring staff, a client can hire an IT consulting company like Cognizant. Consulting companies also offer the flexibility to scale up and down quickly. If business slows down clients can delay projects, but if business picks up consulting companies have more employees that they can add to a project.
Financials
Cognizant’s 2015 revenue was $12.4 billion. Its market capitalization is $30.89 billion. The company offers its services across industries. For fiscal 2015, the distribution of its revenues across industries was 40.3% from financial services, 29.5% from health care, 18.9% from manufacturing/retail/logistics and 11.3% from other. The company has also worked to broaden its revenue base and become less reliant on its top customers as the table below shows.
From Cognizant 10-K
Per GuruFocus, the company has the following financial metrics.
- ROE % 16.42.
- ROA % of 12.02.
- ROIC % of 24.79.
- 12-month rev. growth % of 15.1.
- 10-year rev. growth % of 28.4.
- Debt-equity ratio of 0.09.
- Current ratio of 3.66.
- Price-earnings (P/E) ratio 20.62.
- EV / EBIT 11.84.
Net income and EPS growth has been consistent over the last 15 years.
Final thoughts
I looked at some recent fines for FCPA violations to see if the drop in Cognizant’s stock price was warranted. Below are five examples.
- GlaxoSmithKline (GSK, Financial)Â – The U.K.-based pharmaceutical company agreed to pay a $20 million penalty to settle charges that it violated the FCPA when its China-based subsidiaries engaged in pay-to-prescribe schemes to increase sales. (Sept. 30)
- Och-Ziff (OZM, Financial)Â – The hedge fund and two executives settled charges related to the use of intermediaries, agents and business partners to pay bribes to high-level government officials in Africa. Och-Ziff agreed to pay $412 million in civil and criminal matters, and CEO Daniel Och agreed to pay $2.2 million to settle charges against him. (Sept. 29)
- Anheuser-Busch InBev (BUD, Financial)Â – The Belgium-based global brewery agreed to pay $6 million to settle charges that it violated the FCPA by using third-party sales promoters to make improper payments to government officials in India and chilled a whistleblower who reported the misconduct. (Sept. 28)
- Nu Skin Enterprises (NUS, Financial)Â – The Provo, Utah-based skin care products company agreed to pay more than $765,000 for an improper payment made to a charity related to a high-ranking member of China's Communist Party in order to influence the outcome of a pending provincial regulatory investigation in China. (Sept. 20)
- Jun Ping Zhang – The former chairman/CEO of Harris Corporation's subsidiary in China agreed to pay a $46,000 penalty for violating FCPA by facilitating a bribery scheme that provided illegal gifts to Chinese government officials in order to obtain and retain business for the company. (Sept. 13)
Recent penalties have ranged from $46,000 to $412 million. Improper payments for facilities in India doesn’t sound nearly as serious as GlaxoSmithKline’s $20 million infraction where its subsidiaries engaged in pay-to-prescribe schemes. I tend to believe most companies get a slap on the wrist unless it’s something really serious or there’s a political motive. Cognizant’s infraction sounds like a minor offense though admittedly I’m no legal expert, and there isn't much information.
The abrupt resignation of President Gordon Coburn, who has been with the company since 1996, is the news that bothers me. It makes me wonder if there is something structurally wrong with the company or if sales are worse than projected. In the most recent conference call in August, management lowered guidance for the year citing macroeconomic concerns. It pointed to Brexit as a reason that some customers were delaying projects.
My other consideration is that the consulting industry is extremely competitive. Competitors steal business and employees from each other all the time. Because employees move between companies sometimes there isn’t that much differentiation. Forecasting consulting companies’ short- and medium-term prospects can be challenging because of long sales cycles. For big-dollar projects, the sales process can last over a year.
It’s also extremely difficult for one competitor to unseat another competitor when the client is satisfied. Switching costs can be extremely high when it comes to onboarding and training new personnel. Costco (COST, Financial) customers experienced big headaches when the switch from American Express (AXP, Financial) to Visa (V, Financial) was made. Although American Express and Visa aren’t consulting companies, the same type of confusion could occur if a client changed call center providers.
As a result of these considerations, I prefer a basket approach to investing in consulting companies and will wait until Cognizant releases more information. However, for those readers who are less concerned about the recent developments, Cognizant is a company with an impressive track record and investors may want to take a closer look.
Disclosure: The author has no position in any stock mentioned in the article.
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