Cognizant Technology Solutions Corp (CTSH): Wedgewood Capital Happy with Performance, New Operating Margins

Cognizant Technology Solutions Corp (NASDAQ:CTSH), an information technology, technology, consulting, and business process services firm has been receiving a lot of love from hedge funds recently. CTSH is one the favorite stocks among hedge funds covered by Insider Monkey. There are 52 hedge funds in our database that hold bullish positions in the company. One of the funds that love Cognizant Technology Solutions Corp is Wedgewood Capital which released its 2017 Q3 investor letter recently (you can download a copy here). We are going to take a look at Wedgewood’s investment thesis to understand why CTSH is getting all this attention.

Here is what Wedgewood Capital wrote about Cognizant Technology Solutions Corp (NASDAQ:CTSH) in its letter to investors:

Cognizant has been a strong performer throughout the year. In 2016 it proved to be a bit sluggish, particularly when the strong and steady revenue growth typically reported by the Company experienced headwinds in multiple business segments. In their Financial Services segment, 2016 was marked by large money center bank customers spending more cautiously due to the low interest rate environment. Political uncertainty in the U.S. during the election year also impacted spending by their customers. While these large banks continue to take a conservative approach to spending, management has noted some stability in the banking sector relative to last year.

Recall that when we last wrote on Cognizant’s performance (about a year ago) we mentioned four Cognizant clients in the HMO industry were all attempting to merge with or acquire each other. This M&A activity caused these clients to pause their project spending until the mergers were either finalized or abandoned. It did not help that these large industry M&A transactions were slowed by regulatory hurdles. Both transactions were ultimately blocked by the Department of Justice and,  as we predicted a year ago, spending has since bounced back as these clients are now looking to invest.

Perhaps the largest contributor to Cognizant’s performance has been the announcement and implementation of their Strategic Plan earlier this year. The plan focuses mainly on accelerating the Company’s shift to Digital Services (from a majority IT Services today) through both organic investments and acquisitions. Digital Services make up approximately 26% of total Company revenue (this is up from 23% of total revenue when the plan was first announced). However, these revenues are growing well above the Company average. While the digital market is not without competition, we certainly believe there is enough addressable market for Cognizant to take a reasonable share.

Additional initiatives of the Strategic Plan include improving margins and enhancing capital deployment. Historically, management has targeted a fairly steady operating margin level of 19-20%. As part of this plan, Cognizant is targeting 22% operating margins by 2019, a fairly substantial expansion but one we believe is achievable as the Company optimizes its cost structure. The shift to digital also helps in this area as these revenues generate higher margins in addition to growing faster than the Company average. Capital deployment plans include increased capital returns which include both share buybacks and dividends (the Company had not paid a dividend prior to the announcement of this plan), with a plan in place to return 75% of U.S.-generated free cash flow from 2019 onward.

Cognizant Technology Solutions Corp (NASDAQ:CTSH) has been performing well so far this year. Since the start of the year, the company’s stock has gained over 33%. During the 12-month period, the stock has surged more than 48%. The company reported solid results for the second quarter, with the quarterly revenue increasing year-over-year by 8.9% to $3.67 billion. Its net income was $470 million, or $0.80 per share, versus $252 million, or $0.41 per share, in the second quarter of 2016. Other notable investors that are bullish on Cognizant Technology Solutions Corp (NASDAQ:CTSH) include Diamond Hill Capital and Meru Capital.

Meanwhile, Wedgewood Capital has a bullish viewpoint on Alphabet Inc (NASDAQ:GOOGL), believing in the tech giant’s financial strength and continued high-teens revenue and profitability growth. Click here to read Wedgewood’s investment thesis on Alphabet.