A very public debate has been taking place between Cognizant and Elliot Management Corp – the activist investor that bought a $1.4 billion stake in Cognizant a year ago. Effectively, Elliot has actively sought to alter the course Cognizant’s board has taken for dealing with the changing situation in the IT services industry. As the leading providers in the services industry have accumulated a lot of cash, investors say it makes sense that they should return extra earnings to the shareholders. Let’s look at both positions.
The Debate Essentially Focuses on a Tradeoff
The legacy labor arbitrage market is mature and services providers can no longer maintain their high margins. However, if they transform to digital business models, they have an opportunity to achieve the same or even better margins.
Which vision is the right strategy for their future? As I explained in my recent post, “The Infosys Dilemma,” Cognizant faces the same tradeoff situation currently causing a noisy debate among the founders, board, CEO, and activist investors at Infosys as to which vision is right.
Providers with a legacy arbitrage-based book of business have two options for growth strategies:
- Arbitrage-First Vision. In this strategy, providers use their profitability to invest in mergers/acquisitions, consolidating the industry and becoming even bigger in the arbitrage market. This strategy offsets the declining growth of this market. It also drives shareholder value by returning cash to shareholders through repurchased shares and increased dividends.
- Digital-First Vision. In this strategy, providers use their profitability to invest in transforming into digital companies with new opportunities to compete and grow in the future. This is the path Accenture has taken to drive growth. This strategy is higher risk and involves actively cannibalizing a provider’s existing arbitrage business. Further, it doesn’t allow returning cash to shareholders, as providers need to invest in digital transformation including aggressive mergers/acquisitions to quickly gain digital talent and business.
Cognizant initially chose the second path. But in December 2016, Elliot sent a letter to Cognizant’s board stating the company should be managed differently to achieve a higher stock price. It also stated the firm should return some of its cash to its shareholders by buying back stock. Its opinion was, and is, that the firm has a strong enough balance sheet to undertake both growth strategies but that it needs to increase its margins.
Therein lies the dilemma: there is a tradeoff between margins and growth. The inconvenient truth is digital is less profitable right now, so a digital-first strategy means giving up profitability.
Cognizant’s management agreed to change its position to come into conformance with Elliot’s open letter to its shareholders, agreeing to a substantial return of cash to shareholders and committing to improving its margins. Cognizant is well positioned to execute on both these commitments; however, it is also clear that these commitments add difficulty to executing a digital-first strategy.
The commitment to improve margins is particularly risky at a time when the market is facing increasing competitive intensity resulting in downward pressure on margins. Cognizant’s plans to increase profit margins and drive stock valuations up by emphasizing its arbitrage business will inevitably deemphasize a digital-first strategy, which requires a willingness to trade margins for digital growth.