Does Elliott's Thesis On Cognizant Address All The Headwinds?

Activist shareholder pressure may begin to stifle Cognizant Technology Solutions Corp CTSH in the coming days. Elliott Management, among the largest shareholders in the company by virtue of its 4 percent stake in the company, Monday sent a letter to the company's board, consisting of a three-part value enhancement plan.

3-Part Value Enhancement Plan

Operating Margin Improvement

• Call for 23 percent adjusted operating margin in fiscal year 2018, up from 19.7 percent in 2015. Elliott noted that even after adjusting for the 1.5 percent of sales the company spends on stock-based compensation, its estimated 21.5 percent comparable operating margin in 2018 could still be at a highly conservative 400–500 basis point discount to peers.
• The plan does not seek a reduction in dollar costs but is a highly targeted effort to cut costs.
• Among the areas identified for improvement were delivery, sales and marketing, general and administrative and third-party spend expenses.

Capital Allocation

• Elliott terms the company's capital structure, consisting of $4 billion in net cash, including $1.1 billion of onshore cash and virtually no debt, as highly inefficient.
• The proposed plan calls for a $2.5 billion share repurchase program to be completed by the first half of 2017. The buyback is to be funded by $1 billion of domestic cash on hand and $1.5 billion in debt.
• Elliott also called for the company instituting a ongoing capital return program to return 75 percent of U.S. free cash flow to shareholders.
• Elliott recommends using 25 percent of the U.S. free cash flow and $1 billion per year of incremental foreign cash flow to pursue tuck-in acquisitions.

Enhanced Oversight And Incentive Alignment

• Elliott suggested infusing fresh blood into the board and also the formation of an Operating Committee of the board to supervise and implement the value enhancement plan.
• The firm also called for incentives to be linked more to earnings than to revenues.

In a note released last week, Merrill Lynch downgraded shares of the company to Underperform from Buy and lowered its price target to $48 from $66. The tempered outlook was premised on immigration reform being contemplated by president-elect Donald Trump and the less likelihood of re-acceleration in fundamentals in 2017.

The anticipated slackness in fundamental performance was due to SaaS adoption hurting the company's application maintenance work and stalling revenue growth at its larger clients.

The immigration reform may lead the company to hire onsite labor. According to Merrill Lynch, a 10 percent increase in U.S. onsite labor cost could hurt non-GAAP operating margins by 240 basis points, although it feels the cost increase can be offset by a 6 percent average increase in U.S. bill rates.

The bottom line can be shored up by the cost cuts Elliott is envisaging in the support functions and the share buyback program it has been clamoring for. Additionally, linking incentives more to earnings could help.

In the letter, Elliott Management specified that it believes Cognizant shares can advance to $80–$90 by the end of 2017, up 50–69 percent in about a year.

At the time of writing, shares of Cognizant were up 6.84 percent at $57.25.