Cognizant (NASDAQ:CTSH) has been a strong performer throughout the year. In 2016 it proved to be a bit sluggish, particularly when the strong and steady revenue growth typically reported by the Company experienced headwinds in multiple business segments. In their Financial Services segment, 2016 was marked by large money center bank customers spending more cautiously due to the low interest rate environment. Political uncertainty in the U.S. during the election year also impacted spending by their customers. While these large banks continue to take a conservative approach to spending, management has noted some stability in the banking sector relative to last year.
Recall that when we last wrote on Cognizant's performance (about a year ago) we mentioned four Cognizant clients in the HMO industry were all attempting to merge with or acquire each other. This M&A activity caused these clients to pause their project spending until the mergers were either finalized or abandoned. It did not help that these large industry M&A transactions were slowed by regulatory hurdles. Both transactions were ultimately blocked by the Department of Justice and, as we predicted a year ago, spending has since bounced back as these clients are now looking to invest.
Perhaps the largest contributor to Cognizant's performance has been the announcement and implementation of their Strategic Plan earlier this year. The plan focusses mainly on accelerating the Company's shift to Digital Services (from a majority IT Services today) through both organic investments and acquisitions. Digital Services make up approximately 26% of total Company revenue (this is up from 23% of total revenue when the plan was first announced). However, these revenues are growing well above the Company average. While the digital market is not without competition, we certainly believe there is enough addressable market for Cognizant to take a reasonable share.
Additional initiatives of the Strategic Plan include improving margins and enhancing capital deployment. Historically, management has targeted a fairly steady operating margin level of 19-20%. As part of this plan, Cognizant is targeting 22% operating margins by 2019, a fairly substantial expansion but one we believe is achievable as the Company optimizes its cost structure. The shift to digital also helps in this area as these revenues generate higher margins in addition to growing faster than the Company average. Capital deployment plans include increased capital returns which include both share buybacks and dividends (the Company had not paid a dividend prior to the announcement of this plan), with a plan in place to return 75% of U.S.-generated free cash flow from 2019 onward.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners 3rd quarter shareholder letter.
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