Will heads roll at Cognizant under the strategy of Elliott?

Cognizant Q2 revenue up
Elliott Management, one of the largest shareholders of Cognizant, wants the US-based IT outsourcing company to enhance the board and achieve a value of more than $90 plus per share by the end of 2017 by implementing new plans.

Elliott, which ranks among the largest shareholders of Cognizant with a position of nearly $1.4 billion, manages funds that own more than 4 percent of Cognizant. Elliott sent an open letter to the board of directors including Cognizant Chairman John Klein and CEO Francisco D’Souza.

“We have identified an opportunity to trim function sizes, specifically HR and finance,” Elliott said in the letter. Elliott requested a meeting with Cognizant’s board to share additional thoughts, according to the letter.

Cognizant Technology said it welcomes open communications with all of its shareholders and values their input. The Cognizant Board of Directors and management team review the company’s strategic priorities and opportunities towards the goal of enhancing value for all shareholders.

Cognizant had an introductory discussion with Elliott upon receipt of the letter this morning. The company intends to review the letter carefully and will respond in due course.

According to the letter, Cognizant can achieve a value of $80–$90+ per share by the end of 2017 by implementing the Value-Enhancement Plan, representing upside of 50 percent to 69 percent in just over a year. Elliott also requested a near-term meeting with the Board to share additional diligence and further thoughts.

Cognizant’s stock is down 5 percent year to date, said a report in CNBC.

Jesse Cohn, the 36-year old head of U.S. activism at hedge fund Elliott Management, says during the last five years Cognizant has underperformed its core IT services peers by 83 percent despite growing revenue at a 22 percent CAGR vs. the peer average growth of a 16 percent CAGR over the most recent five fiscal years.
how-cognizant-and-rivals-use-cashElliott comments on Cognizant

Cognizant has deliberately maintained a strategy of targeting margins at a level established nearly 20 years ago under vastly different business considerations.

Cognizant’s target margins are ~1,000bps lower than those of its direct peers. While Cognizant’s peers are focused on achieving higher levels of profitability longer term, Cognizant remains wedded to the same 19 percent–20 percent range it has maintained for 20 years. As peers execute against their own profitability initiatives and increase margins, the profitability gap between Cognizant and its peers will only continue to widen.

Following Cognizant’s first full year as a public company in 1999, revenue has increased by a factor of 140x, from under $90 million to nearly $12.5 billion in 2015. Despite this increase, adjusted operating margins have never deviated outside of the targeted 19 percent–20 percent range. Margins have decreased over the past several years, recently reaching their lowest levels since 2003, when Cognizant’s sales were 3 percent of what they are today.

Cognizant’s inferior efficiency and lower margins have served to suppress cash flow and income statement flexibility that could have been used for prudent and growth-focused R&D and M&A investments.

Cognizant stopped delivering outsized growth. It is actually expected to grow at a slower pace than the average of its closest Indian IT services peers this year and for the third time in the last five years. Cognizant has failed to meaningfully differentiate itself in terms of growth since 2011.

Cognizant possesses a $13.5 billion (and growing) revenue base, $2 billion of cash flow per year, $4 billion of net cash, a meaningful margin expansion opportunity and a strong franchise. Despite these attributes, Cognizant has no dividend, only repurchases shares to offset dilution.

Action plan

Cognizant Value-Enhancement Plan calls for a 23.0 percent adjusted operating margin in FY18E, as compared to a 19.7 percent operating margin in FY15.

More than half of Cognizant’s Directors have been on the Board for at least nine years, including four with more than 13 years of tenure. Of the 12 Named Executives from the company’s proxy materials, eight have been with Cognizant since before its IPO, which was more than 18 years ago.

The newest outside executive joined more than 11 years ago. We would recommend the formation of an Operating Committee of the Board tasked with direct oversight of implementing the Cognizant Value-Enhancement Plan.

Cognizant should introduce more appropriate compensation criteria which include far less reliance on revenue growth and instead allocate weight towards earnings growth and total shareholder return.

Long-term incentive performance share units comprise ~55 percent–60 percent of target executive compensation and are based 75 percent on revenue targets and 25 percent on adjusted EPS targets. Such financial goalposts can be exceptionally damaging to the business, as they reinforce the “growth-at-all-costs” mindset referenced above.

Accenture has no allocation to revenue growth in its long-term performance compensation and instead allocates 75 percent based on operating income and 25 percent on TSR. Accenture has achieved 1-year, 3-year and 5-year TSR outperformance vs. Cognizant of 32 percent, 52 percent and 81 percent, respectively.

Baburajan K
[email protected]

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