Elliott Management Corp., an activist investment firm, has some good advice for Cognizant Technology Solutions Corp.—get rid of an “antiquated, growth-at-all-costs” business model, and focus instead on total shareholder returns .
This column has, in the past, been enamoured by Cognizant’s higher growth compared to Indian IT services companies. As a trade-off for higher growth, the company has asked investors to live with profit margins that are way lower than peers. Cognizant has a stated policy that it will reinvest margins in excess of 20% for growth. As a result, its margins are around 750 and 850 basis points lower than Tata Consultancy Services Ltd and Infosys Ltd, respectively.
Given the struggles Indian IT companies have had with growth in recent years, Cognizant’s aggressive pursuit of growth seemed to make sense. Especially so, when compared to other strategies such as Infosys’s former “margins-at-all-costs” model.
But Elliott rightly points out that Cognizant’s growth has tapered in recent years. This year, for the third time in the past five years, the company is likely to end with lower growth relative to peers.
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Besides, Cognizant has gained enormous scale, and is expected to end the year with revenue of around $13.5 billion. Cognizant had framed its policy on profit margins when it was about 200 times smaller in size. It is one thing to aggressively invest for growth as a small company, but quite another to maintain the same strategy after nearly two decades. It also speaks poorly about the company’s ability to extract benefits of operating leverage.
In this backdrop, Elliott is clearly asking the right questions. Of course, as it points out in its letter to the company, other investors and analysts too have been asking similar questions.
Also, if Cognizant’s outsized investments in its business aren’t resulting in outsized growth, it could well point to large inefficiencies. “The Company’s stated rationale for keeping margins artificially low is to ‘reinvest’. However, based on our substantial diligence, these ‘reinvestments’ are actually disguising a lower level of business efficiency. Cognizant’s peers, for example, also make substantial investments, but they achieve higher operating margins by internally targeting a higher level of efficiency and profitability,” Elliott said in its open letter.
While this went unnoticed earlier because of relatively higher growth, investors have begun to lose patience lately. Cognizant shares trade at a considerable discount to peers.
Elliott also points out that compensation of top executives is linked largely to revenue growth, which reinforces the “growth-at-all-costs” mindset. “In contrast, Accenture has no allocation to revenue growth in its long-term performance compensation and instead allocates 75% based on operating income and 25% on total shareholder return (TSR). Unsurprisingly, Accenture has achieved 1-year, 3-year and 5-year TSR outperformance vs. Cognizant of 32%, 52% and 81%, respectively.”
Cognizant pays no dividend, and while it engages in share buybacks, the quantum is limited to the extent of share dilution due to grant of employee stock options. It returned less than 30% of its free cash flow to shareholders in the past six years; Accenture, in comparison, returned about 100%. Even Infosys and TCS did far better with return ratios of 53% and 67%, respectively, according to Elliott’s calculations.
Apart from a new approach to profit margins and capital return policy, Elliott has suggested the company enhances its board of directors to benefit from new perspectives.
On Tuesday, investors cheered the news of Elliott’s purchase of a 4% stake in the company. Cognizant’s shares ended the day nearly 7% higher. If the company adopts some of Elliott’s proposals, returns will easily outpace that of peers. After all, higher margins alone will result in outsized profit growth.
All told, while Cognizant is facing the heat from Elliott and some other investors, Indian IT companies, too, will do well to sit up and take notice. A well-rounded business model should make room for growth, while improving margins and shareholder returns.