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Attrition accentuated by company-specific issues

Cognizant (CTSH), one of the key peers of our Indian IT services coverage companies, reported its 2QCY22 earnings. 2QCY22 revenue (USD 4.91b, +9.5% YoY in CC) missed consensus by USD20m. CY22 guidance cut was also disappointing (+9% YoY at mid-point, down 100bp v/s earlier guidance). Although a large portion of the cut was from supply-side challenges (attrition rose 500bp to 31% quarterly annualized), CTSH indicated some delay/pause in client spends unlike its Indian IT peers. Pricing commentary is positive though, with management expressing confidence in margin improvement on better pricing. We were also concerned by the commentary on pipeline pushout, although CTSH has been struggling for a few years and it has company-specific issues.

Snapshot of 2QCY22 results – guidance miss disappoints

* CTSH’s revenue at USD4.91b rose 2.0% QoQ/7% YoY (9.5% YoY in CC organic) and was below consensus estimate by USD20m.

* CY22 guidance cut: Revenue growth guidance is now at 8.5-9.5% YoY in CC (v/s 9.0-11.0% YoY earlier). Reported CY22 guidance of USD19.7b missed consensus expectations.

* Inorganic impact in 2022 maintained at 100bp, FX impact was 220bp v/s 180bp previously guided.

* Management retained its EBIT margin guidance of 20-30bp improvement v/s 2021 (at 15.6-15.7%).

* Revenue growth guidance for 3QCY22 came in lower at 7.5-8.5% YoY, below expectations (guidance assumes currency to have a negative 250bp impact as well as an inorganic contribution of approximately 50bp, which reflects the lower-than-anticipated M&A activity)

* Operating margin stood at 15.5% (+50bp QoQ)

* 2QCY22 bookings declined 3% YoY. TTM bookings growth was 13% YoY in 2Q.

* Attrition jumped 500bp to 31% (quarterly voluntary, up 500bp QoQ), 32% TTM.

* Net adds were soft at ~1k in 2QCY22.

Read-across positive for Indian IT Services peers

* Some weakness in demand: The cut in guidance for CY22 and commentary from management indicating some delay/pause in business point to a moderation in demand trajectory due to weakening macro environment.

* Pricing environment: The management stressed that pricing environment is strong with clients willing to take forward pricing discussions and are ready to pay more for certain skill sets. The pricing commentary revalidates the stance of Indian IT peers suggesting pricing tailwind. We believe that improved pricing should help Indian IT companies offset some of the margin headwinds. The improved pricing should start flowing through from 2HFY23.

* Supply-side pressure in the near term: CTSH reported 500bp increase in attrition on a QoQ basis and the management commentary suggested elevated pressures in CY22. Attrition remains one of the prime risks to the industry.

Key highlights from the management commentary

* Demand: Though management suggested no significant slowdown in spends yet, it remained cautious on the impact from slower earnings growth for its major clients that could lead to delays in non-essential and lower-ROI projects. It is not seeing any demand softness in Financial services yet. Pipeline progression has been a little slower than prior quarters with some push-outs into outer quarter periods, at higher levels than normal. Third quarter revenue guidance is adversely impacted by YTD booking performance to some degree.

* Attrition: Management anticipates attrition to remain elevated for CY22. Supply is a bigger constraint than demand according to the management. Given the resource constrained environment, it has exited from certain lower-margin nonstrategic projects.

* Operating margin (2QCY22): Gross margin expansion, INR depreciation, SG&A leverage and pricing were the key positives.

* Operating margin (2022): Headwinds: increased compensation costs, C&E and a return to office costs. Tailwinds: delivery efficiencies, digital revenue mix, pricing and SG&A leverage and discipline.

* Pricing: Market pricing dynamics remained consistent. Clients are more inclined to engage in price increase discussions. Clients are willing to pay for skills and innovation, with efficiencies – including automation and optimized delivery mix – expected to mitigate cost increases. Pricing power stemming from talent shortages will lag behind talent-related cost increases.

Valuation and view

CTSH’s commentary guides for some moderation in demand with elevated supplyside challenges. CY22 guidance was cut and lower-than-expected 3QCY22 guidance also suggested growth moderation both due to slower demand and supply constraints. While supply-side challenges remain a point of concern, the positive margin guidance provides some comfort. We remain watchful of the situation and maintain our positive stance on the sector as long-term demand remains intact with stable margins. Infosys, TCS and HCL Technologies remain our preferred picks within the Tier-I IT space.

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