Cognizant’s Cash Choice is a Lesson for All Service Providers

Cognizant is now in a position where it must make important choices, and by extension, most service providers are likely to face the same situation soon. Elliott Management, an activist investor, took a position in Cognizant. When Elliott compared Cognizant’s performance to other benchmark companies in the services industry, it determined that Cognizant is undervalued and could be managed differently to create a higher stock price. Elliott then sent an open letter to Cognizant’s board and management to lay out its thesis and outline a Value-Enhancement Plan.

The activist investor pointed out that Cognizant has a strong balance sheet and a strong cash position and the firm could return some of that cash to its shareholders by buying stock. The letter also stated that Cognizant has room to increase its margins. The basis for this belief is that Infosys, TCS and some other benchmark firms have higher margins than Cognizant and Cognizant could match those margins.

My opinion? Yes, Cognizant has plenty of capacity to generate cash and a strong balance sheet. And it certainly could return more cash to shareholders without diminishing its ability to continue to consolidate the industry through acquisitions and fund its drive into becoming a digital business. However, I think it is very risky for it to follow the rest of Elliott’s thesis of attempting to match its competitor’s margins.

Cognizant already operates just as efficiently as Infosys and TCS, and its gross margins are very similar to its leading competitor. However, its net margins are lower. What does it do with the difference? Cognizant uses it to invest in customer investments and relationships, thus driving growth in its legacy business; and it uses the money to fund its transformation into a digital company.

Basically, there is a tradeoff between margin and growth. Changing that ratio would cause two impacts:

  • It would interfere in Cognizant’s ability to continue to have distinctive, above-market growth in its legacy business.
  • It would hinder investing in digital transformation.

The future of the services market will be about digital companies. Cognizant understands this and is investing against that to change into a digital company. So, it needs that money instead of returning it to shareholders in terms of extra earnings. In my opinion, asking Cognizant to increase its margins would screw up that digital growth strategy. Funding the transformation into a digital company doesn’t come cheap, so Cognizant needs that money even more today than in the past.

It makes sense that this activist investor would go after the industry. The industry has been accumulating cash, and it is highly profitable. But it’s now an industry in change. It also makes sense that the services industry, and specifically Cognizant, can return those handsome earnings to their shareholders. But as most people often find out through life, what makes sense is not always the best choice.

The changing market conditions will make it difficult for all providers to maintain high margins. Basically, it’s unrealistic to expect them to expand margins when there is downward pressure on all margins, and they need their operating margins.

I think this puts the service providers’ choice in stark relief. Basically, the legacy services industry is now mature and the providers face three options of what to do with their cash:

  1. Use their profitability to acquire and become bigger
  2. Return cash to shareholders
  3. Fund the path to transform into digital companies so that they can compete in the future

Providers are facing a hyper-competitive pricing environment in which it will become harder and hard to maintain their existing margins in their legacy business. However, they may be able to get the same or better margins as digital companies.

I think it would be a mistake to ask Cognizant to increase its net margins and not drive growth and not drive the digital transformation. It would be very short sighted to back away from Cognizant’s current growth strategy.