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Pricing improvement may add to Cognizant profitability

Margin expansion will be driven by SG&A leverage and higher share digital in the business. We believe digital generates around 800-900bps higher gross margins than the legacy business.

Pricing improvement may add to Cognizant profitability
Within overall growth guidance, digital is expected to grow low to high teens (44% of total revenues today) and legacy to grow at mid- to low teens.

Cognizant Technologies (CTSH) provided three-year growth and margin outlook at its analyst day (18 November 2021). The company expects 8-11% CAGR growth over 2022-24 (6-9% organic) and EBIT margin expansion of 20-40bps every year. We believe while the guidance is pretty much in line with expectations, it does provide confidence in stability at the company post an era of reasonably high management churn and also multiple high-profile client issues. Core assumption behind growth guidance of 6-9% is 7-8% industry growth over three years (so largely in line with industry growth) and continued recovery in the banking and healthcare business of the company. CTSH has faced multiple client issues, both in the banking and healthcare verticals in the past three-four years and the company expects more stable and predictable growth going forward (please refer our upgrade note CTSH – Upgrade to Buy: Risk-reward favourable, 22 July 2021).

Margin expansion will be driven by SG&A leverage and higher share digital in the business. We believe digital generates around 800-900bps higher gross margins than the legacy business. Pricing improvement is likely to add to the profitability as well. Headwinds to margins would be the tight supply market and M&A dilution. Also, on expected lines, growth is likely to be at the higher end of the range in 2022, while margin expansion at the lower end due to prevailing supply pressures. Deal wins have been improving and the CEO was confident about the continued turnaround in the banking and healthcare business of the company. Finally, we have previously highlighted the shifting centre of management gravity out of India (CTSH – Attrition and shift in centre of gravity, 4 October 2021).
While this wasn’t directly addressed on the call, we infer from the call that it is core to the company’s strategy and unlikely to change.

Other details: Within overall growth guidance, digital is expected to grow low to high teens (44% of total revenues today) and legacy to grow at mid- to low teens. This would mean digital would be 55-60% of the business in three years. Management reiterated multiple times its strategy to invest in delivery locations outside India, such as Eastern Europe, to be closer to the customer and also provide diversification.

Capital allocation remains broadly unchanged. FCF is expected to be around 100% of net profits. Around 50% of FCF will be invested in M&A, while 25% will go to buy-backs and the rest on dividends.

Valuation and change in estimates: We make marginal changes to our estimates to account for CTSH’s medium-term growth guidance.

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