Cognizant Technology Solutions Corporation — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Unaudited U.S. GAAP financial statements. Dollar amounts are in millions except per-share data. Comparisons are with the corresponding 2017 periods unless stated otherwise.
Business context
Cognizant provides consulting, technology and outsourcing services, with four reportable segments: Financial Services, Healthcare, Products and Resources, and Communications, Media and Technology. Management cited demand for digital services, transformation projects and cost optimization as growth drivers. North America remained the largest market.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $4,078 (+8.3%) | $3,766 | $11,996 (+9.2%) | $10,982 |
| Income from operations | $745 (+15.0%) | $648 | $2,108 (+15.6%) | $1,824 |
| GAAP operating margin | 18.3% | 17.2% | 17.6% | 16.6% |
| Net income | $477 (-3.6%) | $495 | $1,453 (-4.5%) | $1,522 |
| Diluted EPS | $0.82 | $0.84 | $2.48 | $2.55 |
| Non-GAAP operating margin | 21.1% | 20.0% | 21.2% | 19.7% |
| Non-GAAP diluted EPS | $1.19 | $0.98 | $3.44 | $2.75 |
Non-GAAP measures exclude specified items, including stock-based compensation and acquisition-related charges; the nine-month 2018 non-GAAP reconciliation also excludes the $100 million initial funding of the Cognizant U.S. Foundation. These measures are not GAAP and may not be comparable to similarly named measures at other companies.
Q3 revenue grew fastest in Communications, Media and Technology (+17.1%), followed by Products and Resources (+11.5%) and Healthcare (+9.6%); Financial Services grew 2.6%. Management attributed the lower GAAP net income mainly to foreign-exchange losses and higher income tax expense, partly offset by higher operating income. Q3 net foreign-exchange losses were $122; nine-month losses were $233, compared with a $41 gain in the 2017 nine-month period.
Cash flow, balance sheet and capital allocation
- Cash generation: Nine-month operating cash flow was $1,890, versus $1,571. Capital expenditures were $281; purchases of property and equipment were $204 in 2017. Net cash used in investing was $1,077, including $479 for business combinations; net cash used in financing was $1,368.
- Liquidity: At September 30, cash and cash equivalents were $1,339 and short-term investments were $3,424. Combined cash, cash equivalents and short-term investments were $4,763, including $405 of restricted Indian time deposits. Management said available liquidity, excluding restricted assets, was expected to meet operating requirements for the next 12 months.
- Debt: Total reported short- and long-term debt was $724, including $100 of current maturities. The $725 term loan and $750 revolving facility mature in November 2019; no revolver borrowings were outstanding at quarter-end and approximately $750 of capacity was available. The company was in covenant compliance and was evaluating alternative financing.
- Returns to shareholders: Nine-month repurchases were $994 and dividends paid were $352. The quarterly dividend was $0.20 per share; the board approved another $0.20 dividend for payment in November 2018. The company was reviewing its capital-return plan.
Material changes, outlook and risks
- Accounting comparability: Cognizant adopted ASC 606 on January 1, 2018 using the modified retrospective method; prior periods were not restated. Adoption increased reported Q3 revenue by $33, operating income by $37 and diluted EPS by $0.05; nine-month impacts were $85, $104 and $0.14, respectively. Comparisons therefore include an accounting-standard effect.
- Management outlook: Management’s stated objective was to gradually expand non-GAAP operating margin, with a goal of approximately 22% in 2019. This is a target, not a guarantee. The filing does not provide specific near-term revenue or EPS guidance.
- Business conditions: Management highlighted continuing digital demand, but also customer cost containment and discretionary-spending uncertainty. Some banking clients were shifting legacy services to captive operations; healthcare and technology customers faced regulatory uncertainty, and media and communications customers were affected by M&A activity. Annualized employee turnover was approximately 22.3% in Q3, which management attributed to a competitive labor market.
- India tax dispute: The Indian Income Tax Department asserted an additional 33 billion rupees, or approximately $455, related to the 2016 India cash remittance; a separate dispute concerns a 2013 transaction. Cognizant said it believes the taxes paid were sufficient and recorded no reserve. A court stay was in place, but $405 of Indian time deposits were restricted and $68 had been deposited in a segregated account.
- FCPA matters: The company said its internal investigation was substantially complete and that it was cooperating with the DOJ and SEC. It recorded a $28 accrual for a probable loss; timing and final resolution remain uncertain. Further expenses, sanctions or remedial measures could adversely affect results. Related securities and derivative litigation also remained unresolved.
- Other unusual items: The nine-month results included the $100 initial funding of the Cognizant U.S. Foundation. New Jersey legislation enacted in October was estimated to create about $70 of incremental annual tax expense beginning in 2018 before planned mitigation; the company expected tax-planning actions to significantly reduce the impact. Subsequent to quarter-end, acquisitions of ATG and SaaSfocus were completed and an agreement to acquire Softvision was signed; preliminary combined purchase price was approximately $635.
- Other risks: Foreign-exchange movements materially affected reported results and margins. The company also cited competition for skilled employees, fixed-price contract estimation, data security and delivery risks, acquisition integration, and possible changes in regulation and customer spending.
Important facts for investors to verify
- Assess underlying growth and margins after considering ASC 606’s reported-period benefit and the exclusions in non-GAAP measures.
- Track the resolution and potential financial consequences of the India tax disputes, including the restricted funds, and the DOJ/SEC FCPA matter and related litigation.
- Review the 2019 margin objective alongside execution costs, foreign-exchange exposure, labor turnover and customer spending trends.
- Confirm refinancing plans for the November 2019 debt maturities and the future direction of repurchases and dividends.
- Monitor the final purchase accounting, integration and returns from 2018 acquisitions and the proposed Softvision acquisition.