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Technology: CTSH results: on balance negative

Posted On: 2018-05-09 08:49:00

CTSH broadly retained organic revenue growth guidance, cut EPS guidance by 1.4% due to higher tax rates resulting from updated interpretation on GILTI of new US tax code and reported muted numbers for March 2018 quarter on adjusted basis. Elevated attrition rate is a disappointment. Read through for Indian IT is nothing incremental and broadly known i.e. weak retail, muted money center banks and strength in rest. We maintain our stance on modest increase in growth rate for some in FY2019. Infosys and Tech Mahindra are our top picks.

In-line revenue growth; digital contribution increases to 29% of revenues

Cognizant Technology Solutions Corp (CTSH) reported 2.2% sequential revenue growth at US$3.912 bn. Revenues grew 10.3% yoy and 8.2% in c/c. Adoption of ASC Topic 606 (Revenue from Contract with Customers) aided revenues to the extent of U$21 mn or 0.55% of revenues. Revenue growth was solid across all verticals on yoy comparison with the exception of financial services. Digital revenue grew 27% yoy and was 29% of revenues in 1QCY18. Non-GAAP operating margin increased 140 bps yoy to 20.3% but was aided by the adoption of ASC 606; adjusted for this, non-GAAP EBIT margin stood at 19.6%. Management indicated that adoption of ASC 606 will have immaterial impact on revenues and EPS for CY2018. Non-GAAP tax rate of 24.6% was higher-than-expected due to an updated interpretation of Global Intangible Low Taxed Income (GILTI) provision of the US tax code.

Broadly unchanged revenue guidance; non-GAAP EPS guidance cut

CTSH revised CY2018 revenue growth guidance to 8.4-10% from 8-10% earlier. The guidance had the following components of revisions—(1) US$100 mn or 67 bps revenues from Bolder Healthcare Solutions. This acquisition was completed in April 2018 and (2) revision of cross-currency benefit to 0.7% from 1% at the beginning of the year. This led to revenue loss of US$50 mn. Effectively the company has revised the lower-end of the guidance to the extent of the abovementioned two factors but kept the upper end unchanged.

CTSH cut CY2018E non-GAAP EPS guidance to at least US$4.47/share, down from US$4.53 earlier. CTSH has increased ETR to 26% for CY2018E, up from 24% announced earlier. This impact translates into US$0.09/share. ETR increase is due to refining of interpretation around GILTI. Essentially this provision limits the amount of foreign tax credits that is allowed in the US.

Read through for Indian IT—reaffirmation of modest banking and weak retail

CTSH guidance reaffirms what was evidenced from Indian IT results and commentary—(1) Financial services. Growth in insurance is strong and led by large strategic deals. Demand from mid-tier banks is strong in the US. CTSH is witnessing pick up in digital programs from money center banks partly weighed down by optimization of legacy portion leading to modest overall improvement, (2) retail vertical continues to be weak and not a surprise. The rest of the verticals are in robust health.

Stocks have adjusted to near-term performance potential; disconnect still exists in a few names

A relevant question against the backdrop of weak quarter results for Tier 1 with the exception of TCS. We maintain our stance of 1-2% acceleration in industry growth with the distribution of this benefit dependent on four key factors—(1) exposure to drag money center banks, (2) exposure to legacy suite of services, (3) participation rate in digital programs especially in industrialization of digital phase and (4) success in structuring of large multi-service deals. The ideal recipe for growth is lesser drags and greater participation in digital and integrated deals; unfortunately none of the IT companies have such a perfect combination. However after considering implied growth expectations embedded in stock prices, we recommend Infosys and Tech Mahindra as key picks. We like TCS' business model but find valuations expensive. We stay cautious on Wipro and HCLT.

Elevated attrition rates, a bit of a disappointment

CTSH's attrition rates have been above 20% in three of the last four quarters and stood at 20.3% in the March 2018 quarter. The elevated attrition can be partly attributed to a change in the performance management system instituted early last year and voluntary separation of employees that could not be reskilled in digital competencies. The impact of this change seems to have lasted longer than expected. While it has not reached alarming proportions, an elevated attrition rate is certainly worrying.

Key highlights from earnings call

- Guidance: CY2018E guidance of 8.4-10% includes- (1) currency tailwind of 70 bps, down from 100 bps guided in February 2018 and (2) US$100 mn revenues from the Bolder acquisition. In effect organic c/c revenue growth guidance for CY2018E stands at 7-8.6%.

- CTSH reiterated CY2018E non-GAAP operating margin guidance of 21% and target of 22% in CY2019E. The early part of margin expansion was predicated on tightening of operations, utilization rate increase and SG&A spend optimization that was initiated in 2017 and full year benefits that will accrue in 2018. Moving into 2019, mix shift to digital operations that are more profitable than the rest of the business and maturity of platforms business will drive margins further.

- The company is on track to complete its February 2017 plan of returning US$3.4 bn to shareholders by the end of 2018 broken up in the form of—(1) US$2.1 bn share repurchases including accelerated share repurchases launched in 1QCY18, (2) cash dividends to date of US$383 mn, (3) dividend of US$0.2/share announced in May 2018 and (4) utilization of additional US$900 mn for buyback.

- The company brought back US$2 bn to the US. The company has spent about a quarter of the cash brought back on the acquisition of Bolder.

Source: Equity Bulls

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