Cognizant Technology Solutions Corporation (NASDAQ:CTSH) Q4 2022 Earnings Call Transcript

Cognizant Technology Solutions Corporation (NASDAQ:CTSH) Q4 2022 Earnings Call Transcript February 2, 2023

Operator: Ladies and gentlemen, welcome to the Cognizant Technology Solutions Fourth Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. I would now like to turn the conference over to Mr. Tyler Scott, Vice President, Investor Relations. Please go ahead, sir.

Tyler Scott: Thank you, operator, and good afternoon, everyone. By now, you should have received a copy of the earnings release and investor supplement for the company’s fourth quarter and full year 2022 results. If you have not, copies are available on our website, cognizant.com. The speakers we have on today’s call are Steve Rohleder, Chair of Cognizant’s Board of Directors; Ravi Kumar, Chief Executive Officer; and Jan Siegmund, Chief Financial Officer. Before we begin, I would like to remind you that some of the comments made on today’s call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company’s earnings release and other filings with the SEC.

Additionally, during our call today, we will reference certain non-GAAP financial measures that we believe provide useful information for our investors. Reconciliations of non-GAAP financial measures or appropriate to the corresponding GAAP measures can be found in the company’s earnings release and other filings with the SEC. With that, I’d like to now turn the call over to Steve. Please go ahead.

Steve Rohleder: Thank you, Tyler, and thank you all for joining us today. Given the recent news, I wanted to join the call for this quarter to introduce myself and explain the changes we’ve recently announced. For those of you that don’t know me, I’m Steve Rohleder, and I joined the Board as an Independent Director in March of 2022. Last month, I became Chair of Cognizant’s Board of Directors. I previously spent 35 years at Accenture, where I served as Group Chief Executive of Health and Public Services, Chief Executive of North America and Chief Operating Officer. Today, I’d like to briefly discuss our recent CEO transition and the Board changes announced this afternoon supporting our ongoing Board refreshment process. I also want to explain why we’re excited for Cognizant’s next chapter.

Ravi will then introduce himself and share his thoughts before Jan discusses our fourth quarter results in detail. We’ll then proceed to Q&A. Regarding our CEO transition, as we announced a few weeks ago, the Board appointed Ravi Kumar to succeed Brian Humphries as CEO. Brian was a resilient leader providing a steady hand as he steered the company through various challenges, including the global pandemic. On behalf of the Board, management and all of our associates, I want to thank Brian for his contributions, which have helped to position Cognizant to capture a large growing market and fuel profitable revenue growth beyond our short-term challenges. We also appreciate that Brian will remain with the company as a special adviser until March to ensure a seamless transition.

As part of the Board’s strategy to help Cognizant achieve long-term sustainable growth, we also announced today a new Board appointment. Eric Branderiz, a proven financial executive and public company director with demonstrated experience supporting growth in technology and in the energy industries, has been appointed to serve as an Independent Director on the Board. Eric brings significant experience in finance, accounting, M&A execution, risk management and ESG and corporate governance to Cognizant, and we welcome him to the Board. The appointment comes as our Board continues to strive towards optimizing its balance of director skills and tenures as part of its ongoing refreshment program. With Eric’s appointment, the Board has appointed five new independent directors over the last four years.

Maureen Breakiron-Evans, a member of the Board since 2009, has also advised the Board that she will not stand for reelection at Cognizant’s 2023 Annual Meeting of Stockholders. On behalf of the entire Board, we thank her for her more than a decade of astute guidance, exceptional leadership and dedicated service to Cognizant. Given these changes to the Board, our Governance Committee, our committee chairs and myself will perform a comprehensive evaluation of committee composition with an aim toward balancing representation of Board tenure and appropriate key skills and qualifications on our committees. These were topics that I, along with other members of the Board, had the pleasure of discussing with several of our largest investors during our annual governance road show in the fourth quarter.

Now before I turn the call over to Ravi, let me share a little bit about our enthusiasm for his leadership. Over the past few years, Cognizant has navigated a dynamic uncertain market while strengthening its operational and financial fundamentals. Heading into 2023, the Board believes that Cognizant has established a solid operational foundation and now needs to move toward accelerating growth. This agenda requires a focused growth mindset driven from the C-Suite. Ravi has this mindset. He brings a passion for building teams and driving growth in our industry, and we’re confident that he is the right leader to take Cognizant into our next phase with a goal of ultimately delivering significant returns to our shareholders. Ravi also brings to Cognizant best-in-class operations, transformation and leadership expertise at a global scale from a stellar 20-year track record of emphasis.

During his tenure, he oversaw the company’s global services organization and drove growth across its global industry segments. Ravi is a proven strategist who secured significant IT services deals. He led international business operations in India, Latin America, Japan and China, and he pioneered the creation of digital talent pools in the U.S., Europe and Australia. Importantly, during his time at Infosys, Ravi earned a reputation as a people-focused leader with a deep rooted commitment to teams and associates. Since he joined us a few weeks ago, Ravi has proven out this reputation as Cognizant associates have warmly welcomed into the team and are deeply enthusiastic about his leadership. We’re confident that Ravi will help us further our efforts to support engagement and trust internally and drive retention amongst our high-performing leaders and associates.

As we look forward under Ravi’s leadership, Cognizant will have a sharp focus on two key priorities. First, we’ll be focused on meaningful acceleration of revenue growth. Our second key priority will be ensuring that Cognizant is the employer of choice in our industry. Ravi is the right leader to achieve this vision, and the Board looks forward to partnering with him. I’ll now turn the call over to Ravi to introduce himself and to share some additional perspective.

Ravi Kumar: Thank you, Steve, for that very warm introduction. Good afternoon, everyone. My appointment as CEO is one of the proudest moments of my life. I’m excited as well as humbled by this opportunity to lead Cognizant, a company I’ve long admired, closely watched and competed against. As I’ve experienced, Cognizant has a diverse, highly skilled and a fully engaged Board. I’m grateful for the Board’s trust and support and for their efforts to lay the groundwork for me and the company to flourish. I’m also very grateful to my predecessor, Brian Humphries, who led the evolution of Cognizant’s business. He refreshed and broadened the strategy, extended the company’s portfolio and drove the implementation of more rigorous systems and processes.

With a very strong foundation in place, I’m not going back to the drawing board. Instead, I plan to move forward by building on and refining what already exists, which will include calibrating a thinking to a growth mindset. I want to see us offer the full breadth of our industry-specific solutions, whether developed organically or acquired through targeted acquisitions to a large installed base of clients and investor growth. A few days after my appointment, I participated in Cognizant’s annual sales kickoff, which was held in Abu Dhabi. At the summit, 1,000 of our client-facing associates came together from around the world to take stock of all of what we have and what we need to accelerate growth. I was so deeply moved by the warmth and the enthusiasm I was greeted with.

We set ourselves a goal to be an employer of choice, which we believe will be a pivot for growth. I plan to spend the next several months meeting with so many associates, clients, partners and shareholders as much as I can. I will listen carefully with an open mind, build trust and learn all I can about how best to unlock more value for clients, make progress in accelerating top line growth and drive long-term shareholder value. Because I like to be highly visible with clients and associates, my plan is to meet with 100 clients over 100 days whether in person or virtually and to visit with as many of our global teams as I can. Later this quarter, I’m spending several weeks in India and visiting associates at many of our locations across the country.

Having joined Cognizant just three weeks ago, I’m early in my learning curve and need time to get my hands on the pulse of the business. That said, I €“ while already identified several areas that are tied to operating with a growth mindset to focus on immediately. Today, I will look to talk about three of those important areas: first, making Cognizant an employer of choice in its industry; second, strengthening our ability to win large deals; and third, enhancing our operating discipline. A quick word on each starting with employer of choice. Spent time in the IT services industry, and you quickly realize that sustained success hinges on the quality, dedication and scale of our talent. The value we create for clients comes from the knowledge of the skills of our associates.

Because the client experience and the employee experience are so tightly linked, we have the opportunity to create a self-reinforcing cycle. Highly engaged client €“ talent with a passion for clients and a growth mindset attract the best clients. These clients in turn, attract more of the best people, keeping the flywheel turning faster. That’s why one of our goals and one of my specific important roles as the CEO is creating conditions for all our associates to excel. I’m committed to investing heavily in providing associates with continuous learning, upscaling and leadership development, all aimed at increasing the professional relevance. I believe the number one factor that will define success for Cognizant is to become the employer of choice in our industry.

Everything else must be based on that foundation, especially the ability to consistently deliver industry-leading growth, which is the absolute focus of the entire management team. Let’s turn to large deals, which are another top priority given how essential they are to building commercial momentum and enhancing our station as a provider of business outcomes aligned by industry. Accelerating large deal bookings that will align with our risk appetite requires the client centricity and competitive self-confidence to work the corridors of our clients, cultivating and mining existing relationships, while hunting for new ones and always showing up with an informed point of view. Over the last year or so, Cognizant business has advanced its solutioning capabilities along with its project and program management processes.

We have become better equipped to solution and manage large deals and have planned to build on this foundation to reenergize our efforts. In particular, I want to instill a greater sense of pride and empowerment among our client partners and delivery teams to encourage a faster, more agile response to client needs. I have a weekly standing meeting during which I review 10 large deals and do everything I can to help our teams to drive these deals over the finish line. Last week, we were pleased to announce the signing of a 10-year $1 billion renewal contract with a long-standing client, CoreLogic, demonstrating our capabilities and the confidence our clients place in us. The third area of focus is ensuring operational excellence across the company, including our approach to large deals and fulfillment in general.

We are building out an organizational structure designed to bring together a continuum of activities such as industrialized delivery with high productivity rates, market competitive cost takeout initiatives, contract life cycle and risk management, consortium led deals and more. As one Cognizant team, we are also working on internal simplification as a team. We will carry forward to help achieve the company’s full potential. With the market for tech talent showing some early signs of improvement, we are working to optimize fulfillment of existing engagements, unleash our entrepreneur spirit and rejuvenate the growth mindset. Switching gears for a moment, I would like to offer a few perspectives. On the long-term demand environment for technology services I believe we are in a golden era of technology and that software is the new alchemy for every business and industry.

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As the world prepares for a post-pandemic reset of the way we work and live our lives, we see more organizations accelerating their embrace of digital technologies. Industry is at lower levels of digital maturity like health care, life sciences and manufacturing are stepping up their tech intensity. While those that are more digitally mature like financial services, retail and communications are staying invested in digitizing the landscapes. We also interestingly see workplaces rapidly adapt digital technologies as employees get comfortable with continuously toggling between hybrid and physical workplaces. In an era of globalization that has spanned several decades, enterprises have turned to tech services companies to enable their businesses to scale and globalize.

Today, every industry is a tech industry. Technology will be deeply embedded in the core of every business, every product and every service. Therefore, the use of deep software engineering capabilities to transform the core of businesses will be a big player for tech services firms like Cognizant. So too will be the market opportunity that comes from born-digital companies that outsource the technology core and operations. The cloud, needless to say, will continue to remain the biggest general purpose technology we have seen in decades, and be deeply embedded as a digital pillar in every business. Cloud migration, modernization, application services will continue to create significant market momentum. Growth will also be driven by new cloud services like data on the cloud, data exchanges, new SaaS services and cloud security services.

Clients are aware of our deep alliances with the hyperscalers and new best-in-class SaaS companies as well as our ability to co-innovate with these partners. We truly believe clients will continue to turn to us to help orchestrate those cloud capabilities. The shift to the cloud and 5G have also accelerated IoT adoption as use cases grow with better connectivity and proliferating devices and that’s core. Last week, we further bolstered our IoT embedded software engineering capabilities with our agreement to acquire Mobica, an IoT software engineering provider. Mobica also strengthens our near-shoring capabilities in Eastern Europe, which is home to nearly 8,000 of our associates. We see a strong push now to bring AI into business landscape with the expectation that AI will reengineer enterprises as completely as enterprise software did three decades ago.

Of course, as clients navigate a challenging macro environment now, they need to fund their investments in digital transformation by executing cost and efficiency agendas. These same clients are now asking how we can help them achieve their cost reduction ambitions and underwrite savings for their digital initiatives. Given our broad capabilities, we can help clients, whether they need to drive efficiency gains, innovation or an end-to-end transformation of the business. I quickly want to turn for a moment to India, home to about three quarters of Cognizant’s workforce. India is likely to be the world’s technology talent hub for the next decade. India’s population has a demographic profile and digital talent pool unmatched by any other country.

And NASSCOM forecasts some two million IT professionals will be added to India’s talent pool over the next three years. We’ll continue to capitalize on this surge in the IT talent in India as we intensify efforts to recruit from India’s Tier 2 cities as well. Our large associate base in India is an ongoing source of strength and differentiation for Cognizant and one in which we will continue to invest. As confident as I am in Cognizant’s prospects, I’m fully aware, as we have signaled with our guidance for Q1, for quarter one, that we have a great deal of work ahead of us. It will take time to rebuild the pipeline and go after larger opportunities. Please know we put a lot of thought into our decision to hold off on providing full year guidance.

But before making commitments I can stand behind, I really need to spend more time digging into the business and talking to associates and clients. Keep in mind that we are building on a strong foundation. We have a long-standing client relationships, a broad portfolio of industry-specific solutions, a robust and resilient global delivery network, a significant opportunity for international expansion and most important, a reenergized and highly motivated team. I intend to catalyze Cognizant’s heritage culture of bold ambitions, our entrepreneur spirit that emphasizes being fast, agile and adaptable and of course, our camaraderie and teamwork. I’m super energized to lead Cognizant into the next era of growth, and I’ll put everything I have into making this happen.

As I’ve shared with all our associates, our mantra right now is to bring back growth and be the employer of choice. Now it’s my pleasure to turn the call over to Jan, who will take you through the financial details of the quarter before we take over questions. Jan, over to you.

Jan Siegmund: Thank you, Ravi. And good evening, everyone. Fourth quarter and full year 2022 revenue were above the high end of the guidance range we provided on our third quarter earnings call in November and in line with the revised expectations we provided on January 12. Operating margin was negatively impacted by the previously disclosed noncash charge in the quarter, which I will cover in more detail later. of this charge, we were pleased with the continued progress towards our operating margin goals driven by commercial discipline, the depreciation of the Indian rupee and SG&A leverage. During the quarter, we made progress improving fulfillment, driven in part by a meaningful reduction in voluntary attrition, which declined to 19% on a quarterly annualized basis from 29% last quarter.

This has allowed us to further decrease subcontracted usage and will enable us to put greater focus on driving improved commercial momentum in the quarters ahead. That said, the macro environment remains uncertain, and we continue to see pockets of weakness across several key verticals. Now moving on to the details for the quarter, fourth quarter revenue was $4.8 billion, representing an increase of 1.3% year-over-year or 4.1% in constant currency. Year-over-year growth includes approximately 40 basis points of growth from our acquisitions and a negative 60 basis points impact from the sale of Samlink completed at the beginning of 2022. Full year 2022 revenue was $19.4 billion, representing an increase of 5% year-over-year or 7.5% in constant currency.

Year-over-year growth includes approximately 100 basis points of growth from acquisitions and a negative 60 basis points impact from the sale of Samlink. In Q4, digital revenue grew 4% year-over-year or 7% in constant currency. This resulted in full year 2022 digital revenue growth of 11% or 13% in constant currency. Digital mix was unchanged from last quarter at 51%, up two points from the prior year period. Q4 bookings increased 12% year-over-year, including the large agreement with CoreLogic that we announced last week. This opportunity is primarily a renewal of existing work with some modest increase in scope during the latter years of the contract. For the full year, we recorded bookings of $24.1 billion and a book-to-bill of approximately 1.2 times, unchanged from the trailing 12-month book-to-bill we reported last quarter.

Outside the large renewal, bookings momentum remains muted exiting this year. This has put pressure on our Q1 outlook, which I will cover shortly. Moving on now to segment results in the fourth quarter, where all growth rates provided will be year-over-year in constant currency. Within Financial Services, revenue declined 1% reflecting a negative impact of 180 basis points related to the previously disclosed sale of our Samlink subsidiary. This was partially offset by growth among public sector clients in the UK and insurance clients. The revenue weakness is being driven by our banking and financial services practice, which we expect will remain under pressure for the next several quarters. Ravi, the entire team and I are laser-focused on reevaluating our go-to-market strategy, enhancing the strength of this portfolio and have initiated a series of actions, including certain leadership changes, that we believe will give us the best opportunity to improve our performance.

We are seeing early signs of success with select global banking relationships where we have successfully shifted our portfolio mix towards higher growth in strategic areas. This gives us confidence that we are moving in the right direction. However, more meaningful improvements will take time to implement. Health Services revenue grew 5%, consistent with last quarter. We experienced similar growth among both Healthcare and Life Sciences clients, which partially reflects some normalization of demand that had been driven by COVID. As we discussed last quarter, we have seen some pockets of softness within the segment, driven by the macro environment and regulatory complexity. Despite these challenges, we continue to review our Health Sciences capability as industry-leading and remain excited about the growth opportunities over the medium term.

Products and Resources revenue grew 7%, a modest deceleration from last quarter. Revenue was negatively impacted by slower growth among manufacturing, retail and consumer goods customers, which we believe primarily, reflected the softening of the macro environment. This was offset by continued strength among consumer goods, automotive, logistics and utility customers. Communications, Media and Technology revenue grew 9%. Growth again was led by our technology business, where our work with digital-native clients has driven growth in our core portfolio. Our growth has moderated somewhat as growth among some of our largest clients have slowed, but remains positive. We are closely monitoring trends and developments affecting the tech industry. Continuing with year-over-year growth in constant currency from a geographic perspective in Q4.

North American revenue grew 3%. Growth was led by CMT and Health Sciences. Our global growth markets, or GGM, which includes all revenue outside of North America grew approximately 8%. It also included a negative 220 basis points impact from the sale of Samlink. Growth was again led by the UK, which grew 16% and included double-digit growth in Financial Services including public sector clients. Now moving on to margins. In Q4, our GAAP and adjusted operating margins were 14.2% as there were no non-GAAP adjustments in the quarter. On a year-over-year basis, both GAAP and adjusted operating margins declined by 110 basis points. This includes the previously disclosed negative 120 basis point impact from a noncash impairment of capitalized costs related to a large volume-based contract with a Health Sciences customer.

Our operating margin benefited from SG&A leverage, while gross margin pressure from increased compensation costs was partially offset by delivery efficiencies and disciplined pricing. We also experienced a meaningful tailwind from the depreciation of the Indian rupee, which represented an approximate 110 basis point benefit net of hedges year-over-year. Our GAAP tax rate in the quarter was 27%. Adjusted tax rate in the quarter was 26.8%. Q4 diluted GAAP EPS was $1.02 and Q4 adjusted EPS was $1.01, down 7% and 8%, respectively. GAAP and adjusted earnings per share were each negatively impacted by $0.08 in connection with the impairment of capitalized costs related to a large volume-based contract with the Health Sciences customer. Now turning to the balance sheet.

We ended the quarter with cash and short-term investments of $2.5 billion or net cash of $1.9 billion. DSO of 74 days was flat sequentially and increased by five days year-over-year. Free cash flow in Q4 was $612 million, representing approximately 115% of net income. This brings full year free cash flow to $2.2 billion, representing approximately 100% of net income, in line with our expectations. We are pleased with our performance in 2022. However, a change in U.S. tax law that became effective last year now requires companies to capitalize rather than currently deduct R&D expenses. As a result, like many other companies, this will impact our free cash flow in 2023. We expect capitalization of R&D costs for tax purposes to negatively impact free cash flow by $600 million, which includes deferred payments for the 2022 tax year as well as increased payments for 2023.

With this change, we expect our cash conversion ratio to be below our target of 100% of net income in 2023. Moving on to capital deployment. During the quarter, we repurchased approximately 5 million shares for $300 million under our share repurchase program and returned $139 million to shareholders through our regular dividend. This brings total capital return to shareholders through share repurchases and dividends to $2 billion for the full year. In the quarter, we also completed two acquisitions: Austin CSI and Utegration for a total purchase price of approximately $370 million. In addition, we announced the acquisitions of Mobica and the professional services and management practices of OneSource Virtual. These acquisitions are expected to improve our digital revenue mix, enhance our consulting capabilities.

Our capital allocation framework remains unchanged. Over the longer term, we continue to expect to deploy a balanced capital allocation policy, returning to an aggregate of approximately 50% of free cash flow to shareholders in form of dividends and share repurchases and allocating the remaining 50% to inorganic investments. Turning to our forward outlook. As Ravi mentioned, and you will see in our earnings materials, we are only providing revenue guidance for the first quarter of 2023. Given our bookings momentum in 2022 and the uncertain macroeconomic environment, we expect our full year 2023 performance to be below the multiyear goals we provided in late 2021. We intend to provide an update on the full year 2023 expectations for revenue and adjusted operating margin next quarter.

For the first quarter, we expect revenue in the range of $4.71 billion to $4.76 billion, representing a year-over-year decline of minus 2.5% to minus 1.5% or a decline of minus 1% to flat in constant currency. Our guidance assumes currency will have a negative 150 basis points impact as well as an inorganic contribution of approximately 100 basis points. We look forward to sharing more as Ravi continues to get up to speed. As he discussed, we remain very excited about the medium-term market opportunity. We also believe that while the current macroeconomic uncertainty has led to some pockets of slowdown, it also presents an opportunity for Cognizant to help our clients operate more efficiently while continuing to invest in new digital capabilities.

With that, we will open the call for your questions.

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Q&A Session

Operator: Thank you. Our first question comes from the line of Ashwin Shirvaikar with Citi. Please proceed with your question.

Ashwin Shirvaikar: Thank you and congratulations and welcome Ravi and Steve as well, congratulations to you. It’s good to reconnect. I think my first question is growth mindset, I get that, what are some of the explicit steps you might need to take incrementally to return to that growth mindset, if you can speak to your early view on what’s needed for sales investments, capability investments, just the G&A investment to chase large contract, things like that?

Ravi Kumar: Thank you, Ashwin, for that question. Good to connect with you. Having spent a significant time in this industry. I would say to build a growth mindset. There are a number of things we need to do. But I would probably highlight three of them as I talked to today, the most important priorities. First and foremost, Cognizant has to be an employer of choice in this industry. What I mean by that is spending time in the IT industry, IT service industry, what I mean by that is, you create a self-reinforcing cycle with employees and clients. Sustained success is based on quality, dedication and scale of the talent, but client experience and employee experience are so tightly linked. We have the opportunity to build a self-reinforcing cycle with engaged talent with a passion for clients and the growth mindset, which attracts the best clients.

So that whole flywheel has to be self-reinforcing. It means a lot of things, all the way from retention to upscaling to leadership development to infusing the project and program leaders. Remember, we are a company of projects and programs, which essentially means as they walk the corridors, they mine our clients, these project leaders. And equally, they talk to our associates every day. So that is a starting point of where you try to build a trust with that player and continue to create that self-reinforcing virtual cycle does they call it. I think you talked about large deals. I think large deals has investments on both sides, investments on dealmakers, deal influencers, ability to create that momentum by supporting our client initiatives in various transformational initiatives of theirs.

But equally, at the back end, you have to start to work on solutioning capabilities and the ability to build a continuum all the way from addressing cost takeout initiatives to manage services initiatives to large deals will come with people take over opportunities. And of course, productivity improvements. So there’s a lot of tooling and infrastructure. I think Cognizant already has some of it, you have to build on it, and then go behind this opportunity. It’s equally important that we build operational discipline, which also helps us to create the growth mindset all the way from fulfilling those deals to building market competitiveness on cost takeout initiatives to contract life cycle and risk management to consortium like deals and partnerships and a whole bunch of things.

Well, do we have all of this in place? Yes. I think a lot of these things have already been set and I would say in the last few years at Cognizant. I have to orient this to a growth mindset and start to double down on the opportunities, which are there in the market. In the short run, some of this will mean additional investments, but in the medium to long run, you have to create that pool of investments inside by taking out costs so that you can then sustain that momentum for the future.

Ashwin Shirvaikar: Got it. Thank you for the obvious thought you put into that answer. The second question is on the health care contract that was a problem in the quarter. Any granularity on sort of separating out the top and bottom line impact? And is it link-fenced now? In other words, at least the margin impact taking into account entirely in 4Q? Or is there a forward-looking impact? What’s the forward-looking revenue impact as well?