Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Karen McLoughlin - Chief Financial Officer and Principal Accounting Officer

Analysts

Kathryn L. Huberty - Morgan Stanley, Research Division

Cognizant Technology Solutions Corporation (CTSH) Morgan Stanley Technology, Media & Telecom Conference February 26, 2013 4:20 PM ET

Kathryn L. Huberty - Morgan Stanley, Research Division

Welcome to the Cognizant presentation. I'm Katie Huberty, Morgan Stanley Tech Hardware and IT Services analyst. And I'm very pleased to have Karen McLoughlin, CFO of Cognizant, on stage. We're going to kick off the presentation with a few remarks from Karen, and then we'll jump into Q&A.

Karen McLoughlin

Sure. Thanks, Katie, and good afternoon to everybody. Thanks for having us. So I don't want to get into a lot of detail around the numbers. I think by now everybody's read our earnings release that we gave a couple of weeks ago. But I just want to give sort of a wrap-up of the year and what we see happening.

So last year, we obviously finished the year at 20% revenue growth for 2012, which continued to be industry-leading revenue growth in our industry, and right in line with the guidance that we had provided last May, when we released our Q1 results. But I think what's important is some of the trends we saw in the business. So last year continued to be a very successful year for Cognizant. We added 23 strategic clients last year, bringing our total to 214 strategic clients. And those are clients that we expect to have a relationship with at least $5 million or upwards of $50 million of revenue.

And we also actually had 16 clients that generated over $100 million of revenue for us last year and did all of this while maintaining very high customer satisfaction levels, in fact, the highest that we've had in 4 years. So on the customer side, we're very pleased with the growth we saw on the business and the penetration with our customers.

On the employee side of the business, which is -- obviously, this is important. We actually added over 19,000 people last year. Did this while maintaining among the lowest attrition rates in our industry. So our attrition was just under 11% for the year and also had the highest employee satisfaction scores that we've had in our history. So really pleased with the way that we're able to execute, both in terms of our supply side of our business as well as the demand side of our business.

In terms of the trends that we started to see last year, I think very consistent with what we've talked about for a while now, where we talked about this concept of what we historically call the dual mandate, so clients needing to drive efficiency and effectiveness while driving innovation. We now have sort of evolved that dialogue into a conversation of clients needing to run better while run different and so continuing to need to drive cost effectiveness into their business. But this notion of innovation and transformation continues to really become more and more critical for our customers. And having a partner that can work with them to deliver both sides to that equation is really becoming critical both to their successes, as well as our success. And we see this really evolving in terms of the growth that we're seeing coming from what we call our Horizon 2 businesses, which constitutes consulting, BPO and infrastructure services, as well as the emergence of our Horizon 3 businesses and, particularly, what we call the SMAC stacks of social, mobile, analytics and cloud. And while the Horizon 3 business continues to be a very small piece of our business in terms of revenue dollars today, the traction and the penetration that it's gaining with customers has actually exceeded our own expectations. And so, we've talked to -- on our call a couple of weeks ago about the fact that we're now delivering SMAC services in 60 of our top 100 customers. And I think this evolution toward more innovation and more transformation is certainly a trend that we would expect to see continuing into this year and certainly was a big driver of our success in 2012.

Kathryn L. Huberty - Morgan Stanley, Research Division

Great. Last 5 years, Cognizant grew revenue 28% annually, which is a growth rate that I think any technology company would love to report to their investors. In a tough macro environment, you've guided to 17% growth, which is still quite attractive. Can you just kick off the discussion, talking about how does Cognizant methodically drive incremental revenue growth and go out even in a tough environment and find those incremental markets and opportunities to chase?

Karen McLoughlin

So I mean, I think, historically, Cognizant has chosen to play in a select group of industries and markets and deliver a fairly select group of services. And for us, it's really been about deep penetration and deep relationships within our customers, so not trying to be all things to all people. And we've seen, over the next years, as the business has evolved and as our clients have evolved that this notion of really having domain expertise is very, very critical to the customer. And at the end of the day, this is still a people business. But yes, we're still delivering IT services. But it's people that are behind this and the ability to have very strong client relationships and for clients to trust the partner that they're working with, I think, is paramount. And that really goes back almost to the history of the company. We've always grown up in this model of what we call Two-in-a-Box, where we have an on-site client partner and an offshore delivery director and the whole team is structured in a Two-in-a-Box mechanism, so that we can bring the best of the relationship side of the equation with the execution side of the equation to our customers. And we actually see this continuing to become more and more important as the business grows. Because what happened in the last few years is, as we've now started to develop new service offerings, like the Horizon 2 offerings and the BPO, consulting and infrastructure, our market within a customer has now expanded significantly. So previously, we were -- grow up doing application development and application management work. Now we have this whole new range of service offerings and then add that eventually to the Horizon 3 offering. So our market within a customer has essentially doubled in the last few years. Because of the service offerings we can deliver to them and because we have such strong client relationships, we're able to penetrate those additional offerings and that, obviously, provided a lot of the growth.

Kathryn L. Huberty - Morgan Stanley, Research Division

You don't necessarily have to go find a new vertical, find a new geography to drive growth. I mean that you'll do over time as well. But you can grow within the installed base.

Karen McLoughlin

Absolutely. And that's what we've shown over the years. Typically, in any given year, over 90% of our revenue in a year comes from clients that we had at the beginning of that year. So the ability to penetrate both through service offerings, also with additional geographies so -- many of our clients are multinational customers. So as we can expand into other areas that their servicing, that's helpful as well. But we have a lot of room to grow in the core business, and then we selectively make investments, whether it be new geographies or new businesses, such as energy and government and so forth. But we can do those in a more refined manner.

Kathryn L. Huberty - Morgan Stanley, Research Division

Sure. There were some comments on the last earnings call that alluded to tough discretionary spending environment, a cautious tone around the discretionary side of the business. But as you brought up, the tough macro is causing companies to run their business more efficiently and then run it differently, as they adopt things like the SMAC technologies that you highlighted. How do you think about the balance of the 2, the weaker IT budgets, the weak spending environment, but the need to change how you run your business? And is that an opportunity as we go through the next 12 months?

Karen McLoughlin

It's definitely an opportunity. We've seen this for the last few years now with the exception of the crux of the recession. For the last several years, clients' IT budgets have been flat, slightly up 1% or 2%. But that's an environment that we've very comfortable operating in. Because as you point out, clients know that they need to transform their business, whether it be for regulatory reasons or just to keep up with the changing business environment that they're in. And so, they're looking for the partner who can bring both those pieces together, to help them drive down the cost of their business as usual or existing core business, while freeing up investment dollars. And they need partners who can deliver both sides of that equation, not just one and bring them together in an integrated manner, that allows the customer to do what it needs to. And that's certainly been something we focused on for the last few years and, I think, will continue to be a big piece of the program moving forward.

Kathryn L. Huberty - Morgan Stanley, Research Division

Last fall, there was -- I think Gordon commented that the budget environment was flattish for 2013. Now that we are a couple of months into the year, does that seem to be where customers are falling out with a flat to slightly up IT budget?

Karen McLoughlin

Yes. We haven't really seen any change from what we expected. We started talking to customers last fall. As they were beginning their budgeting process, most of them are now wrapping that up and certainly have landed right where we would have expected it to. It's sort of a flat to maybe slightly up in a few places.

Kathryn L. Huberty - Morgan Stanley, Research Division

And the guidance for the year implies a back-end loaded year, which is typical seasonally. And it's been a theme that is clear in all the presentations this week. Companies are a little more cautious on the first half, more bullish on the second half. How would you characterize your visibility into 3Q -- in calendar 3Q and 4Q?

Karen McLoughlin

So I think it's consistent with what we normally see this time of year. I think Q1 is always generally a slower quarter for us, as clients are starting to finalize their budgets and decide when and how to kick off any discretionary spending. In particular, life sciences tends to be slow in Q4. So we have some seasonality in the business, in different parts of the business. So that we would expect to play out as it normally does. I think in the 17% guidance that we provided earlier this month, there was about $90 million of incremental revenue from 2 acquisitions that we talked about: one was the MediCall acquisition which we closed in Q4 of last year, and the second was the C1 Group acquisition that will close later this quarter. So obviously, you'll see a little bit of a ramp because of the C1 acquisition, when that comes in later in this quarter. And then we'll have a full quarter run rate of that in Q2. But typically, we see this sort of ramp, depending on the year, obviously, and how discretionary spending plays out. You can see a bigger ramp in Q2 and then it starts to stabilize a little bit during the year. But I think it will play out somewhat normally. And in terms of visibility, I wouldn't say we have any less visibility that we typically would have.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. Shifting to the end markets, the financial vertical is going through a lot of change, notwithstanding all the regulatory and compliance issues that have come about over the last couple of years. How is that creating opportunities for Cognizant? Is there incremental revenue this year, as you work with those customers through the regulatory changes? And is it incremental? Or is it a 0 sum game? Do they have to go find those dollars from somewhere else in the budget?

Karen McLoughlin

So let's take that into a couple of pieces. So for us, our banking and financial services sector also includes insurance. And the insurance market for us had a very nice 2012. We are seeing a lot of expansion across our insurance clients, particularly in some of our new service offerings: consulting and BPO and infrastructure and so forth. And that trend continued throughout 2012, and we expect to see very nice growth there. 2012 for the banking sector was a little more lumpy, and there's almost 3 pieces of banking that I would break into. One is the smaller sort of Tier 2 banks here in the United States, where they were late to the outsourcing market but have been very big adopters of the model once they came. And so we saw nice growth from those clients throughout 2012. Clearly, their spend isn't as big as the large multinationals. But there's still a very nice market there. Then you have the large European headquartered banks, large global banks, who, again, we've seen very nice growth throughout the year from. And those banks, along with the North American banks, I'll talk about in a minute, are really looking to change their business model where they need to drive down their cost structure. They have a lot of different challenges they're facing in their environments. And so, we're seeing a lot of very interesting conversations and work take place with those customers around transformational-type opportunities. The place last year we had a little more volatility was really in the large North American headquartered banks. And that was primarily in Q1 and the beginning part of Q2. Actually going into the Q3-Q4 time frame, we started to see some recovery in that sector of the business. And as you point out, there is quite a bit of regulatory work that needs to get done for many of the large banks or from many banks across the globe but particularly for that sector. What we expect to see is there are trade-offs, right? Clients -- almost every client in every industry now, is faced with some kind of constraint budget. And so I think we would expect to see some trade-offs. So they'll do the regulatory work in lieu of doing something else. The question is, again, are there other things we can do to help them drive the savings to free up more work within the same budget dollars and take essentially a bigger market share of their budget going forward. And that's obviously what we're focused on.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And similarly, can you talk about the opportunity with the U.S. health care reform in that vertical?

Karen McLoughlin

So I think it's a similar issue with the U.S. health care companies. Obviously, our strength is on the payer side of the business and separate that out from life sciences for a moment. But in the payer side of the business, a lot of the work around ICD-10 and so forth was already under way. So that's not really a big driver of increased revenue going into 2013. Most of that works well started. The issues is really around the Healthcare Reform Act and what are the impacts there. And certainly, a lot of consulting work is going on in the health care space now as clients evaluate what they need to do. Starting to see some work around regulatory changes there. Hasn't been a huge driver of the growth yet. And I do think in the health care space, I think clients will be quite focused on how do we make those trade-offs, right? And there's a lot of pressure on the health care companies right now. So I do think they're -- you really will have to work within the constraints of their budget. If there is incremental spending, that's great. But certainly, that's not something we would assume at this point.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And offsetting that is a drug pipeline in pharma that's quite weak and you would expect that to hit the growth rate in 2013.

Karen McLoughlin

Yes. So just as we saw in 2012, we saw a big pullback in pharma in Q1. You did see some recovery in Q4 in pharma, but that was -- that's mainly seasonality. There is some seasonality to that business, a little bit more so than some of the others. We expect the pharma and life sciences business to grow double digits in 2013. But it will grow slower than the company average. And certainly, our clients are still feeling the pain of the lack of new pipeline. The pharma clients are talking about stronger pipelines going into '14 and beyond. But at this point, we think, '13 will continue to be soft.

Kathryn L. Huberty - Morgan Stanley, Research Division

One of the pleasant surprises last quarter was very strong growth in Europe, the fastest in 5 quarters, despite everything that's going on in that region. Is that a sustainable growth rate? And what are the drivers behind it?

Karen McLoughlin

So Europe's been really interesting. We've talked now for a while that we think Europe, as a long-term market, is a great opportunity and has the potential to be as large as the North American market over time. And certainly, we started to see an increase in the pipeline in Europe, and we talked last year about a new relationship we had with Philips. That did start to kick in, in Q3. And so that was some of the growth. It's certainly not all of the growth that we saw in Q4. I think what's important in Europe is, historically, a lot of our business had been discretionary spend, so places where you didn't have an impact on the workforce. And now what we're seeing with a lot of our European customers and/or new opportunities is clients being willing to talk about changing their structure and actually tackling some of the workforce issues. Similar to the challenges in the U.S., there aren't enough engineers coming out of the schools in Europe. You have an aging workforce. So they need to look forward and figure out how they're going to get work done over the next several years. And so, you're starting to see a very different dialogue and a lot more conversation around what we would call traditional outsourcing, work happening. I don't think that happens overnight, and I don't know that it's necessarily a linear track, right? Continental Europe is quite small. So it's -- in terms of quarter-to-quarter sequential growth, one customer or one large project can move the needle up and down a couple of points. So I don't know that will be linear. But certainly, we would expect Europe to begin to grow faster than company average or to continue to. And long term, we think the opportunities are very strong there.

Kathryn L. Huberty - Morgan Stanley, Research Division

So a long-term structural trend but it will be lumpy along the way.

Karen McLoughlin

I think it'll be a bit lumpy. At least until we get a little more scale.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And emerging markets or developing countries are growing about twice the corporate average growth rate, yet your exposure to those markets are lower than some of your peers. How much of a priority is that? And are there investments that you have to make to be competitive on price?

Karen McLoughlin

Actually, I don't know that it's necessary a pricing investment that we have to make. I think it's really about building out the capabilities. And what you're seeing in Asia is consistent with how we've grown the business over the years. We pick a few investments and we go after them very hard and make them successful, and then we move on to the next group. We don't try to tackle everything at once. And so, after North America, Europe was obviously the big focus. Now it's some of the rest of world following on behind Europe. And again, even there, we've chosen to be selective about which countries we're in. We're in a handful of countries, and we're trying to make the right investments in those countries. And oftentimes, that's really about the people investments. So it's about getting both the local hiring so local country managers, local sales teams, people who have the relationships, understand the culture of the local environment and then bringing the global delivery model to bear with that. So I think we're very excited about the opportunities in Asia and the countries that we're in. And you, I think, would expect to continue to see faster than company average growth there. But it is off small dollars so...

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. Shifting to competition, IBM and Accenture both reported a pretty drastic deceleration in outsourcing signings growth, understanding it can be lumpy. But I'd throw HP in there as well who reported last week and talked about weak signings in their business. Is that -- in your mind, is that a sign of the macro times? Or is that a sign of share shift and -- particularly share shift to Cognizant?

Karen McLoughlin

I think it's a number of things. And one of the reasons why I don't think we necessarily see some of that is, I think about the types of deals with, say, an IBM is in, right? They tend to be in very, very large deals that have multiple components of the hardware and the services and so forth. And so they're not necessarily deals that we're always playing in. So I think for us what we see is we continue to move up the value chain and so we're moving into bigger deals and more service offerings and so forth. But we're less impacted by some of the $1 billion-plus-type transactions. So that's not a space that we've historically played in. I do think customers maybe aren't entering into as many of those deals. And in some cases, I think they're breaking them into smaller pieces and trying to mix maybe the best of breed with some different opportunities. So that may be some of what they're seeing there as well. But I don't think -- certainly, in terms of the trend for the organization -- the industry as a whole, I don't think that's an issue.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. Shifting to the financial model, you have operated at the upper end or above the 19% to 20% operating margin target for a couple of quarters now. Is there a consideration internally to raise the bar? Or is the goal still to reinvest heavily in growth and keep the margin at that level?

Karen McLoughlin

Sure. So we talked about a target -- non-GAAP operating margin target of 19% to 20%, and as Katie mentioned last year, we ran right at 20% on a full year basis. That was a little bit by design to be honest. Clearly, we took our revenue guidance down last May. And although we were still very pleased with driving 20% revenue growth last year, it was not as good as we had expected it to be. And so one of the targets we set for ourselves was to make sure that we could at least deliver back on our EPS guidance to our shareholders, which we did. We actually exceeded our original guidance by $0.01. So that was a little bit intentional on our part. But in terms of how we manage the company, honestly, we believe there's still so much room for growth in this industry. And our board actually does not reward us for not investing in the business. So every dollar above 20%, we consider to be lost investment opportunities. And so certainly, our strategy is to continue to be in this range and to continue to drive investments so that we continue to drive industry-leading revenue growth for the foreseeable future.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And last quarter, wage inflation, the salary increases weighed on the gross margin line. Is there anything you can do to offset that wage inflation over time? Or is it just a function of growing into the higher salaries with a better macro and spending environment?

Karen McLoughlin

So I think there's a couple of things. Clearly, wage inflation has been high in India the last several years. Our expectations are that, over time, that wage inflation may get tempered a little bit and start to stabilize a little bit. There's quite a bit of supply right now in the Indian market. And obviously, growth rates have flowed through a number of competitors. So we think, obviously, that will help. I think the other thing is, frankly, managing utilization and pyramid and making sure that you have the right mix. We historically have had the luxury of running at slightly higher staffing pyramids than some of our competitors. And over time, we need to make sure that we're managing that effectively, as well as continuing to get rate increases in our contracts when the time is right and when those come up for renewals, so really a balance of all of those pieces that will help us manage margin going forward.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. I'm going to ask one more question, and we'll see if there are any in the audience. You had mentioned MediCall and the acquisition of the assets from C1 Group. As you think about driving more and more growth in Horizon 2 and Horizon 3, how should we think about the rate of acquisitions, maybe comparing it going forward versus what it looked like historically?

Karen McLoughlin

So our acquisition strategy hasn't really changed. But as we've talked about for some time now, what we're focused on are really acquiring acquisitions, preferably in the Horizon 2 space: the consulting and BPO and infrastructure. If we can find them at the right price, it makes sense for us. Geographic expansion -- so the C1 Group does a number of things for us including geographic expansion but particularly with we've been very focused on looking for acquisitions in Europe. If we can find them in Asia or Latin America or some of the other newer geographies, that would be fabulous as well. I think you will continue to see us start to look for acquisitions in the Horizon 3 space. Again, pricing is always a challenge in some of the newer business models that are emerging. But clearly, I think we'll continue to balance our growth with organic growth and with a tuck-in that's close in each acquisitions going forward.

Kathryn L. Huberty - Morgan Stanley, Research Division

If you have a question, if you'll just raise your hand, we have mics that they can bring to you. Any questions from here? I'll ask one more, and then I'll come back and see if there are any last, last questions. We have about 3 minutes left. You mentioned 19,000 hires last year, which is an impressive number. The industry, as a whole, is messaging, looking into 2013, hiring along with revenue growth and not getting ahead of themselves, trying to figure out the macro. So I guess first question, how much does that lower level of hiring impact industry growth? And two, and maybe more important structurally is, the street has always modeled these businesses as a function of how many people were hired, therefore, that will drive revenue growth. Is that relationship hold as much going forward as it maybe did in the past? Is the business model changing?

Karen McLoughlin

So generally speaking, this is still a headcount-driven business. Over time, as some of the non-linear Horizon 3 businesses start to become a bigger part of the business, you'll see some change there. But we would not expect that to be a steep curve, for instance, imagination, maybe a minor tweaking of it in the short term for sure. I think the thing with hiring -- so last year, we added a net of 19,000. So to add 19,000, we're obviously hiring well over 30,000 people. The balance -- it's a real balance between how many of your hired or campus hires are fresh out of college and then your lateral hires. And for us, we've typically tried to target that over the long term at a sort of 50-50 ratio. And the lateral hires are really almost a just-in-time hiring model. So the good thing there is we can ramp that up or down pretty quickly at the drop of a hat, if we need to. And because of the brand recognition, we now have, not just in India, but here in the U.S. and in other parts of the world, we're able to attract that lateral talent quite easily and quickly when we need to. And so, we're able to really balance that. So it's not necessarily a one-to-one correlation. So the people we hire in '13 won't necessarily be for '13 revenue. Obviously, the campus hires are sort of 6 to 9 months after they started, when they really start generating revenue. So you're always balancing both the short term and the long term, and we'll continue to do that.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay, good. Any last questions in the audience? Okay. We'll wrap it up there. Thank you very much.

Karen McLoughlin

Thank you, Katie.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Cognizant Technology Solutions' Management Presents at Morgan Stanley Technology, Media & Telecom Conference (Transcript)
This Transcript
All Transcripts