Cognizant slips after sprinting for a decade

Ever since Francisco D'Souza took over as CEO of Cognizant in 2007, it looked as if the company could do no wrong — the US-based software provider outgrew the industry even when rivals floundered during the global financial crisis. But over the past year or so, it has been looking ragged and beginning to resemble rivals it vanquished not so long ago. At least for now.

"They have run a marathon for almost a decade at the pace of sprint," said a senior executive at one of the top three Indian IT firms. "But the latest numbers show mortality is catching up with them, and there is no Holy Cow, not even IBM."

Last week, Cognizant's earnings surprised not just investors, but also its rivals. The company, for the second time ever in its two-decade history, cut its full-year revenue growth forecast by 2.5%. The lower forecast means the company's revenue will now be at least $220 million less than earlier projections.

The spoilers were: Europe, where revenue fell 1% sequentially, longer sales cycles and continued weakness in its best-performing sectors, including manufacturing, retail and healthcare.

For Cognizant, this period of slow growth and weakness in key customer accounts could potentially mean ceding more ground to its closest rival Tata Consultancy Services (TCS), and more importantly, the danger of losing the revenue growth momentum the company had got so used to. "This is a reality check for us — there are changes in decision making within, some India-based executives are unhappy with power centres being shifted to the US, and nobody likes this slowness," said a senior company executive, requesting anonymity.

Another Cognizant executive based in the US said slowness in revenue growth will hopefully get people out of their comfort zones. "No matter how much you want, there's always this addiction with growth where you tend to overlook the weaknesses — now is the time to look beyond all good things."

After the April to June quarter earnings, Cognizant shares on Nasdaq were trading 16% lower.

What baffled investors the most was Cognizant cutting down its revenue growth forecast, especially given that the September quarter has always been the strongest over the past few years.

"The upper end of Cognizant's revenue growth guidance range for September 2014 quarter is less than half of September quarter growth in any of the last (at least) seven years," JPMorgan analysts said in their note after the earnings.

Not surprisingly, both JPMorgan and Susquehanna International Group downgraded Cognizant.

Over the past few years, and especially since the Lehman crisis of 2008 that saw Infosys and Wipro slip from the glory days, Cognizant has grown its annual revenue at double the industry growth rates.

It has even outpaced TCS, India's largest software services company, consistently since then in terms of revenue growth. In fact, when TCS reported flat revenue growth for calendar year 2009 (and so did others), Cognizant grew its business 16%, underscoring the domination it was beginning to showcase.

However, as things stand today, some analysts including JPMorgan's Viju K George believe TCS could for the first time beat Cognizant in revenue growth during calendar year 2014.

Strangely, the things that helped Cognizant cement its position as the fastest-growing IT services company — a stable portfolio of top customers, dogged focus on healthcare and financial services customers apart from the North American market — have now become a drag. The company's key strength was that it gained over half its business from few, large customers in select business segments of healthcare and financial services.

Analysts started waving the red flag this June when Cognizant executives warned of a slowdown in the company's healthcare business. The same month, SIG analyst James Friedman downgraded his rating to 'neutral' from 'outperform'. Partha Iyengar of Gartner said Cognizant needs to come out of this "immediate turmoil" faster and stronger, and without too much of management distraction. "Because it will be a problem if reaches a point where the current turmoil becomes a distraction," Iyengar said.

Cognizant vs TCS
Amid slower growth, the top challenge will be to continue its pursuit of narrowing revenue gap with bigger rival TCS.

Analysts such as George of JPMorgan are already flagging it. According to the JPMorgan note, Cognizant has just about 60% of the workforce of TCS but its revenues for the period ended March 2014 is nearly a third lower than TCS and its EBIT margins are a good 9-10% points lower (TCS's EBIT margins of 27% versus Cognizant's GAAP EBIT margins of 18-19%).

"Despite all of this, TCS is closing the growth premium relative to Cognizant over time and now looks set to be growing faster than Cognizant for Road Ahead

No one is writing off Cognizant yet. For its part, Cognizant still enjoys top management stability, and continues to win big deals — the $2.7-billion contract signed with Health Net during the June quarter was its biggest win.

The challenge for Cognizant will be to make up for the lost momentum over the next six months. D'Souza explained during the investor briefing after earnings announcement that it could "become difficult to catch up." "Sometimes, we're seeing clients reassessing priorities, shifting dollars from, say, run better to run different kinds of initiatives. And other times, it's just been just straight delays, frankly, where projects get pushed out," D'Souza said.

Gartner's Iyengar said things were not fizzling out yet for Cognizant and it appears as if the company is trying to change the business mix. "We are likely to see few more quarters of conservatism from them."

"TCS seems to be handling scale better than Cognizant despite being appreciably larger in size," the analysts said.

Despite being described as being "company specific" by the management, Cognizant's challenges underscore issues faced by even TCS — that of overdependency on just a few (in TCS' case one) customers.

TCS, for instance, gets nearly $800 million annually from Citibank, with plans to take it closer to the billion-dollar mark.

"The real issue is that even a company with this profile is not immune to volatilities, and a handful of customers can have this impact — its introspection for TCS and others too," said a company executive.

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