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Cognizant Technology Solutions Corporation (NASDAQ:CTSH)

Q2 2006 Earnings Conference Call

August 2, 2006 9:00 am ET

Executives

Julie Prozeller - Financial Dynamics

Lakshmi Naravanan - President, CEO

Francisco D’Souza - COO

Gordon Coburn - CFO

Analysts

Adam Frisch – UBS

Andrew Steinerman – Bear Sterns

Moshe Katri – Cowen and Company

Bryan Keane – Prudential

Julio Quinteros – Goldman Sachs

Cynthia Houlton – RBC Capital Markets

Sandra Notardonato – Robert W. Baird

Edward Caso - Wachovia

Rod Bourgeois - Bernstein

Presentation

Operator

At this time, I would like to welcome everyone to the Cognizant Technology Solutions second quarter 2006 earnings conference call. (Operator Instructions) I will now turn the conference over to Ms. Julie Prozeller with Financial Dynamics. Ms. Prozeller?

Julie Prozeller

Thank you, operator, and good morning everyone. By now you should have received a copy of the company’s second quarter 2006 earnings release. If you have not, please call our offices at 212 850 5600 and we’ll be sure to get a copy sent to you. On the call, we have Lakshmi Naravanan, President and CEO, Francisco D’Souza, COO, and Gordon Coburn, CFO of Cognizant Technology Solutions.

Before we begin, I’d like to remind you some of the comments made on today’s call and some of the responses to your questions may contain certain forward-looking statements. These statements are subject to risks and uncertainties as apprised in the company’s earnings release and other filings with the SEC.

I would now call like to turn the call over to Lakshmi. Please go ahead.

Lakshmi Naravanan

Thank you, Julie, and good morning everyone. Thank you for joining us today for our conference call. Today we will discuss Cognizant’s second quarter 2006 earnings and the management succession plan, both of which we announced this morning. I am joined this morning as usual by Francisco D’Souza, our Chief Operating Officer, and Gordon Coburn, our Chief Financial Officer.

We are pleased with the financial performance of Cognizant in Q2 and are really happy about the executive-level promotions as we announced, leading to the management succession plan.

Let me start by discussing the management succession plan. As you are all well aware, our strategy has always been focused on making ahead of the curve investments to ensure that our organization can support our aggressive growth trajectory.

Today we have announced a further investment in Cognizant’s future, to take us to the next level as a mighty, billion-dollar company. After careful planning, and with the support of the Board of Directors, today we announce that I’ll be taking on the new fulltime role of Vice Chairman of the Board and our Chief Operating Officer, Francisco D’Souza, will take over as President and CEO effective as of January 1, 2007. In addition, Gordon Coburn, currently Chief Financial Officer, will be promoted to Chief Financial and Operating Officer.

During more than a decade at Cognizant, Frank has played an integral role in building our client relationship management, sales and marketing and global delivery organizations into world class operations. Frank is widely recognized in the industry for his strategic vision and operational excellence which are two strengths complimentary to Cognizant’s ability to achieve its financial and operational goals and continue its industry leading growth. I look forward to working with Frank over the next several months to ensure a smooth transition of my responsibilities as CEO.

Once the transition is complete, I will remain closely involved in my role as Vice Chairman of the company. As we have grown beyond $1 billion in revenue and have become a Tier I industry leader, it has become clear that we need to formally devote time and attention to many industry issues which impact our firm. In the role of Vice Chairman, I will focus on these issues, for example, acting as Cognizant’s advocate to various industry organizations such as NASCOM, where I currently hold a leadership position, work with educational institutions to develop the faculty as well as the students to be industry ready and so on, as I continue to work alongside Frank in further strengthening the Cognizant brand and mentoring our next generation of leaders.

Gordon Coburn, in his new role as Chief Financial and Operating Officer, will continue to lead the company’s financial operations while taking on additional global responsibilities for enhancing Cognizant’s cross business unit processes and capabilities in areas such as talent, infrastructure and systems to support our continued growth. Gordon has been an invaluable member of the executive management team since the early years of the company, and I’m confident that he will continue to be a strong leader and successful in his expanded role.

Frank’s current responsibilities will be divided between two seasoned Cognizant veterans who intimately understand our history, culture and ingredients to our success.

Chandra Sekaran, who has been an executive officer of the company since 2004, has been promoted to President and Managing Director, Global Delivery and will oversee Cognizant’s development operations around the world.

Rajeev Mehta has been added to the executive team as Chief Operating Officer, Global Client Services, will assume responsibility for the company’s sales, business development and client relationship management organizations.

Both Raj and Chandra have been instrumental to Cognizant’s successes over the last decade. Chandra has been with Cognizant for the last 12 years, serving most recently as Executive Vice President and Managing Director. During this time, he has demonstrated exemplary leadership capabilities and managed many aspects of the business, including offshore delivery, key alliances, capacity growth, process initiatives and business development. Chandra has played a key role in growing the employee base from about 200 to more than 20,000 in various development locations in India, and nurturing the culture of Cognizant.

Raj, who joined Cognizant in 1997, most recently served as Senior Vice President and General Manager of Cognizant’s financial services business unit, leading the group, the largest within Cognizant, to recognized industry leadership. In this capacity, he has been responsible for sales, business development, client relationship management and full P&L management.

I’m confident that this expanded executive team, which has worked together over the last several years to build Cognizant, is the right team to maintain our industry leadership going forward, both in terms of stature and performance.

Now, turning to highlights for the second quarter, we are very pleased with our strong financial performance which spanned all the units of our business across our industry verticals, service offerings and customers markets. We’ve continued to see substantial sequential and year over year revenue growth from our leading verticals, which are financial services, healthcare and life sciences, two newer industries like telecommunications and media. We were also very pleased with the solid performance of our entire portfolio of service offerings in the second quarter. We posted healthy, double-digit sequential growth in infrastructure management, testing, data warehousing, advanced solutions, customer relationship management and ERP based on estimating demand for our services. Once more we have continued to see growing demand in new customer markets, particularly Europe, where I’m pleased to report that growth this quarter exceeded the company average.

Looking at our second quarter results in detail, we exceeded our guidance to investors, generating $336.8 million in revenue, which was $20 million above our guidance and a percentage increase of 59% from the second quarter of 2005. GAAP EPS was $0.37 for the quarter, up from $0.32 last quarter. Non-GAAP EPS, which excludes stock-based compensation expense, was $0.21 compared to $0.25 in the second quarter of last year.

We also added a total of 56 new clients in the quarter, five of which are considered strategic, which means that we think they have the potential to generate between $5 and $40 million or more in annual revenue for Cognizant over the long term.

Our GAAP operating margin was 18% and our non-GAAP operating margin was a really strong 20%, at the top end of our long-term target range of 19% to 20%, even though we continued to make strategic investments in the future growth of the business.

I am very pleased with our financial performance during the first half of the year. Our ability to produce consistently strong financial and operating results continues to demonstrate the success of our strategy, our ability to sustain our momentum and outpace the market going forward.

As Cognizant accelerates beyond the $1 billion annual revenue mark, we continue to focus on investing in the business to maintain our industry-leading growth. We recognize that our success would not be possible without the consistent dedication and high-quality of work from our employees at every level of the business around the world.

We continue to focus on bringing the best minds to Cognizant and maintaining the highest standards of performance to significant investments in campus recruitment, talent management, development and leadership training programs, which I’d like to tell you about in a little more detail.

Touching on campus recruitment, in the second quarter we increased our headcount by 11% sequentially, adding a net of over 3,900 employees. Cognizant visits approximately 150 engineering institutions across India and we strive to differentiate ourselves early on by reaching out to college juniors through our unique campus ambassadorial program in which Cognizant alumni share their experiences with students.

In addition, we continue to enhance our recruitment efforts by re-evaluating salary levels in order to ensure that our offers to prospective employees are very attractive and in line with industry averages.

To this end, we recently increased entry level salary offers by 20% for graduates who will be joining us during the 2007 season and have already seen the benefits of this in our recruitment efforts. It’s important to note that our wages have remained within the range we are predicting.

Another important aspect of recruitment is talent management development, which allows us to quickly train and re train our associates and is integral to our ability to scale our operation while managing our growth.

Through our in campus program we work with top universities to make courses available to then start training before new hires even leave the campus. More than 6,000 new hires will go through the program this year and we expect these numbers to increase substantially next year.

We also focus on training and development in-house through Cognizant Academy, which we have continued to expand as we grow the company. Recent initiatives have enabled a true, blended learning approach to both our managers and our associates using a combination of e-learning, podcasts, discussion forums, virtual classrooms and physical classrooms to deliver training. These resources have dramatically increased the effectiveness of our learning programs, while giving our associates increased flexibility to broaden their skills.

We’re also engaged in some very innovative initiatives like assisting finishing schools, implementing faculty development programs in coaching lecturers and professors in universities to work collaboratively with Cognizant.

I now would like to turn the call over to Frank, who’ll give color on some of the operational highlights in the quarter and the emerging growth areas.

Francisco D’Souza

Thanks Lakshmi, and good morning, everyone. First I’d like to say that I’m honored that the Board has appointed me to lead Cognizant beginning next year. I’m looking forward to working with Lakshmi during the transition and on an ongoing basis as we continue to grow Cognizant.

I’ve had the privilege of working closely with Gordon, Chandra and Raj over the last decade to build the great company we have become today, and I’m confident that this team will further strengthen the platform we have in place to deliver significant value to our customers, employees and shareholders going forward.

As Lakshmi mentioned, I’ll briefly discuss several of the key operational highlights of the quarter before turning the call over to Gordon.

During the second quarter, we continued to generate momentum across our vertical businesses, particularly in our industry recognized leading verticals, financial services, healthcare and life sciences.

We further expanded our strategic customer relationships by leveraging our deep industry expertise to align our client’s IT investments with their business processes and strategies to make their businesses stronger.

Healthcare and life sciences posted 17% sequential growth and 85% year over year growth respectively. We also further expanded our leadership position in our financial services vertical, generating 20% sequential revenue growth and 56% year over year growth.

During the second quarter, we also saw strong demand in our emerging verticals, particularly in telecommunications and media, and continue to see growth in manufacturing and logistics.

In telecommunications, we are experiencing strong demand for our business intelligence services and in media we are seeing strong demand in particular areas such as digital asset management.

With our manufacturing and logistics clients, we continue to see strong demand for our enterprise solutions, including ERP implementation and maintenance and regulatory compliance solutions.

As Lakshmi mentioned, demand for Cognizant’s major service offerings continues to grow. In particular, we have benefited from client’s investment in strategic ERP and CRM initiatives.

Our partnership with SAP continues to drive significant traction across industries such as manufacturing, pharmaceuticals and banking. In particular, our deep knowledge of the next generation NetWeaver platform through Cognizant’s NetWeaver test center has enabled us to win several strategic relationships with global customers including complex, large-scale implementation, program management and multi-year support engagements across North America and Europe.

As we said in the first quarter, we continue to see more companies in Europe embracing offshore outsourcing. Specifically in Europe, we are seeing solid traction across pharmaceutical companies for multi-year, multi-location support of their SAP systems that are governed by very stringent regulatory processes, and also greenfield implementation of SAP that requires a deep understanding of the molecules to the market pharmaceutical continuum across the three phases of drug discovery, manufacturing and sales and marketing. For example, we are currently working with a large European company in the pharmaceutical, chemical and plastics markets to redesign and re implement their SAP systems, enabling the company to streamline their business processes across 11 countries in Europe.

Another promising area of future growth for Cognizant is information technology infrastructure services. We are seeing increasing demand in this area as we have developed a suite of infrastructure management solutions designed to maximize the value of our client’s IT infrastructure. Our services in this area include infrastructure monitoring and management, consulting in systems integration and IT service desk solutions. Our integrated approach to IT infrastructure operations enables our clients to accurately and precisely measure IT infrastructure performance and service levels, from the server room to the end users’ desktop. Our consulting and systems integration services in this area include areas such as performance optimization, offshore ability assessment, migration and consolidation.

We now deliver these services, which can be seamlessly integrated into our application-level services, to an increasing number of customers across key verticals ranging from financial services and healthcare to telecommunications and media. For example, we are currently working with one of our long-term strategic clients in the healthcare industry to provide both application and infrastructure management services for key applications that drive their business. Our ability to create a single solution covering applications and infrastructure for production systems has enabled this particular client to optimize business availability and increase customer responsiveness.

Furthermore, infrastructure services continues to fuel the growth of our upcoming verticals such as media, where we recently took on responsibility for the infrastructure and IT operations of a leading New York-based publishing company.

Another major technology trend that we anticipate will be a driver of growth for Cognizant is the increasing adopting of service-oriented architectures amongst our customers. Through our SOA service offerings, we address key areas such as business process re-engineering, application integration, business collaboration and services-based information sharing.

Our clients are seeking to gain competitive advantage by transforming their business processes to reduce operational costs, leveraging existing investments in IT assets and offering new and innovative services to their customers. Our offerings, such as [Right Start SOA] and [Safe Way SOA] accelerate and ensure that our customers planning a migration to service-oriented architectures, do not destruct their existing IT ecosystem.

A recent example of this work was just completed with Schwan’s, the multibillion dollar leader in the frozen foods industry. We worked with Schwan’s to migrate their core business systems, comprised of 31 applications in all, off of the mainframe to a Microsoft.net environment. This sizeable program entailed replacing 7 million lines of code and migrating over 900 gigabytes of data, all of which are used by more than 10,000 users at the company.

Through this successful legacy modernization, Schwan's was not – Schwan's not only has a more efficient technology platform but, more importantly, has a full, loosely coupled environment which provides their business with increased flexibility.

In another example, we recently partnered with a leading global travel service provider following a series of mergers and acquisitions which left them with several siloed applications that were not reusable, interoperable or cost effective. By implementing a successful SOA strategy, Cognizant has been able to create a shared travel platform to increase synergies across their business units, improve responsiveness and time-to-market.

As Lakshmi mentioned, one of our key strategic priorities is ensuring that we recruit the best and the brightest engineering and business school graduates to join Cognizant and support our future growth. As a result of our efforts and the company's strong reputation, Cognizant continues to enjoy a prime position in elite engineering and management institutions across India. Our ability to bring in the top candidates from amongst the best institutions has been very successful, thanks to our brand equity on the campuses and the strong relationships we’ve developed because of our industry leading growth, open culture, non-hierarchical work environment, challenging assignments and global mindset. This is evidenced by the fact that Cognizant continues to secure the first or second recruitment slots in the majority of the top engineering schools across India that we visit. These are just a few examples of the numerous areas of emerging opportunities for Cognizant, and we will continue to invest in the people and the capabilities to fuel additional areas of growth to supplement our current strengths.

I will now turn the call over to Gordon who will take you through our numbers in greater detail. Gordon?

Gordon Coburn

Thank you Francisco, and good morning to everyone. I would like to provide some additional information on the second quarter and then discuss our financial expectations for Q3 as well as full year 2006.

Revenue for the second quarter significantly exceeded our prior guidance and expectations due to continued application ramp-up of clients won over the past few years, significant knowledge transfer of additional application management projects, as well as continued greater than anticipated strength in development spending, a trend that started for us in 2003.

Revenue growth accelerated to 18% sequentially, and 59% year-over-year. During the quarter, we continued to see healthy volume growth across a broad range of services and industries. Our core businesses remain vibrant and our pipeline is robust.

During the second quarter our financial services segment, which includes our practices in insurance, banking and transaction processing, grew by more than $58 million year-over-year and represented 48% of revenue for the quarter.

Healthcare grew over $33 million year-over-year and represented 22% of revenues.

Retail, manufacturing, and logistics grew by over 14 million, representing approximately 16% of revenues for the quarter. The remaining 14% of our revenues came primarily from other service-oriented industries including telecom, media and new technology. Those industries grew by over $18 million compared to Q2 of last year.

As Francisco mentioned, financial services grew by 56% year-over-year and 20% sequentially. Healthcare grew 85% year-over-year and 17% sequentially. Growth in our healthcare segment was in particular driven by the numerous life sciences clients we have won and are now ramping up. Retail, manufacturing and logistics grew 38% year-over-year and 16% sequentially, and the other segment grew 62% year-over-year, and 15% sequentially.

For the quarter, application management represented 51% of revenues and application development was 49%. Both services grew significantly in Q2. On a year-over-year basis application management grew 58%, and application development grew 61%. On a quarterly sequential basis, application management grew 22% and development grew 14%, reflecting the strong demand environment for our entire service offerings.

Within our maintenance and development service lines, we were particularly pleased with the continued interest shown by our clients in our specialized services, as well as our ability to meet this demand.

Our ERP and CRM practices grew by over 125% combined. Our data warehousing practice, which we believe is the clear leader in the industry, also grew well above company average. And finally, our testing practice grew by approximately 125%.

In addition, our infrastructure management practice, advanced solutions group, and business process outsourcing business all grew at rates faster than the company average.

During the quarter, 87% of revenue came from clients in North America. Europe was over 12% of the total revenue, and the remaining 1% of revenue came from the Asian market. Our European business grew 21% sequentially and 70% year-over-year, as we continue to invest in that region.

We added 36 new customers during the second quarter. We closed the quarter with an active customer base of approximately 270 clients. During the quarter, we added five accounts which we consider to be strategic and have the potential to become significant revenue sources for us in the future, bringing our total number of strategic clients to 77. We ended work for approximately 24 clients during the quarter, all of which were very small clients.

Turning to costs, on a GAAP basis cost of revenues increased 60% for the quarter as compared to the second quarter of last year. On a non-GAAP basis, which includes the impact – which excludes the impact of equity-based compensation, cost of revenues increased 57%. The increase is due to additional technical staff, both onsite and offshore, required to support our revenue growth.

We increased our technical staff by over 2,700 people during the quarter and ended the quarter with almost 27,800 technical staff. This is a net increase of over 9,800 technical staff from June 30th of last year.

Gross margin was 44.1% for the quarter on a GAAP basis. On a non-GAAP basis, which excludes the impact of equity-based compensation, gross margin in Q2 was 45.1%, a decline of 50 basis sequentially and an increase of 70 basis, compared to the second quarter of last year.

On a sequential basis, gross margin was negatively impacted by our annual compensation adjustments and an increase in our bonus accrual, well above target levels due to our strong performance, partially offset by the favorable movement of the Indian rupee.

SG&A expenses including depreciation were $87.8 million on a GAAP basis, up from $51.6 million in the second quarter of last year. GAAP SG&A expense in Q2 of this year included approximately $3.4 million of equity-based compensation expense in the quarter.

As a percentage of revenues, GAAP SG&A was 26.1% for the quarter. Non-GAAP SG&A was 25.1% of revenue, up 70 basis points in the second quarter of last year and up 80 basis points sequentially from the first quarter of 2006 as we accelerated investments to differentiate our services and relationships in the marketplace.

GAAP operating income for the quarter increased 43% to $60.7 million. On a non-GAAP basis, which excludes the impact of equity-based compensation, operating income for the second quarter was $67.4 million, up 59% from last year. Our non-GAAP operating margin for the quarter was within our target range of 19 to 20% as we increased discretionary spending and absorbed our annual seller increases during the quarter.

Interest income for the second quarter increased to $3.9 million compared to $2.1 million in the second quarter of last year. Interest income increased due to a higher global cash balance and an increase in short-term interest rates. We had $1.5 million foreign exchange gain during the quarter, primarily due to the weakening of the rupee throughout the quarter.

Our GAAP tax rate for the second quarter was 16.6% and the non-GAAP tax rate, which excludes equity compensation costs, was approximately 16.2%. Our GAAP tax rate for the quarter and expected rate for the full year are in line with our prior guidance.

Turning to the balance sheet, our balance sheet remained healthy. We finished the quarter with approximately $468 million of cash and short-term investments, up over $140 million from June 30, 2005 and up over $45 million from March of this year.

During the second quarter, operating activities generated approximately $51.6 million of cash.

Financing activities, primarily the exercise of stock options, generated $14.8 million of cash. These amounts were partially offset by approximately $24.4 million of capital expenditures, including expenditures on our India construction program.

In addition, we generated approximately $3.7 million of cash due to currency translation adjustments.

Our collection of trade receivables during the quarter continued not to be as strong as we would have liked. Based on our $266 million balance on June 30, we finished the quarter with a DSO, including unbilled receivables, of 72 days compared to 71 days for the same period last year and 69 days in Q1 of 2006. During Q2, excluding unbilled receivables, our DSO was approximately 62 days. The quality of our receivables portfolio remains exceptionally strong.

Our unbilled receivables balance was approximately $38 million at the end of the second quarter, up about $15.6 million from June 30, 2005 and up $4.9 million from Q1 of this year. The increase in unbilled receivables resulted primarily from the timing of billing milestones and more importantly, the volume associated with our continued revenue growth. Approximately 60% of our June 30 unbilled balance was billed in July.

During the second quarter, overall 25.2% of our revenue came from fixed-price contracts, down from 25.9% in the first quarter of this year and 25.4% in the second quarter of 2005. When we look at the mix by solution type during the quarter, 31% of our development revenue and 20% of our maintenance revenue came from fixed-price contracts.

Turing to headcount, at the end of the second quarter, our worldwide headcount, including both technical professionals and support staff, totalled approximately 29,675. This represents a net increase of over 2,900 people during the quarter, and approximately 10,400 people compared to June of last year. Approximately 50% of our Q2 hires were recent college graduates who will enter our training program, and the remainder were lateral hires of experienced IT professionals.

Based on our 2006 revenue expectations and our ongoing success in recruiting, we currently expect to exceed 36,000 employees globally by the end of 2006, and we are moving along well towards this goal, with over 31,000 people in the company today.

Turnover, both voluntary and involuntary, was 15% annualized during the second quarter compared to 17% annualized in the second quarter of 2005.

Onsite utilization increased slightly to around 87% for the quarter.

Offshore utilization, excluding recent college graduates who were in our training program during the quarter, was approximately 69%. Including trainees, offshore utilization was approximately 57% for the quarter.

We had approximately 2,400 unbilled people in our training program at the end of the quarter.

I would now like to comment on our growth expectations for Q3 and full year 2006.

As Lakshmi and Francisco mentioned earlier in this call, the investments we are making are producing results. The investments are allowing us to differentiate ourselves in the marketplace, both in terms of winning and growing new clients, and expanding our service offerings.

In addition, our client and employee satisfaction levels remain at a level for which we are proud. This has resulted in stronger than expected results in Q2, and is allowing us to significantly increase our full year guidance for 2006.

We are now projecting revenue for the third quarter of 2006 of at least $363 million. This represents 8% sequential growth, and 54% year-over-year growth.

We continue to have significant revenue visibility due to our high level recurring revenue and long-term nature of our customer relationships. In fact, today we have customer commitments for well over 90% of our third quarter revenue guidance.

For the full year 2006, based on the strong demand environment for offshore services and our favorable experience in ramp-up rates, we now project the revenue to be at least $1.37 billion, up $70 million from our most recent guidance and up $110 million from our initial guidance for 2006.

This represents growth of at least 54%. As has been typical in prior quarters we expect the majority of our growth for Q3 and full year of 2006 will come from the ramp up of clients won over the past few years.

During 2006, we intend to continue to closely monitor our spending and expect our operating margin for the remaining quarters of this year to remaining in the 19% to 20% range before the impact of equity-based compensation, in line with our historic margin level and prior guidance.

As stated in our previous occasions, please note that our operating margin target is non-GAAP and excludes the impact of equity compensation expense.

With this expected level of revenue growth and our expected operating margins, we are currently comfortable with our ability to deliver in Q3 GAAP EPS of $0.38 and non-GAAP EPS of $0.42, which excludes equity-based compensation.

This guidance includes the anticipation of a Q3 share count of approximately 151.5 million shares, a steady tax rate of 16.6% on a GAAP basis and non-GAAP 16.3% which is the year-to-date number, and an operating margin in the upper half of our guidance range excluding equity comp.

Based on current business trends, we are increasing our expected GAAP EPS guidance for the full year to at least $1.45, up from our prior guidance of at least $1.37, and full year non-GAAP guidance of at least $1.62, which excludes equity-based compensation. This guidance also includes the anticipation of a full year share count of approximately 151 million shares. In addition, the guidance assumes a consistent tax rate with our current rate, and a full year operating margin at the top end of our 19% to 20% guidance range on a non-GAAP basis.

We expect the vast majority of our Q3 and full year growth to come from existing clients, particularly the strategic deals that we’ve won over the past year and are successfully ramping up. With that, I would now like open up the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Adam Frisch of UBS.

Adam Frisch - UBS

Congratulations to you and the rest of your team on these fantastic results. Gordon, a quick question for you, does your new role mean that you are going to get a new briefcase? Or are you going around the lucky beat-up green one?

Gordon Coburn

The beat-up briefcase has been very lucky so I intend to keep that one until the holes get too big.

Adam Frisch - UBS

Okay sounds good. In getting more serious now, the 20% increase in salary to the 07 hires, is that across the board and does that materially cut into the cushion that exists in your operating margin above the 20% top end bogey?

Gordon Coburn

Yeah, let me be very clear about that. The 20% increase relates to offers that we are putting out now for college students who will be joining us during the 2007 season. The impact of that change for 2007, holding everything else constant, would be about 50 to 60 basis points and the reason for that, even though its large number of people, it’s a relatively small portion of our cost base. So we do not see a change in our range and, you know, it's built into our planning for 2007.

Adam Frisch - UBS

Is there any kind of ripple effect, then, that happens with the other levels of people, or do you just give a more upfront and then a raise once they finish the training program is last, so does it keep everything pretty much in line?

Gordon Coburn

There will be a little bit of a ripple effect, but the ripple effect is not significant

Adam Frisch - UBS

Okay. Second quarter, posted your best sequential growth rate, I think, in your company's history despite being your biggest quarter, if I'm not mistaken, despite the multiple headwinds that you talked about on your prior call. So Gordon, if you could, just talk about what drove it and what does it suggest about the second half in the year? Should we expect somewhat of a slowdown here?

Gordon Coburn

Sure. Yeah, there are couple of things that occurred in Q2. Probably the single biggest thing, and you saw it in the growth and application management for the first time in a long time actually growing faster sequentially than application development, part of what happened – we saw a real spike in application management work and when you have that kind of spike, you have a lot of onsite knowledge transfer. So, you kind of get this surge where you have a lot of people come onsite, obviously at higher billing rates, and then go back offshore. And that's one reason why you saw very strong growth in Q2 and our guidance for Q3. Obviously it's very healthy at 54%, but on a sequential basis is slower than Q2 because now that’s – some of that management work, you know, their [KT] is done and we’ll start to move it offshore. But let me let Frank and Lakshmi comment more strategically on what we’re seeing that's driving this more general phenomenon of, you know, why we are dong so well.

Francisco D’Souza

It's Frank, Adam. I think, you know, overall, and we've talked about this on prior calls, we’re really benefiting from the investments we’ve made in three primary areas.

The first is, and we talked about them on the call this morning, the first is just across all of our industry vertical segments, the investments we've been making in domain experts and in folks on the client facing – in the client facing organization are really paying off. We’re able to engage with our clients more strategically, engage with them on more complex engagements on, on really working with them to solve their business problems. And so that’s sort of driving growth, very healthy growth across all of our verticals.

This quarter was characterized by strong growth across, as I said earlier, both the large verticals, the historic, the big Cognizant verticals and also the smaller verticals where we see increasing traction.

The second trend that we are benefiting from is the increased adoption and acceptance of offshoring in Europe. As we said, this quarter Europe grew faster than the company average and we continue to feel optimistic about the demand in Europe and also our ability to service that demand as we put - continue to strengthen the team on the ground in Europe.

And then finally, you know, the increasing set of services that we've been investing in, particularly things like ERP implementation, our IT infrastructure services that I touched on. These are new service lines that we've invested in considerably over the last several quarters and we are now starting to see real traction for those services in the marketplace. I think all of those three things are coming together to generate some significant demand.

Adam Frisch - UBS

Okay, great, and then just a final housekeeping question. Gordon, I noticed your guidance for EPS next quarter does not include the words at least, so I was wondering if you could just manage expectations and what's behind that? Is there, the margin guidance was pretty specific, but what's going on on the EPS line?

Gordon Coburn

I think that's the - similar to the language that we used last quarter. I think we used approximately.

Historically we've never used at least when talking about the next quarter up.

Adam Frisch - UBS

Okay, thanks guys. Again, great job.

Operator

Your next question comes from Andrew Steinerman of Bear Sterns.

Andrew Steinerman – Bear Sterns

Hi there, congratulations. My question has to do with application development. I noticed the surge in application management, obviously application development still grew strong, and it seems like the outlook is still very healthy. I was just wondering, just looking at the application development side, do you see any slowdown in some clients in terms of discretionary spending?

Lakshmi Naravanan

No, Andrew, I think the application development side has also been growing substantially. This is somewhat technology driven; I think we talked about the service-oriented architecture. As more and more of these organizations adopt the new technology the development effort increases. And the discretionary spending is also something that is consistent like as we have seen in the past quarter, because the benefit of this new technology is kind of immediate and the business impact us quite substantial. So, we see a large number of our customers willing to invest in these new technologies going forward.

Andrew Steinerman – Bear Sterns

Right. And so, when you look at financial services client like I think about my own firm your stock market has sunk for a couple of months now, you haven't seen any change of client patterns even in financial services?

Lakshmi Naravanan

No, even in financial services we haven't seen any significant change from the prior quarters. The investments that have been committed for technology infrastructure upgrade, et cetera, are continuing. There is no pull back.

Andrew Steinerman – Bear Sterns

Thank you very much.

Gordon Coburn

Thanks, Andrew.

Operator

Your next question comes from Moshe Katri of Cowen and Company.

Moshe Katri – Cowen and Company

Hey, thanks. Good morning and congratulations for Frank. A couple of things. Just to confirm Gordon, you said the currency benefits were about $1.5 million during the quarter?

Gordon Coburn

There are two parts of the currency that’s in motion. In non-operating income, below the line, there was a $1.5 million gain and that's comes from currency - from the balance sheet translation. In addition to that, baked into our operating expenses, we also had the benefit from the rupee moves in our favor. So, there is sort of something above the line as well as a decrease on below the line.

Moshe Katri – Cowen and Company

What was the other benefit? Can you quantify that?

Gordon Coburn

The rupee moved by just over 2%. Every 1% movement is worth about 20 basis points of margin.

Moshe Katri – Cowen and Company

Okay that's great. And then, how do we offset the 50 to 60 basis points margin impact next year from the 20% increase in salaries?

Gordon Coburn

As you know, we have lots of levers to pull just like, you know, this year we pulled levers depending on what's happening with volume, what's happening with onset offshore mix, utilization, the more general salary pool, bonus levels, so, you know it's, in the realm of things, 50, 60 basis points is not – is not a lot of money to come from one way or the other.

Moshe Katri – Cowen and Company

All right, so it's pretty manageable and then during the second half, should we see a re-acceleration in application development, sequential revenue growth versus application management, or we are going to keep on saying to strength in application management that's been kind of unusual?

Gordon Coburn

That one we don't guide to. The reality is, you know, we will do what's right for the customer. Yeah, we are saying healthy demand on both sides of the business, so it starts to become just very client specific in terms of what projects hit when and how quickly do they ramp up. To be very clear, yeah, both sides of the businesses are very healthy.

Moshe Katri – Cowen and Company

Okay, and then in terms of turnover, that's been in the mid-teens right now. Do you think this is where it's going to be at by the end of the year, or at this point do you think that's kind of stable at this point?

Gordon Coburn

If you – turnover has seasonality. Generally Q2 and Q3 are the higher quarters, Q1 and Q4 are lower. For both Q1 and Q2 of this year, we’ve been running lower than we ran last year, and our target is to be in the low teens on a full year basis and that's our target coming into the year and that target has not changed.

Moshe Katri – Cowen and Company

Okay and then finally, can you talk about top one and top five clients in terms of revenue concentration and remind us where it year ago and sequentially?

Gordon Coburn

Sure. We don't report top one, we have no clients over 10%, but the top five clients were 30% of revenue and grew roughly in line with the company.

Moshe Katri – Cowen and Company

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Bryan Keane of Prudential.

Bryan Keane – Prudential

Hi, good morning. I guess, since demand is really terrific, I guess the question comes how fast can you hire to keep up with it? And what kind of supply constraints do you see in the upcoming future quarters?

Lakshmi Naravanan

I think that's, like you said, the demand is quite strong in our customer base, as well as the new opportunities. The thing that we are most focused on today is on fixing the supply side.

We don't see much of the problem over the next four to six quarters. All our efforts currently are to sustain that level of input into the organization because one of the concerns that we have is longer-term we are relying on the education infrastructure in India. Will that be in a position to support the increasing demand, not just from us, but from the entire industry?

So, there are several initiatives that we have undertaken in order to collaborate with the education institutions to have the right quality of people come on board.

And two, this also requires a certain higher level of investment within Cognizant as part of Cognizant Academy to train and develop people, both at the technical levels, but more importantly at the managerial and the leadership level. I think the last quarter we talked about the management development program and the High Five leadership development program, which is coming along well. And we have launched several initiatives at the mid level to create a greater bandwidth and a great pool of project managers and technical and domain experts who can who can really come in and deliver growth in this organization.

And this is frankly, this one of the reasons why I'm taking on a different type of role, clearly to work with the education institutions, the academics, and also build a brand for Cognizant so that we are in a position to continue to attract large number of people from business schools, from educational institutions, and also set up some institutional infrastructure to sustain the supply of qualified people on a long-term basis.

Bryan Keane – Prudential

Now, these extra investments you’re talking about, especially in training, does that change the profile of the company, you know, the long-term pro forma operating margins of 19 to 20?

Lakshmi Naravanan

That does not change the long-term impact of the operating margin. That will continue to remain in the 19% to 20% range. The investments that we make of some that are done at the education institutions level, we just help them do those, make some of those changes so that the people coming out of colleges are industry-ready, and there are some that we have to do in our academy, and a lot of it is driven by technology. You know, I talk about the learning mechanisms, the e-learning, et cetera. So, these are all – while they are investments, these are not substantial in terms of dollar terms, but they apply technology to get to the level that we require.

Bryan Keane – Prudential

Okay. And then just to follow-ups. Just a comment…

Gordon Coburn

Bryan, I'm sorry to interrupt, we have only 10 minutes then people have to drop-off for another call. So, let me just let some other folks ask a question, if that's okay, and we catch up with other questions offline.

Bryan Keane – Prudential

Okay, great. Thanks. Congratulations.

Gordon Coburn

Okay, Bryan. Thank you.

Operator

Your next question comes from Julio Quinteros of Goldman Sachs.

Julio Quinteros – Goldman Sachs

Hi, guys. I have one question in 10 parts. Sorry about that. My question is actually pretty simple to, as it relates to the 10% bump on campuses that Infosys discussed and the 20% that you guys are talking about, can you just explain to me how, what those variances are and whether you guys have sort of caught up with them, or what the delta would be there in terms of the campus salaries? And then, related to that, just the issue with regards to the turnover. It looks like it was 11%, Q1, and 15% this quarter, but that's an annualized number correct?

Gordon Coburn

Let me just hit the second question, and Lakshmi will take the first one. Turnover is 11% annualized in Q1, 15% annualized in Q2. Both of those quarters were lower than they were in the same quarters last year. So we’re actually a couple points better than we were last year in each quarter.

Lakshmi Naravanan

And coming back to the question on campus salaries, actually the – the top three or four companies have the best lots as far as recruitment is concerned. We stated that in the majority of the campuses that we went to this year, we were either No. 1 or No. 2. So, we had access to the best people there. And that's because the top companies offer compensation within a narrow band, and this band has moved by about 10 to 20% over the last 2 years. Some companies particularly the Tier 2 companies who went to the campuses later, had to offer greater salary in order to attract people from these universities last year. And now, the Tier-1 companies are having to do it effective next year. To that extent, the band remains within the 10 to 20% range. We have to increase a little more than the other companies because we were at the middle or slightly lower than the middle range of the band. Now, we are in the upper half of the band.

Julio Quinteros – Goldman Sachs

Got it, and then I will just back to Gordon. The turnover, can you just sort of break up the turnover number a little bit between sort of entry level, mid-management and senior management, where are you seeing the turnover?

Gordon Coburn

Really no change in that. It’s always been at the lower levels. It's quite rare that we move people to senior levels unless, you know, it's more of a mutual decision. So, it's at the lower levels primarily in India. You know, you’ll see a little bit more in the US as we’re doing more U.S. hiring of technical staff, but no change in the general characteristics of where it's coming from.

Julio Quinteros – Goldman Sachs

Okay, great, thanks.

Operator

Your next question comes from Cynthia Houlton of RBC Capital Markets.

Cynthia Houlton – RBC Capital Markets

Just a quick question on bill rates concerning - it sounds like you had a lot of onsite work especially in the app management, anything different going on with bill rates, either offshore or onsite?

Francisco D’Souza

Sure. The two discrete pieces, onsite and offshore, were quite constant sequentially. On a blended basis they moved up a little bit, obviously, because we moved to a little bit more onsite but - and you have a couple underlying things going on there. You have deals getting bigger, obviously large customers, you know, get more favorable rates. We’re doing a mix of business certainly from very high-end work to, you know, jobs where the BPO rates are obviously at lower rates. But, we’re, you know, it's a very stable rate environment. We are not seeing anything that's causing concern.

Cynthia Houlton – RBC Capital Markets

Thank you.

Operator

Your next question comes from Sandra Notardonato of Robert W. Baird.

Sandra Notardonato – Robert W. Baird

Hi, thanks. First question is, should we be expecting any other changes to follow the executive management's announcement that you made today such as a sales force reorganization, or other things to help support the next growth phase? And then secondly, if I can get the growth of the customers that would represent your top six through ten. You gave the first five. If I could get the six through ten, that will be great.

Lakshmi Naravanan

Yeah. I mean, let me talk about the organization changes and the succession plan. Clearly, as we continued to grow, we need to increase the management bandwidth. The set of promotions and the changes that we announced today are preparing the organization's – preparing Cognizant to meet the demands of rapid growth and to be a multi-billion dollar company. Surely, it will be followed by additional changes in the organization in terms of people from within taking greater responsibility, as well as inducting more people at both the senior and the middle levels in the organization. This is something that we have been doing in the last couple of years. We have inducted at least a coupe of very senior people into the organization, who have been well inducted into the organization, who are discharging responsibilities that are consistent with the overall goals and strategic vision of the company. So, we would anticipate some more changes at the middle and the senior management levels in the organization. That will be driven largely by the executive team, the five members that we announced that we put up in announcement today, they will drive the next level of changes in the organization to prepare for growth

Gordon Coburn

And Sandy, just to answer your second question, for the top ten, I don't have six to ten, no, but for the top ten in total, we were a little over 41% of revenue and the top ten grew pretty much in line with company average sequentially, just a touch below it.

Sandra Notardonato – Robert W. Baird

Okay, thank you

Operator

Your next question comes from Edward Caso of Wachovia.

Edward Caso - Wachovia

Great, thanks. Gordon, can you give us an update on your BPO business as a percent of revenue, what the outlook is, are you still getting attraction there? It wasn't mentioned today.

Gordon Coburn

As you know, we don't breakout, you know, the service offerings by percentage of revenue but clearly we’re gaining traction there, and we’re actually feeling quite good about it. Let me let Francisco and Lakshmi comment, you know, give some more color around that.

Francisco D’Souza

Yeah, just in terms of the BPO business, I think we have always said and talked about on this call, our strategy with the BPO business has always been to focus on BPO opportunities that fit two characteristics. One is, they have a high degree of industry knowledge within the process so that we can leverage the investments that we are making in industry experience, its folks and building domain expertise through our industry verticals. And the other characteristic we look for are business processes that have a high degree of IT content, so that we can leverage our core competency in IT and systems. And what we are finding and what we have found in the last few quarters is that that segment of the BPO market is beginning to see increased traction in India. It took time for customers to get comfortable with moving those types of processes into a global environment. We’re starting to see that happen. So, over the last two or three quarters, we’ve actually started several pilots across many of our industry verticals from healthcare - from big verticals like healthcare and financial services to smaller verticals like media, in the BPO space, all of them focused on these higher-value, knowledge-intensive and IT-intensive BPO processes.

Gordon Coburn

Ed, be sure to remember that for BPO it will impact headcount well before materially impacts the revenue, because BPO is still heavily offshore and billing rates tend to be lower than for IT. You know, it takes a lot of people to move the needle in a material way on revenue.

Edward Caso - Wachovia

Thank you.

Operator

Your next question comes from Rod Bourgeois of Bernstein.

Rod Bourgeois - Bernstein

Hey, guys. Can you give an update on where you are sourcing your gross headcount additions from? In other words, how much of your headcount additions is coming from campuses versus lateral hires or other sources?

Lakshmi Naravanan

No. Typically we have between 65% to 70% of our people coming from campuses and the remaining 30% to 35% at the lateral level, and the lateral level is predominantly via the hires that we make outside of India. On average, for example, we hire anywhere between 30 to 35 people per week here in the U.S. which is, I mean, a substantial number. Likewise, we hire a fair number of lateral hires in India too, and referral is the single big best source. People within the company who like the culture, who understand the culture and the direction of the company refer to us their colleagues who come in and join.

Rod Bourgeois - Bernstein

Now I guess my question is, as your headcount addition requirement goes up, are you seeing any shift towards more lateral hiring or more campus hires?

Lakshmi Naravanan

No, its --over the last 2 years it has remained consistently in that band, 60% to 70% of campus hires from the remaining lateral. We expect that trend to continue.

Gordon Coburn

So, Rod, what that translates into is, we are putting out a lot of offers right now for people will join us in 2007, because there is, basically a year lead time on the calls hires. And, you know, if revenue is really strong, that means we have to go out into the open market a little so that can move what the final mix is between, between college and lateral but, as Lakshmi said, yeah, we try to target that 65% range or so, and you'll see, obviously year-to-date we are running about 50% and part of that is seasonality. Q3 is a huge quarter for the college kids coming in. Where exactly we end up for the year depends on where final headcount ends up.

Rod Bourgeois - Bernstein

Great thanks for that.

Gordon Coburn

Great and with that, its 10:00 a.m. I know many of you have to jump for another earnings call so why don't we have Lakshmi, a closing talk?

Lakshmi Naravanan

Yes. Let me conclude with these concluding remarks, and I have to thank you once again for joining our call today. We’re pleased with our financial performance during the second quarter, both across our verticals and our service offerings. We are confident that we have right strategy in place to continue delivering strong financial and operating performance throughout the remainder of 2006 and we believe, more importantly, that the expanded executive management team we announced today firmly positions Cognizant to continue our growth well into the future, and we all look forward to talking to you in the next quarter. Thank you very much.

Operator

Thank you ladies and gentlemen. This concludes Cognizant Technology Solutions second quarter 2006 earnings conference call. You may now disconnect.

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