Cognizant's valuation discount to continue

Company's profits missed expectations; revenue growth as well as guidance lags that of Infosys

Nasdaq-listed Cognizant’s March quarter results were disappointing on multiple fronts. First, it lowered the top end of its calender year 2016 revenue growth guidance from the 14.4 per cent indicated in February to 12.8 per cent after adjusting it for current demand trends; the bottom end of revenue guidance remains 10 per cent.

Second, though March quarter revenues at $3.202 billion were marginally below Street expectations of $3.23 billion, net profit (adjusted for one-offs) at $460.12 million missed expectations by a good 4.4 per cent.

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Third, the management continued to remain cautious on demand trends in the health care, and banking, financial services and insurance (BFSI) verticals, which together form 70 per cent of its revenues. Does this imply weak times for the other information technology biggies as well? Not quite.

This is because peers  Tata Consultancy Services (TCS) and Infosys posted much better revenue growth in the quarter. For instance, TCS and Infosys’ dollar revenues grew 1.5 per cent and 1.6 per cent sequentially in the quarter versus a 0.9 per cent sequential decline at Cognizant.

Also, Cognizant’s dollar revenue growth forecast for 2016 lags that of Infosys at 11.8-13.8 per cent (for FY17), though it is only a tad more than Nasscom's growth forecast of 10-12 per cent. Both TCS and Infosys are bullish on the BFSI vertical even though Cognizant has turned cautious on this vertical in the past two quarters.

All these factors indicate that Cognizant might be losing market share to its peers. The slower growth can also be partly due to a high base effect, say analysts.

In this backdrop, Cognizant now trades at discounted valuations compared to TCS and Infosys. At current levels, TCS and Infosys trade at 18.4 times and 17.8 times the 12-month forward estimated earnings, against 16.5 times in case of Cognizant. Historically, the Cognizant stock has commanded a premium of 21 per cent and seven per cent over TCS and Infosys, respectively.

Sustained improvement in financial performance is necessary for Cognizant's valuation discount to narrow with peers, say analysts.

Overall, the sector is witnessing increasing competitive intensity. This is also reflected in muted outlook on pricing by all companies. Most companies witnessed pricing pressure in the quarter. They believe this metric will be flattish with a downward bias going forward.

The March 2016 quarter also witnessed further increase in polarised performance by the top four Indian IT companies with TCS and Infosys doing better than HCL Technologies and Wipro. In this backdrop, most analysts remain positive on the former two companies and believe upside potential is higher at Infosys at current levels and continued industry-leading growth.