Cognizant's Strong Customer Relationship Helps Drive Its Moat

Equity Analyst

Julie Bhusal Sharma

Cognizant is one of the leading IT services providers in the world and was known as a growth darling for its revenue growth of 20%-40% during 2010-15. While we don't see Cognizant returning to that level of growth in the near future, reacceleration in growth is not farfetched. We think Cognizant can deliver this via thoughtful investment in enhancing technical capabilities, more robust strategy consulting operations, and a more diversified client base. With such a focus, we think Cognizant has the potential to strengthen its already moaty business, which benefits from significant switching costs and intangible assets based in its technical expertise.

Cognizant has admitted that it is first and foremost perceived as a back-office enterprise outsourcer, but we think its existing technical capabilities are strong in more nuanced enterprise IT solutions, such as artificial intelligence services, which will help it become better known for digital transformation. While Cognizant has not lagged in its digital capabilities, we think there’s more work to be done for the company to distinguish itself from competitors as a cutting-edge IT service provider. We believe Cognizant is well aware of this potential and has a healthy balance sheet to push forward in its technical capabilities. Still, a pipeline of work from in-house consultants could help bring down the costly activity of highlighting one’s technical capabilities.

For these reasons, we think Cognizant’s slow entrance into traditional consulting will be a worthy cause in the long run. We think these efforts will be more worthwhile if Cognizant can diversify its client base away from healthcare and financial services. With such strategies in motion, we expect Cognizant to pick up the pace on its growth in 2022 after one anomalous year of revenue declines followed by strong recovery in 2021 due to the COVID-19 pandemic.

Business Strategy & Outlook

We assign Cognizant a narrow moat rating stemming from its intangible assets and customer switching costs associated with its services, which we find to be common moat sources across the IT services landscape. 

Cognizant operates under two service lines: consulting and technology services, and outsourcing. Under the former, Cognizant offers traditional enterprise consulting as well as application development, system integration, and software and application testing. Under its outsourcing division, Cognizant provides application maintenance and infrastructure and business process services. We think Cognizant exhibits switching costs, particularly in business process outsourcing as a service. Examples of BPaaS offerings include claims processing and healthcare plan administration. BPaaS is often a hearty extension of a company’s operations that requires significant tailoring to a client’s needs. BPaaS contracts tend to last several years, which we believe to be a function of the significant time it takes to adjust to a clients’ wants and needs; these could differ significantly from even a competitor in the same vertical. In addition, we think application maintenance and infrastructure services exhibit high switching costs due to their mission-critical nature. If enterprise software experienced significant downtime or suffered a poor software release, or if a company’s servers were not properly maintained or well balanced in terms of loads, a company could bear immense costs. Cognizant ranks highly among competitors when it comes to infrastructure and cloud services offerings, ranking number three in HFS Research’s rankings based on execution, innovation, and adapting to customers’ needs. The greater the deal size, the more friction there will be in switching infrastructure service providers. We therefore take Cognizant’s large deal size to be indicative of the high switching costs among the company’s clients. 

Spanning both its outsourcing and consulting business, Cognizant reports that more than 90% of overall revenue each year is derived from existing customers at the beginning of the year. With less than 10% revenue growth in recent years, that leaves dollar renewals each year at least growing minutely, which we think supports our switching cost argument. We think that the costs of even shorter-term projects under Cognizant’s consulting and technology services umbrella bear switching costs because of the high costs of failure if software implementation does not go as planned or if quality assurance testers fail to detect software vulnerabilities. This makes familiarity with Cognizant a friction in switching IT servicers for the next project. 

However, we think switching costs are not as high as at some of its competitors’ consulting arms, like Accenture, because very little of Cognizant’s consulting business is traditional consulting, which we think brings the most uncertainty in project outcomes, making familiarity with an IT service provider even more important in deciding whom to hire for the next short-term project. We think traditional consulting, which would compete with the likes of Deloitte and Accenture, makes up only a small portion of revenue, given that only about 2% of Cognizant’s employee base works in its traditional consulting arm. On the other hand, larger contributors to consulting revenue, like systems integration, are less ambiguous tasks to contract out, in our opinion.

We think Cognizant benefits from intangible assets as a moat source due to its technical expertise gained from putting enterprise solutions to work across hundreds of companies and refining its solutions with every new deployment--a benefit we find often across the IT services industry. An example of Cognizant’s technical expertise is its strong artificial intelligence services, which are in the leader category, according to IDC and Forrester. We think specialized knowledge is compounded by Cognizant’s vertical focus. For example, Cognizant is considered the top healthcare IT services provider by HFS Research, with Accenture and Optum ranked two and three, respectively. Cognizant has been able to achieve higher revenue growth in the healthcare and communication, media, and telecom verticals compared with some of its other IT services peers due to such specialization. However, we think Cognizant has lower returns on invested capital than some of its peers, given its greater specialization in industries compared with other IT services companies. For example, Cognizant relies heavily on the healthcare and financial-services industry compared with its peers. We think this leads to lower returns on invested capital, as we think such specialization results in a mix toward more offerings spread across fewer companies, meaning less scaling effect per offering. This effect is magnified with consolidation in such specialized verticals, especially in healthcare. Despite lower returns on invested capital than peers, we think Cognizant’s still healthy returns due to technical and industry expertise will endure over the next 10 years.

Narrow

Economic Moat

Cognizant Technology Solutions

Cognizant Technology Solutions Corp. engages in the provision of information technology, consulting, and business process outsourcing services. It operates through the following business segments: Financial Services, Healthcare, Products and Resources, and Communications, Media, and Technology. The Financial Services segment consists of banking and insurance services. The Healthcare segment involves healthcare and life sciences. The Products and Resources segment consists of retail and consumer goods, manufacturing and logistics, travel and hospitality, and energy and utilities. The Communications, Media, and Technology segment includes communications, information, media and entertainment, and technology. The company was founded by Wijeyaraj Kumar Mahadeva and Francisco D'Souza in 1994 and is headquartered in Teaneck, NJ.

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