Cognizant Technology Solutions Corporation — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. Unaudited results; amounts in U.S. dollars unless stated otherwise.
Business context and financial performance
Cognizant provides consulting, technology, outsourcing and business-process services. Management’s strategy centers on expanding digital services while improving operating efficiency.
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $3.670B | $3.370B | $7.216B | $6.572B |
| Operating income | $606M | $591M | $1.176B | $1.145B |
| GAAP operating margin | 16.5% | 17.5% | 16.3% | 17.4% |
| Net income | $470M | $252M | $1.027B | $693M |
| Diluted EPS | $0.80 | $0.41 | $1.71 | $1.14 |
| Non-GAAP operating margin | 20.0% | 20.3% | 19.5% | 20.1% |
Revenue grew 8.9% in Q2 and 9.8% in the first half. Q2 segment growth was led by Communications, Media and Technology (+16.8%), Products and Resources (+13.2%) and Healthcare (+9.5%); Financial Services grew 4.1%. North America remained the largest market, while U.K. revenue declined 7.4% in Q2, including a negative currency effect.
Cash flow, balance sheet and capital allocation
- First-half operating cash flow was $798M, versus $438M a year earlier. Investing activities used $298M and financing activities used $1.421B.
- Cash and cash equivalents were $1.157B at June 30, down from $2.034B at year-end 2016. Cash, cash equivalents and short-term investments totaled $4.378B; approximately $3.987B was held outside the U.S.
- Total debt was approximately $991M: $244M current and $747M long-term. The company had $150M drawn on its revolving facility and reported about $600M of remaining capacity. It was in compliance with debt covenants.
- Trade and unbilled receivables were $2.680B and $409M, respectively. Days sales outstanding were 73, compared with 72 at year-end 2016.
- Financing outflows included $1.544B of share repurchases and $89M of dividends paid. The $1.5B accelerated share repurchase was funded with U.S. cash and revolving-credit borrowings. The company announced a plan to return $3.4B to shareholders over two years; an additional $1.2B of repurchases was planned for the second half of 2017 and 2018. A $0.15-per-share dividend was declared for payment in August.
Material changes and unusual items
- GAAP operating margin fell year over year despite revenue growth; non-GAAP margin also declined. Management cited higher compensation and operating costs, rupee appreciation and 2017 realignment charges. Q2 2016 included a $27M fixed-price contract loss, which partially offsets the comparison.
- Net income benefited from a lower tax provision: the 2016 comparison included substantial tax expense from the India cash-remittance transaction, while first-quarter 2017 included $72M of recognized benefits from uncertain tax positions. First-half 2017 also included foreign-exchange gains. These items make reported earnings growth less indicative of underlying operating trends.
- The company incurred $50M of first-half pre-tax realignment costs, including severance, advisory fees and lease termination costs. A voluntary separation program was expected to reduce annualized compensation expense by approximately $60M.
- First-half repurchases and dividends drove cash down; revolving-credit borrowings increased. The company had $844M outstanding on its term loan and $150M on its revolver at quarter-end.
Outlook, management commentary and risks
- Management targeted a 22% non-GAAP operating margin in 2019 while continuing revenue growth. Realignment costs were expected primarily in 2017; the filing does not provide a specific revenue or EPS forecast for the remainder of 2017.
- Management expects demand for digital services and transformation projects, while customers also pursue cost containment. Larger, complex engagements may have longer sales cycles and ramp-up periods, increasing quarterly variability.
- Key uncertainties include banking customers’ cost controls, healthcare regulatory uncertainty, weakness in retail, Brexit-related effects, foreign-exchange volatility, wage and staffing pressures, and broader economic and regulatory changes.
- An internal investigation is examining potentially improper payments tied to company-owned facilities in India and other smaller payments. Approximately $6M in payments from 2010–2015 had been identified; Cognizant notified and is cooperating with the DOJ and SEC. Securities class-action and shareholder derivative litigation is also pending. The company could not estimate a possible loss and recorded no accrual; it expects further investigation and remediation expenses and warns sanctions could materially affect results.
- A material weakness in internal control over financial reporting remained as of June 30, 2017, and management concluded disclosure controls were not effective. The company reported remediation actions, but said changes must operate over time before effectiveness can be evaluated.
- The company intends to keep most foreign funds invested abroad; repatriation could create additional U.S. tax expense. It expected available cash, operating cash flow and revolver capacity to cover operating needs for the next 12 months.
Important facts for investors to verify
- Progress and final cost of the India investigation, any DOJ/SEC action, related litigation, and remediation of the material weakness.
- Whether margin performance improves as realignment actions take effect, including progress toward the 22% non-GAAP margin target for 2019.
- Underlying earnings after separating tax benefits, foreign-exchange effects and other non-GAAP adjustments from operating performance.
- Cash generation, receivables collection, debt and revolver usage, and execution of the announced shareholder-return plan.
- Revenue trends by segment and geography, especially Financial Services and the U.K., and exposure to rupee and other currency movements.