- Markets expect CTSH to see Adjusted ROA fade from current stable 33% levels to historically low 26% levels over the next 5 years
- Management is confident about their operational efficiency and cost reduction initiatives and about their offerings, implying they should be able to maintain profitability while continuing to grow the business
- CTSH currently trades at a 6.3x Adjusted P/B metric, which is cheap compared to its peer group, and with robust growth prospects, there is potential for multiple expansion with limited equity downside
Embedded Expectations Analysis
As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations from firm’s valuations and historical performance trends, to give a clearer picture into what the market is projecting.
CTSH is currently trading at a 16.0x UAFRS-based P/E (V/E’), which is just below historical averages. At these levels, the market is pricing in expectations for Adjusted ROA to continue declining, from 33% in 2016 to 26% in 2021, accompanied by 12% Adjusted Asset Growth. This implies the market believes the level of profitability the firm has achieved sustainably for the last 16 years is unlikely to continue, likely driven by increasing competitive, regulatory, and economic pressures. However, several indicators, including historical profitability trends, valuation relative to peers, and management sentiment signal that these expectations are likely too negative.
Performance and Valuation Prime™ Chart
Cognizant Technology Solutions Corporation (CTSH) is a professional services outsourcing firm. The company employs an industry-specific consultative approach to help clients in the financial services, healthcare, and manufacturing/retail/logistics industries, as well as communications, information, media and entertainment, and high technology. The firm is primarily focused on improving their clients’ operational efficiency through advanced analytics and heavier emphasis on digitalization. As already-massive demand for advanced digital solutions has continued to grow, CTSH has been able to consistently grow their revenues and their asset base.
Historically, CTSH has seen robust, relatively stable profitability, with Adjusted ROA improving coming out of the Great Recession to 38%-41% levels from 2011 through 2015, before fading this past year to 33%. Meanwhile, Adjusted Asset Growth, which from 2001-2008 was fairly aggressive, ranging from 39%-69%, has tapered off, while remaining strong, ranging from 2%-31% since 2009.
Given CTSH’s historically robust 5x-6x cost-of-capital profitability paired with their consistently robust Asset’ Growth, the market’s current expectations for profitability to fade to historically low levels over the next five years are likely too bearish.
For context, the PVP chart above reflects the real, economic performance and valuation measures of Cognizant Technology Solutions Corporation (CTSH) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
Peer Analysis – Valuations Relative to Profitability
A major benefit of adjusting as-reported financial statements is to clear away accounting distortions to allow for more accurate peer-to-peer comparisons. To this end, we have included a scatter chart below that plots CTSH against its peers based on their UAFRS-based P/B (V/A’) and Adjusted ROA (ROA’).
Looking across industries, markets, and time, there has been a very strong relationship between a company’s ROA’ relative to the corporate average ROA’ (6%), and the multiple the market will pay above the value of the company’s Asset’ base, in terms of a UAFRS-based P/B multiple. A company that generates a 6% ROA’ will tend to trade at a 1.0x UAFRS-based P/B, and a company that generates an 18% ROA’ will trade at a 3.0x UAFRS-based P/B, etc.
Relative to its peers, CTSH appears undervalued, with its 6.3x UAFRS-based P/B and 39% Adjusted ROA, placing it slightly cheaper than its competitors, not considering the firm’s robust growth potential based on their historical growth trajectory. In order to justify current valuations, CTSH would need to see their potential growth opportunities completely dry up, while their profitability would have to stabilize near historical averages.
Analyst and Management Expectations
Analysts have more bullish expectations, expecting Adjusted ROA to rebound to 39% levels by 2018, accompanied by 4% Adjusted Asset growth. Analysts appear to believe the firm will have success with their cost reduction and operational efficiency initiatives.
In addition, Valens’ qualitative analysis of the firm’s Q1 2017 earnings call highlights that management is confident they have a number of operational efficiency and cost reduction work streams underway, and that their customers are transforming their operating models to digital. Moreover, they are confident their voluntary separation program will improve their cost structure moving forward, and that their healthcare solutions will improve membership engagement, and combine clinical and claims data to advance population health care management initiatives.
Given management’s confidence about their operational efficiency and cost reduction work streams, membership engagement, and their offerings, CTSH appears poised to maintain current levels of profitability, implying equity upside is likely warranted.
Performance Drivers – Sales, Margins and Turns
It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm’s profitability and performance.
Relative stability in Adjusted ROA has been driven by trends in both UAFRS-based Earnings Margins and Asset Turns. Adjusted Earnings Margins improved from 12% in 2001 to 14% in 2002, before stabilizing at 14%-15% levels through 2008. While they subsequently improved to 17% in 2010, Adjusted Margins have since steadily compressed back to 14% levels. Meanwhile, Adjusted Asset Turns declined from a peak of 2.9x in 2001 to just 2.1x in 2008, and have ranged from 2.4x-2.7x since. At current valuations, markets are pricing in expectations for Adjusted Earnings Margins and Adjusted Asset Turns to continue declining to historical lows, which may be too bearish considering current management sentiment and historical trends.
Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation
When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for CTSH at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset Growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.
To justify current prices, CTSH would need to see Adjusted ROA fade to historically low levels, accompanied by single-digit annual Adjusted Asset Growth over the next five years. Given the fact that the firm has never grown its Adjusted Asset base by less than 12% notwithstanding outlier 2% growth in 2009, and considering management’s positive sentiment surrounding their ability to improve their operational efficiency and about their ability to continue improving their offerings and engagement levels, markets appear to be pricing in the worst-case scenario, limiting near-term equity downside.
Moreover, when considering fundamental tailwinds and management communication signals, the firm may exceed market expectations, potentially driving material equity upside going forward.
To find out more about Cognizant Technology Solutions (CTSH) and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.