COGNIZANT TECHNOLOGY SOLUTIONS CORP quarterly report, Q3 FY2019

Cognizant Technology Solutions Corporation — Q3 2019 Form 10-Q

Reporting period: Three and nine months ended September 30, 2019. Unless otherwise noted, financial amounts are in U.S. dollars and millions. The filing is unaudited.

Business context and reporting period

Cognizant provides consulting, technology, digital, application, infrastructure and business-process services to customers across Financial Services, Healthcare, Products and Resources, and Communications, Media and Technology (CMT). North America contributed 75.9% of Q3 revenue. Management described demand for digital services as an opportunity, alongside customer cost-optimization efforts and macroeconomic and regulatory uncertainty.

Key financial metrics

Metric	Q3 2019	Q3 2018	Nine months 2019	Nine months 2018
Revenue	$4,248	$4,078	$12,499	$11,996
Income from operations	$669	$745	$1,827	$2,108
Operating margin	15.7%	18.3%	14.6%	17.6%
Net income	$497	$477	$1,447	$1,453
Diluted EPS	$0.90	$0.82	$2.57	$2.48
Operating cash flow	Not provided for quarter	Not provided for quarter	$1,561	$1,890

Q3 revenue rose 4.2% year over year, or 5.1% in constant currency. Nine-month revenue rose 4.2%, or 5.5% in constant currency.
Q3 GAAP net margin was 11.7% in both years. Nine-month net margin was 11.6%, versus 12.1% in 2018.
Cost of revenue increased 8.1% in Q3 and was 63.1% of revenue, versus 60.8% a year earlier. Nine-month cost of revenue was also 63.1% of revenue, compared with 60.8%.
Adjusted operating margin, a non-GAAP measure, was 17.3% in Q3 versus 18.5%; for nine months it was 16.5% versus 18.5%. Adjusted diluted EPS was $1.08 in Q3 versus $1.05, and $2.93 for nine months versus $3.04.
Q3 revenue growth was strongest in Products and Resources (+11.9%) and CMT (+9.4%); Healthcare declined 1.2% and Financial Services grew 1.9%. Nine-month segment growth was led by CMT (+12.7%) and Products and Resources (+11.2%).
Cash and cash equivalents were $2,343 at September 30, 2019, and short-term investments were $734; $419 of the latter was restricted. Total current assets were $7,391 and current liabilities $2,919.
Cash from operations for the first nine months was $1,561, down from $1,890. Investing activities provided $1,963, principally reflecting net investment sales; financing activities used $2,316.
Debt included a $750 term loan, of which $38 was current and $709 was reported as long-term debt net of financing costs. No revolving-credit borrowings were outstanding. The $1,750 revolving facility had approximately $1,934 of total available capacity under credit facilities; the company reported compliance with debt covenants.
The company returned $2,349 to stockholders in the first nine months: $2,006 in share repurchases and $343 in dividends. Q3 returns were $219 in repurchases and $111 in dividends.

Material changes versus the prior comparable period

Revenue growth did not translate into operating-profit growth: Q3 operating income declined 10.2%, while nine-month operating income declined 13.3%. Management attributed margin pressure chiefly to delivery-personnel costs growing faster than revenue, with additional effects from acquisitions, Healthcare customer contract renegotiations and the Customer Dispute.
Q3 net income increased 4.2% despite lower operating income, helped in part by a smaller foreign-exchange loss and a lower effective tax rate. The nine-month effective tax rate fell to 24.5% from 26.7%.
Nine-month operating cash flow decreased by $329, which management linked primarily to lower operating income and higher cash taxes. Days sales outstanding was 78 days, compared with 75 at December 31, 2018.
The company adopted the new lease standard on January 1, 2019, recognizing $905 of operating lease assets and current and noncurrent operating lease liabilities on the September 30 balance sheet. The filing says adoption did not materially affect the income statement or cash flows.
Share repurchases were substantially higher year over year; cash and cash equivalents rose from $1,161 at December 31, 2018, while short-term investments fell from $3,350, reflecting investment maturities and sales.

Outlook, management commentary, risks and unusual items

2020 Fit for Growth Plan: Announced October 30, 2019, after the quarter. Measures are expected to generate $150–$200 of pretax charges, mainly severance and facility exits, substantially completed by the end of 2020. Management expects $500–$550 of annualized savings run rate in 2021, before planned investments in technology, sales and marketing, reskilling, acquisitions and partnerships.
The plan targets elimination of approximately 10,000–12,000 mid-to-senior-level roles, with a net workforce reduction of approximately 5,000–7,000 after reskilling and reduced lateral hiring. The company also expects to eliminate approximately 6,000 roles as it exits certain content-related work. Management estimates this exit could reduce CMT North America revenue by $240–$270 on an annualized basis, with a ramp-down over one to two years; customer relationship effects could extend to other services.
Separately, Q3 realignment charges were $65, including employee separation, retention and third-party costs. Management expects approximately $30 of additional retention-program charges in Q4 2019 and $17 in the first half of 2020. Previously completed separations were expected to reduce annualized compensation expense by about $140.
A Healthcare customer is disputing payment obligations under a large volume-based contract. Cognizant reduced its estimate of variable consideration in Q3; negotiations continue and the ultimate amount recognized may differ. The filing does not provide a clear value for the Q3 revenue or earnings effect.
The company accrued $117 in Q1 for potentially retroactive Indian employee defined-contribution obligations. The calculation remains uncertain and the ultimate obligation may differ materially.
In the Indian tax disputes concerning 2013 and 2016 share repurchases, the tax department asserted an additional $467 related to the 2016 transaction. Cognizant has not recorded a reserve, stating it believes applicable taxes were paid. Court proceedings remained ongoing; $419 of Indian time deposits was restricted, with a further $70 deposit also described in other current assets.
The company completed its FCPA investigation and paid approximately $28 to the DOJ and SEC in February 2019; the DOJ issued a declination. Securities class-action and shareholder derivative litigation remains unresolved, and the company says it cannot estimate potential losses.
Other risks highlighted include customer insourcing and consolidation, discretionary-spending and macroeconomic uncertainty, UK/EU and other regulatory developments, immigration restrictions, foreign-exchange volatility, cybersecurity and service-delivery risks, and the ability to retain skilled employees. Annualized employee turnover was approximately 24.1% in Q3.
Cash and investments held outside the U.S. totaled $2,834, including $2,433 in India. Management expects available resources, excluding restricted assets, and credit capacity to meet operating needs for the next 12 months. Unrepatriated Indian earnings were approximately $5,203; estimated additional tax if all were repatriated was approximately $1,093.
Subsequent events: Cognizant acquired Contino in October 2019 for $220 cash consideration and declared a $0.20-per-share dividend payable November 29, 2019.

Important facts for investors to verify

Progress and realized savings under the Fit for Growth Plan, including actual restructuring charges, workforce reductions, and the timing and revenue impact of exiting content-related services.
Subsequent developments in the Healthcare Customer Dispute and any resulting changes to revenue estimates, collections or contract economics.
Outcomes and cash implications of the Indian tax disputes and the defined-contribution obligation, including restrictions on Indian cash and investments.
Whether revenue growth can improve operating margins as delivery costs, hiring and subcontractor expenses evolve; compare GAAP results with the company’s non-GAAP measures and adjustments.
Operating cash conversion, receivables and DSO, alongside capital returns, acquisition spending and liquidity available after restricted balances.
Exposure from unresolved securities and derivative litigation, customer indemnities, foreign exchange, and the company’s ability to retain skilled personnel.