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Cognizant Technology Solutions Corp. (CTSH)

Q3 2009 Earnings Call

November 3, 2009 8:00am ET

Executives

David Nelson - Vice President Investor Relations

Francisco D'Souza - President and Chief Executive Officer

Gordon Coburn - Chief Financial and Operating Officer

Analysts

Bryan Keane - Credit Suisse

Rod Bourgeois - Sanford C. Bernstein & Co.

Moshe Katri – Cowen & Company

Ed Caso - Wells Fargo Securities

Jason Kupferberg – UBS

Nabil Elsheshai - Pacific Crest Securities

Glenn Greene – Oppenheimer

Joseph Foresi - Janney Montgomery Scott

George Price - Stifel Nicolaus & Company

Ashwin Shirvaikar – Citigroup

Operator

(Operator Instructions) Welcome to the Cognizant Technology Solutions Third Quarter 2009 Earnings Conference Call. I would now like to turn the conference over to David Nelson, Vice President of Investor Relations.

David Nelson

By now you should have received a copy of the Company's third quarter 2009 earnings release. If you have not, a copy is available on our website www.cognizant.com. The speakers we have on today's call are Francisco D'Souza, President and Chief Executive Officer and Gordon Coburn, Chief Financial and Operating Officer of Cognizant Technology.

Before we begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward looking statements. These statements are subject to the risks and uncertainties as described in the Company's earnings release and other filings with the SEC.

I would now like to turn the call over to Francisco D'Souza.

Francisco D’Souza

We’re extremely pleased to report one of the strongest quarters in the history of Cognizant. We delivered $853.5 million in revenue, well above our guidance, and an increase of 16% year over year and 10% over last quarter. Our revenue addition of almost $77 million over Q2 was our largest ever absolute sequential increase in revenue. As a key point, we’ve had many strong quarters in prior years in the midst of growth markets but to deliver the largest ever absolute sequential increase in revenue in the company’s history in the current economic environment is particularly gratifying.

I’ll let Gordon cover the details of the financial and operating metrics for the quarter in a few minutes which were strong across the board. Today’s results demonstrate not only that we are using this economic slowdown as an opportunity to build a stronger company but that we’ve extended our lead relative to others in the industry.

Of particular importance, our Q3 performance was very balanced with great consistency of results across our industry sectors, service offerings, and geographies. This consistency shows the value our clients see in the Cognizant business model and experience regardless of the market that we serve. Over the past several years we’ve reinvested in our model to provide not only cost savings but increased client innovation and effectiveness on one platform. In today’s economy our clients have shared with us that this model is more relevant then ever.

To put additional color around our strong results this quarter I’ll focus my comments this morning on four areas: First I’ll be discussing the Q3 industry level demand environment and our resulting over performance. However, this is only one part of the story since our strong results when contrasted with the rest of the industry are the result of more then industry level demand dynamics.

The second topic I’ll discuss today is Cognizant’s unique value proposition to the market and some take away points from our Q3 results in that respect. Third, since our value proposition is closely tied with our strategy of reinvestment I’ll quickly touch on some of the key investments and two acquisitions that we announced in recent months. Finally, I’ll provide some commentary about our outlook for the rest of the year.

Let’s start with a look at the Q3 demand picture. As we told you during last quarter’s call we entered Q3 with a strong pipeline across our full range of service offerings but we remained cautious with regard to how quickly these projects would close and convert to revenue. What surprised us this quarter was the speed at which decisions were made. As it turns out, the relative stability, if not recovery of our clients businesses, helped accelerate the sign up and launch of a number of projects.

As the pace of decision making accelerated during the quarter our strong client facing teams were ready to react and capitalize on the opportunities. At the height of the recession these teams defended our position and revenues with clients. These same teams are now playing offence as the demand environment has stabilized.

While we benefited this quarter from increased demand and faster decision making, our strong results when contrasted with the rest of the industry, are the result of our solid differentiated value proposition in the marketplace. We are deeply committed to giving our customers the best experience in the industry. To us this means progressing our client partnerships beyond operational engagements like cost take out and labor arbitrage and developing higher value relationships that encompass real business effectiveness and innovation.

Clients are increasingly turning to us because we can provide them with efficiency and innovation on one single tightly integrated global platform. Greater business effectiveness is achieved through our continual improvement of service quality and the ability to commit to improve business outcomes for clients while innovation is achieved through partnering closely with our clients to source new avenues of revenue and productivity by devising new ways of orchestrating their business operations.

Our service delivery is enabled by a Web 2.0 platform which we call Cognizant 2.0 which is proving to be a powerful differentiator for us in the industry. Cognizant 2.0 allows us to bring all our expertise from around the world to bear on each and every client engagement. In the same way that Web 2.0 social networking sites on the internet have created powerful networking effects. Cognizant 2.0 is connecting Cognizant associates, clients and other stakeholders, allowing us to pool knowledge and experience across our global operations and collaborate with clients in new and innovative ways.

To illustrate the power of our value proposition I’d like to mention our role as strategic global partner for Sanofi Pasteur, the largest company devoted entirely to developing and researching human vaccines including the hypercritical H1N1 or Swine Flu vaccine. Sanofi Pasteur has selected Cognizant as its global partner for clinical trial data management among other areas. Using a core team located in France, the US and India.

Today we’re executing over 30 large clinical studies in partnership with Sanofi Pasteur. Most notably we have helped the company meet aggressive H1N1 deadlines on five critical studies. Our partnership has enabled the company to increase effectiveness as measured by time to value and reduce process hiccups for bringing vaccines to market. Importantly our pricing model at Sanofi Pasteur is transaction and outcome based, demonstrating the evolution of our services delivery model.

Sanofi Pasteur is also a great example of the power of globally distributed teams to improve effectiveness, an approach that’s central to our Cognizant 2.0 knowledge sharing platform. This engagement demonstrates many of the key dynamics that are driving the growth of our Life Sciences business, a focus on reducing operating costs while at the same time driving greater effectiveness across the business.

Our ability to give customers the best experience in the industry is a direct result of our strategy of aggressively reinvesting in our business. Let me briefly update you on some of the key reinvestment highlights from this past quarter.

Investment in building our capabilities in BPO/KPO and infrastructure management services remains a key focus area. Both of these service offerings have shown robust growth. In addition to our ongoing investment in talent we announced two strategic acquisitions that will continue to bolster our capabilities in these two areas.

First, in September we announced the acquisition of the assets of Pepperweed Advisors which strengthens our IT infrastructure service practice by broadening our portfolio of consulting offerings, advising on business performance, risk management, and infrastructure cost management. Similarly we have signed a definitive agreement to acquire the UBS-India service center which boosts both our KPO/BPO and IT infrastructure capabilities.

This transaction which is expected to close at the end of this year will also deepen our financial service domain knowledge, strengthen our geographic footprint, and serve as a platform for us to provide similar services to other clients. We’ve also signed a multi-year agreement to provide a range of business process outsourcing, knowledge outsourcing, IT and remote infrastructure management services to UBS divisions around the world.

We also continued to invest in expanding our global delivery network. We opened our 52 delivery center in Manila recently initially to provide BPO services. Also, we expanded our Phoenix delivery center to include BPO services alongside application development, application maintenance and testing. We have similarly expanded other sites in the US and Canada as part of our strategy to deepen our near shore and in country capabilities.

Of course while it’s important to open new sites globally the real challenge is not in bringing new centers online but rather how we stitch these centers together into a collaborative and integrated delivery platform. Cognizant 2.0 as mentioned previously is a powerful platform for integrating our global delivery network.

As a final note, before I turn to our outlook for the rest of the year, I’d like to highlight our operational execution for this quarter. As many of you know, over the last six quarters we have gradually increased employee utilization at Cognizant. Many of your have questioned the impact of higher utilization on our ability to ramp up to increased demand. This quarter demonstrates that despite running at historically high levels of employee utilization we have processes to handle surges in demand and can ramp up to take advantage of opportunities when they occur.

Our supply chain is tight and we are able to quickly translate demand signals to increased supply of talent. We continue to sharpen our ability to forecast demand and the requirements for specific skills so that we can scale up while maintaining high levels of utilization.

Let me now turn to our outlook for the remainder of the year. We are guiding to revenue of at least $880 million for the fourth quarter and $3.255 billion for the full year. This represents a projected 3% sequential increased for Q4. Though we saw impressive results in Q3 in our pipeline remains robust, we are taking a justifiably cautious approach when providing Q4 revenue guidance based on several factors.

First, although we saw an acceleration in decision making during Q3, as we go through the 2010 budget season over the next few months we believe the demand pattern may be less predictable then normal due to uncertainties around the size of budgets and timing of finalization. Our guidance assumes that the client decision making process will slacken and projects that come to a close may not yet immediately renew until such time as clients finalize the years budget.

Additionally, a robust economic recovery seems unlikely in the near term and hence unlikely to create a catalyst for accelerated incremental discretionary spending. Finally, it should be noted that the fourth quarter has more holidays and thus fewer billing days then the third quarter. As a result, as in almost every year in the past decade we would expect slower sequential growth in Q4 versus Q3.

I want to make clear that despite the uncertainty of the pace of decision making in the coming months, the fundamentals of our business remain strong. Specifically, our pipeline is robust and we are actively engaged with clients to bring these opportunities to close. Our services portfolio is stronger then at any time in the past and key service offerings like IT infrastructure services and BPO and KPO are showing traction. Finally, our geographic expansion to new markets continues to show results and drive real growth.

Now I’ll turn the call over to Gordon who’ll detail our financial and operating results.

Gordon Coburn

I’d like to provide some additional information on the third quarter and then discuss our financial expectations for the remainder of 2009. As Francisco mentioned, our strong revenue performance was broad based with all of our major industry segments experiencing healthy demand. During the third quarter our financial services segment which includes our practices in insurance, banking, and transaction processing, grew 9.5% on a sequential basis and 7.4% year over year. It represented 42.7% of revenue for the quarter.

We experienced healthy sequential growth in both the banking and insurance components of this segment. Within financial services many of our key clients are indicating that the worst is over for IT spending reductions and are more positive about the prospects for their 2010 budgets then a few months ago. The current demand within financial services is fairly broad including merger integration efforts, regulatory compliance especially in our credit card business and risk management where clients are developing systems to help better measure and manage risk.

Healthcare continued its strong performance during the quarter with 10.8% sequential growth and 30% growth compared to the third quarter of last year. We experienced healthy growth among both our life sciences clients and our healthcare insurance clients. This segment represented 26.5% of revenues for the quarter.

Retail manufacturing logistics results was also strong, growing 10.7% sequentially and 27.1% year over year representing 17.2% of revenues for the quarter. We are particularly pleased with the strength that we saw in our retail sector where many of our clients are early in their transition to global delivery and see the weak economy as a catalyst to accelerate these programs. In fact, revenue from our retail clients grew over 15% sequentially in the third quarter as these clients completed projects prior to the normal holiday season development lockdown in the fourth quarter.

The remaining 13.6% of our revenues came primarily from other service oriented industries of communications, media, and high tech which grew 8.4% sequentially and 9.5% year over year.

For the quarter, application management represented 56% of revenues and grew 22% year over year and 10% sequentially. Application development was 44% of revenues and grew 10% year over year and just over 9% sequentially.

During the quarter 78.3% of revenues came from clients in North America, Europe was 19.2% of total revenue and 2.5% of revenue came from the Asia/Pacific/Middle Eastern/South American markets. On a reported basis Europe grew 18% sequentially in the third quarter. Currency movement positively impacted European revenue growth in the third quarter on a sequential basis by approximately $6.4 million due primarily to the strength of the pound, Swiss franc and Euro. However, compared to the third quarter of 2008 the movement of the European currencies negatively impacted growth by over $12 million.

As anticipated on a sequential basis pricing remained relatively stable. We had a gross addition of 46 new customers during the third quarter. We closed the quarter with 570 active customers. During the quarter, the number of accounts which we considered to be strategic and have the potential to ramp up to at least $5 million or more in annual revenue increased by five. This brings our total number of strategic clients to 139. We continue to see the trend towards our newer strategic customers embracing a wider range of Cognizant services at an earlier stage in the relationship.

Turning to costs, on a GAAP basis cost of revenues exclusive of depreciation and amortization increased 17.2% for the quarter as compared to the third quarter of last year. Third quarter cost of revenues include approximately $3.3 million of stock based compensation expense as well as the reversal of $192,000 of stock based and fringe benefit tax expense. This reversal is due to the repeal of the India fringe benefit tax during the third quarter, retroactive to April 1, 2009.

The increase in cost of revenues is primarily due to additional technical staff both on site and offshore required to support our revenue growth. We increased our technical staff by more than 3,800 during the quarter and by approximately 8,200 compared to September 2008. We ended the quarter with over 63,600 technical staff.

Third quarter SG&A, depreciation and amortization expenses were $216.1 million on a GAAP basis up from $162 million in the third quarter 2008. GAAP SG&A expense at Q3 2009 included approximately $8.6 million of stock based compensation expense and the reversal of about $1.1 million of stock based and the fringe benefit tax due to the repeal of the India fringe benefit tax.

GAAP operating income for the quarter increased approximately 13.4% to $161.8 million. On a GAAP basis which excludes the impact of $11.8 million of stock based compensation expense and the reversal of $1.3 million of fringe benefit expense. Operating income for the quarter was approximately $172.4 million up 12.8% from last year. Our GAAP operating margin was 19% for the quarter. Our non-GAAP operating margin which excludes stock based compensation expense and stock based fringe benefit tax impact was 20.2% for the quarter, just above our target range of 19% to 20%.

The margin over performance was primarily driven by our continued improvement in utilization and the higher anticipated revenue during the quarter, partially offset by an increase in our variable compensation expense.

The average rate for the Rupee was 48.3 in the third quarter 2009 versus 48.7 in the second quarter and 43.7 in Q3 of last year. $90 million of Rupee operating expense cash flow hedges settled in Q3. This resulted in a gain of approximately $2.6 million which was recognized in operating expenses. For the remaining quarters of 2009 we have an outstanding forward contract for hedges of $88.9 million of Rupee operating expenses at an average rate of 49.6. In addition, we currently have $450 million of Rupee operating expense hedges in place for 2010 at an average rate of 49.4 and $360 million for 2011 at an average rate of 48.5.

Interest income for the third quarter was $4.7 million compared to $5.3 million third quarter of last year and $2.6 million in the second quarter of this year. Interest income has declined year over year due to the continued decline in short term interest rates compared to last year. We had a $2.7 million of non-operating expenses, this was comprised of a net $2.9 million foreign exchange loss during the quarter related to balance sheet re-measurements and associated hedges primarily associated with the movement of the dollar versus the rupee, pound and Euro. The remaining $200,000 in non-operating income resulted from the mark to market requirements related to our auction rate securities portfolio.

Our GAAP tax rate for the third quarter was 16.6%. We expect the full year 2009 tax rate to be approximately 16.5%. As we mentioned on our second quarter earnings call the India government has extended the benefits of certain of our tax holidays through March 2011 which had been scheduled to expire in March 2010.

Our diluted share count for the second quarter was 302.6 million shares. We did not repurchase any shares during the third quarter under our 2008 Board authorized repurchase program.

Turning to the balance sheet, our balance sheet continues to strengthen. We finished the quarter with approximately $1.34 billion of cash, short term and long term investments, up over $195 million from the end of Q2. During the quarter, operating activities generated over $208 million of cash, financing activities generated over $21 million of cash comprised of the proceeds of auction exercises and related tax benefits as well as our employee stock purchase program.

We spent approximately $32 million of capital expenditures during the quarter and $4.5 million for acquisitions and related costs. In addition, we benefited from approximately $2 million in currency translation adjustments. For full year 2009 we expect to spend between $100 and $120 million in capital expenditures. This is a further reduction from our original expectations due to the timing of our new facilities and infrastructure requirements.

Based on our $685 million balance on September 30 we finished the quarter with a DSO including unbilled receivables of 74 days compared to 75 days in the same period of 2008. The unbilled portion of our receivables balance was approximately $98 million at the end of the third quarter, an increase of about $15 million compared to Q2. Approximately 63% of the September 30 unbilled balance was billed in the month of October.

During the third quarter 31% of our revenues came from fixed price contracts up from 30% in the second quarter 2009 and up from 26% in the third quarter 2008. When we look at the mix by solution type during the third quarter 32% of our development revenue and 30% of our maintenance revenue came from fixed price contracts. We are pleased to continue to trend of increasing the percentage of our revenues coming from fixed price contracts.

Turning to headcount, at the end of the third quarter our worldwide headcount including both technical professionals, and support staff totaled over 68,000. This represents a net increase of over 3,900 people during the third quarter. Annualized turnover including both voluntary and involuntary was approximately 12.3% during the third quarter.

Third quarter attrition represented more then a 500 basis point improvement versus the third quarter 2008. As discussed previously our medium term strategy has been to increase the company’s utilization levels due to scale economies and historical heavy overinvestment in bench resources. Q3 results show a continued payoff on this strategy. Offshore utilization was approximately 74% during the quarter. Offshore utilization excluding recent college graduates who were in our training program during the quarter was approximately 78%. On site utilization was approximately 90% for the quarter. At the end of Q3 we had over 3,400 unbilled people remaining in our training program.

I’d now like to comment on our growth expectations for the remainder of the year. For the fourth quarter 2009 we are projecting revenue of at least $880 million with significant revenue visibility due to high level of recurring revenue and the long term nature of our customer relationships. In fact today we have customer commitments for well over 90% of fourth quarter revenue guidance.

For full year 2009 we continue to expect industry leading revenue growth based on current indications we are increasing our prior guidance and expect revenue of at least $3.255 billion. This represents growth of at least 15.5% compared to our prior guidance of at least 11.5%.

As Francisco mentioned earlier our strategy of aggressive reinvestment is delivering results and we intend to continue this strategy in the fourth quarter. Therefore we are expecting our operating margin for the remainder of this year to be in our historic range of 19% to 20% before the impact of equity based compensation expense.

Therefore we are comfortable with our ability to deliver in Q4 GAAP EPS of $0.45 and non-GAAP EPS of $0.49 which excludes estimated stock based compensation expense of $0.04. This guidance anticipates a Q4 share count of approximately 305 million shares and a tax rate of 16.5%. The guidance excludes any future non-operating FX gains or losses.

For full year 2009 based on current business trends we are increasing our GAAP EPS guidance to $1.75 from our prior guidance of $1.66 and now expect our full year non-GAAP EPS to be $1.88 excluding $0.13 of stock compensation and fringe benefit tax expenses. This guidance anticipates a full year share count of approximately 301.2 million shares and this guidance also includes any future non-operating FX gains and losses.

With that we’d now like to open the call for question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bryan Keane - Credit Suisse

Bryan Keane - Credit Suisse

I wanted to ask as the demand comes back and hiring picks up can you keep the offshore utilization this high, I think it was 74% for the quarter or should that drop as we pick up the hiring?

Gordon Coburn

You’ll see more volatility in the utilization number including the trainees because we’ll be bringing on a bunch of trainees. Excluding trainees we’re pretty much at our target level. We’ll have some volatility up and down but no material trends one way or the other.

Bryan Keane - Credit Suisse

I’d like to ask about pricing, what’s the pricing environment look like right now? There’s been a lot of talk about wage inflation in the industry. Some of your competitors have been talking about increasing wages. Can you talk about what you guys are doing there?

Gordon Coburn

Pricing is playing out the way we expected. It was essentially stable during the third quarter. It was up a little bit onsite, down a little bit offshore. Some of that offshore was mix as BPO and ITIS obviously grew faster then the rest of the business. I think a message quite consistent with what a lot of the other top players are saying that there’s certainly stability in the market in terms of pricing.

Wage inflation for 2009 we’ve taken the approach of clearly sharing the success of the company this year with our employees and as I mentioned we increased our variable compensation accruals and we expect to payout healthy bonuses to our employees who made the success possible. Obviously there are two ways we could have done it in 2009; we could have increased base salary like a couple of our competitors have done. We think it’s more appropriate to have a direct link between performance and rewards for our employees. We think our employees are going to be happy and we keep that as a variable expense.

For 2010, too early to know how things will play out.

Operator

Your next question comes from Rod Bourgeois - Sanford C. Bernstein & Co.

Rod Bourgeois - Sanford Bernstein & Co.

I wanted to inquire about the budgeting process. Are you getting early signs that this will be more of a normal budget timing season or are you expecting that we may have hiccups in the budgeting process as we’ve had in past year. If you can specify when at this point you expect to get clarity on your clients 2010 plans that would be very helpful.

Francisco D’Souza

As I said, our planning assumptions at this point are that we will see somewhat of a slackening of demand as clients go through the budget cycle. Our planning assumption is that the budget cycle will take a little longer this year then it would in say a normal year. The indications we have right now are that it won’t be like it was during the 2009 cycle where budgets really didn’t get finalized until in many cases the second quarter. I’m expecting that budgets will be finalized by late in the first quarter at the outside. It’s still too early to have a definitive view into that.

I think many of our clients are taking somewhat of a wait and see approach to see how this quarter comes and how things look for the rest of the year before they make a final commitment as to when they’re going to lock down the budgets. Too early to tell when we will have a definitive view into the finalization. Right now we are assuming its going to be towards the end of the first quarter.

Rod Bourgeois - Sanford C. Bernstein & Co.

Last year you did your customer conference and then gave your guidance right after that in the mid February timeframe. Is that the plan for next year as well?

Gordon Coburn

No, the timing is going to be different due to a bunch of logistics we’re going to have our customer conference in April.

Rod Bourgeois - Sanford C. Bernstein & Co.

In terms of areas of growth, were there any areas of the business where the growth was just surprisingly strong? We’re hearing that the remote infrastructure management outsourcing business for you guys is getting very good traction. Was that an area of growth surprise or where there other areas in your business that were just particularly pleasing in terms of the growth breakout?

Francisco D’Souza

Let me highlight three or four areas for you. First of all I the stabilization and return to growth in the BFS sector is worth highlighting. Clearly we’re hearing from clients that the worse is behind in terms of cuts and slowdowns in that sector. We had seen that a little bit in Q2 but it was nice to see that continue through Q3. As you saw in the quarterly sequential numbers BFS came back very nicely with 9.5% sequential growth.

Other places that I’ll highlight we had a very strong quarter in our retail business. Retail as a group grew as a sub-group within the retail manufacturing and logistics segment grew 15% sequentially so very strong quarter. Part of that was driven by the fact that there were a lot of things that our retail clients wanted to get done and locked down by the end of the third quarter, getting themselves ready for the so-called golden quarter, the fourth quarter the shopping season and so on and so forth. That was the second one I’ll highlight.

Like you pointed out, the infrastructure management business and our BPO business continued to grow very, very nicely for us. They grew about 18% sequentially on a combined basis during the third quarter so strong growth in those businesses as well.

Rod Bourgeois - Sanford C. Bernstein & Co.

Should we expect your operating margin to drop back into the target range for 2010 as you invest more in growth? Is that the explicit expectation that we should have at this point?

Gordon Coburn

You should expect we’ll be back in our target range in Q4 as well as 2010.

Operator

Your next question comes from Moshe Katri – Cowen & Company

Moshe Katri – Cowen & Company

When we’re modeling our 2010 quarters how should we think about the progression of the quarters? Should we assume the typical seasonality? Maybe you can also comment on the effective tax rate for next year and maybe 2011. Are we at a stage where we should start continuing to see application development revenues accelerate from here?

Gordon Coburn

Let me start with the tax rate. We would no expect any material change one way or the other in 2010. If there’s no change in regulation, there’s a lot of discussion going on for 2011 but if there were no change we would have a material increase in 2011 as the STPI holidays go away. India’s government has put out a proposal looking at fairly broad reap after the tax structure. It’s really too early to predict 2011.

In terms of seasonality next year, as you know, our normal seasonal pattern is Q2 and Q3 tend to be our strongest quarters. Whether that will play out again next year or not it will depend on the timing of the budget cycle and then in Q4 of next year do you have a budget flush or not. Typically Q2 and Q3 of each year tend to be our strongest quarters.

You had a third part which I forgot.

Moshe Katri – Cowen & Company

The third part was application development revenue, should we continue to see an acceleration from here?

Gordon Coburn

A little too early to know both in Q2 and Q3 on a sequential basis essentially maintenance and development grew at about the same pace which was at big pickup in development from what we’ve seen for about a year prior. Do they continue at the same pace or does development start to outpace maintenance? A little too early to know for next year.

Moshe Katri – Cowen & Company

A final question about 2010 budgets, any preliminary commentary about the direction of 2010 budget in terms of growth or declines? What do you think about clients funding commitments to offshore related projects for next year as well?

Francisco D’Souza

I think in general as we’ve been saying for some time now the slowdown has created an acceleration in clients in thinking about the off shoring lever from their standpoint so they’re looking to see how they can outsource and offshore increasingly more, optimize their offshore programs. As I said, they’re not just looking at it from a standpoint of efficiency or cost savings or labor arbitrage we’re now having discussions with them about how to help them make their businesses more effective, how to help them innovate and generate revenue on the top line. The types of conversations we’re having are broadening well beyond the traditional cost savings, operational excellence and labor arbitrage type of conversations.

Directionally in terms of where budgets are headed, I think candidly we have a little bit of everything. There are some clients where budgets will be down slightly. I’m not hearing anything about across the board dramatic reductions in budgets. I’m hearing flat to slightly up in some cases so it’s really all over the map. I don’t think you’re going to see dramatic increases or dramatic decreases in budgets going into next year.

Operator

Your next question comes from Ed Caso - Wells Fargo Securities

Ed Caso - Wells Fargo Securities

A lot of your competitors have talked about non-linear growth. I’m curious how you view that comment and maybe any efforts you might be doing beyond utilization and fixed price.

Francisco D’Souza

We have a series of initiatives underway to look at non-linear revenue growth opportunities in all of our businesses. I would categorize them in a couple of different areas. The first is in the core businesses our core horizontals and verticals, our service lines and verticals we’re looking at each and every service that we offer clients and putting together transaction based or outcome based pricing models for those businesses.

For example, the Sanofi Pasteur example that I gave during the call is an example of a place where we’re working with the client on outcome based pricing. Some of our service offerings like IT infrastructure services and BPO lend themselves very much to outcome and transaction based pricing. We’re focused on those areas where the underlying nature of the services lends itself to transaction based pricing.

On the other side, more in what I would consider at this point very much in the R&D bucket, we’re looking at platforms like Cognizant 2.0, the possibilities of cloud technology and things like software as a service all as possible ways to create non-linear growth opportunities for the company. I would categorize those as R&D investments or R&D projects at this point as opposed to projects that will deliver non-linear revenue growth in the next few quarters.

Ed Caso - Wells Fargo Securities

Could you set a size for the BPO business for us percent of revenue growth rates, where you think it’s going and implications for your average price?

Gordon Coburn

BPO is give or take 5% of revenue today, clearly growing materially faster then the rest of the business. Much more heavily offshore then the rest of the business and average billing rates will be lower. Obviously labor costs are lower as well. We’re starting to get traction there; we’re very pleased with both the traction we’re getting in BPO and infrastructure management.

Operator

Your next question comes from Jason Kupferberg - UBS

Jason Kupferberg - UBS

You’ve obviously had some great revenue out performance each of the past two quarters here. I wanted to get a sense of how much of this you would characterize as pent up demand, if you will, converting to revenue faster then you would anticipated as opposed to underlying customer spending trends improving on a sustainable basis. What I’m trying to get a sense of is as the materialization of this pent up demand pulls forward revenue that you originally might have thought would not come until 2010 just trying to parse out those pieces as we start to think about potential growth trajectory of the company next year.

Francisco D’Souza

It’s obviously very, very difficult to try to quantify that distinction you’re making with a great degree of precision. I can just give you qualitative comments around that. I think that the revenue over performance we’ve seen is a little bit of both. I think there is a little bit of pent up demand, if you will. I think clients put things on hold during the worst of the recession that were not absolutely core to keeping the business running or keeping the lights on. As the environment has stabilized a little bit those projects are coming back so there is a little bit of a backlog of those projects. Like I said, what was surprising to us in the quarter was the pace at which decisions were made on those projects.

What I don’t think, we are not assuming that the revenue out performance that we’ve had in the third quarter translates into a new normal or new baseline of spending going forward. We do think that there was somewhat of a surge as a result of these projects getting approved and that we’ll return to some level of normal going forward which is what’s reflected in our fourth quarter guidance.

Jason Kupferberg - UBS

I wanted to probe on the wage front a little bit more. I know you said 2010 is still kind of TBD. Obviously some competitors made some off cycle decision to think you guys normally make your decisions effective July 1. Is there the potential that you might move up that timeframe for making your decision given what might be happening in the competitive environment or do you feel like some of those moves by other vendors were really more of a catch up kind of thing rather then fully pulling ahead on the wage front?

Gordon Coburn

We will continue to be fully competitive on total compensation in the marketplace. You have to separate variable and base. This year I would expect we’ll probably pay the highest bonuses in the industry. Others put it into base salary. We think it’s good to have a direct correlation between performance and reward. It makes people very motivated and they see the direct benefits of their efforts. What we do next year will depend on what other competitors do. Once again we have been, are and will continue to be fully competitive from a total compensation standpoint in the marketplace.

Jason Kupferberg - UBS

When you think about the average number of service offerings that are currently being used by your strategic customers within their first 12 or 18 months being a client of Cognizant, can you characterize that number and talk about how much potential upside remains there?

Francisco D’Souza

I think a couple of qualitative comments there. First of all, like we’ve said in the past two quarters or so we’ve mentioned it on the calls. What we’re seeing is a trend where new customers are adopting broader range of service more quickly then we’ve seen in the past. In the past it wasn’t an unusual trend for us to sell one service offering, get that stabilized with the client and then cross sell other service offerings around that a year or two later. Now what we’re seeing is increasingly clients buying multiple services from us within the first year or two of their engagement with Cognizant. We’re seeing an acceleration from that standpoint.

I don’t have the number with me right now but if you could categorize say we have four major service groups, application services, BPO services, IT infrastructure services, and consulting services, these are the four major grouping. It’s still a minority of our customers that use us for all four of those service offerings.

Operator

Your next question comes from Nabil Elsheshai - Pacific Crest Securities

Nabil Elsheshai - Pacific Crest Securities

A follow-up on the retail strength, do you have a sense how much of that was, as you said, the seasonality of getting stuff done before Q4 versus retailers maybe coming back to increased investment in IT spending?

Francisco D’Souza

I think its both, to be candid with you. I think that the retailers are certainly coming back to spending and you also have to understand that retail as an industry has been relatively under penetrated from an off shoring standpoint so there are natural opportunities for retailers to move work offshore.

Having said that, retail has always, in good times and in bad times, has had this phenomenon of locking down or significantly locking down during the so-called fourth quarter, the golden quarter because they don’t want to introduce uncertainty and risk during the important quarter from new systems and going into production. I think that a little bit of the Q3 over performance was due to getting stuff done by the end of the third quarter but there is an underlying trend here of retailers increasingly moving to have offshore model.

Nabil Elsheshai - Pacific Crest Securities

On the competitive front you mentioned a couple times having increasingly strategic conversations with your clients. Does that put you in a different competitive category or put you more up against the multi-nationals?

Francisco D’Souza

For several quarters now what we found is that in an increasing number of our engagements our competitor set has included the multi-nationals. Obviously still a significant number of situations where we’re competing against the India players as well but we are increasingly finding ourselves in competition against the multi-nationals and the traditional SI and consulting firms.

Nabil Elsheshai - Pacific Crest Securities

On hiring, any color you can give on the rate of hiring and also some of your competitors have been setting up more near shore including in the US, development centers, any plans for that with you guys?

Francisco D’Souza

Let me talk about the near term centers then I’ll turn it over to Gordon on color on hiring. As we said, during the quarter we opened a development center in Manila but we also significantly expanded our near shore and in country US capabilities. We expanded our facility in Toronto, Canada for near shore, we expanded the Phoenix facility to include BPO as a new service offering. We also expanded two or three of our other local in country US delivery centers from a capacity standpoint. We did quite a lot during the quarter to expand our in country and our near shore capabilities for US customers.

Gordon Coburn

In Q3 we significantly accelerated both our lateral hiring and the intake of the college graduates. When we look at the intake of the college graduates we both accelerated to finish out the 2008 class as well as accelerating the intake of the 2009 class. In fact, in another couple weeks we’ll be on campus starting to recruit for the 2010 class. We have a good pipeline and we’re bringing the people on sooner then expected.

More importantly, as we needed to into the market for lateral hires we’ve been very successful and expect to continue to be very successful in attracting the best and the brightest to Cognizant. Obviously our growth provides unique career opportunities for people. I think many people realize joining a company that’s the market leader in terms of growth provides greater opportunities that may be difficult to find elsewhere. We will continue to hire aggressively as we finish up this year and then depending on what demand characteristics are next year we’ll have a very robust pipeline.

Operator

Your next question comes from Glenn Greene – Oppenheimer

Glenn Greene – Oppenheimer

I wanted to go back to the quicker decision making impact on the quarter which drove some of the upside. Could you give us some color on how the pipeline’s been replenished post the quarter and maybe a little bit of color across verticals how the pipeline going forward is looking?

Francisco D’Souza

I think that all of our pipeline metrics remain strong going into the fourth quarter. Traditionally the fourth quarter is a strong pipeline quarter for us because even though budgets aren’t approved, clients start to discuss potential projects with us in preparation for budgets getting approved. We have a very strong pipeline going into the fourth quarter and I see no reasons to be concerned on the pipeline side as we go into the fourth quarter.

In terms of color, the pipeline, if I break it down is largely consistent with the trends that we’ve discussed broadly in the business, well balanced I would say across the verticals and horizontals and service offerings and well balanced across the geographies. I think there might be, for example, there might be some small pockets, I’m thinking retail for example we may not see quite as strong growth in the fourth quarter because of the lockdown issues and so on and so forth. At a macro level, take a 50,000 foot view the pipeline is fine for the fourth quarter and going into next year.

Glenn Greene – Oppenheimer

Could you give us what the incremental incentive accrual was in the quarter?

Gordon Coburn

We haven’t broken out the specific amount but it certainly reflects the stronger performance that we’re realizing both in revenue and operating performance. It certainly positions us to have at least among major players the strongest bearable payout in the industry.

Operator

Your next question comes from Joseph Foresi - Janney Montgomery Scott

Joseph Foresi - Janney Montgomery Scott

I was wondering if you could tell me a little bit about volumes were like this quarter maybe compared to last quarter and talk a little bit about the discretionary spending that maybe you saw continue this quarter?

Gordon Coburn

The vast majority of the growth was volume related, as you mentioned pricing was give or roughly flat no material movements in onsite offshore a little extra in terms of billing days. This is a little benefit on currency but the vast majority of this was volume related. What was the second part of your question?

Joseph Foresi - Janney Montgomery Scott

I know you talked about in June maybe seeing a spark of discretionary spending. It looks like this quarter that grew. I wonder if you could talk about the flow of discretionary spending this quarter maybe heading into next.

Gordon Coburn

The trend really started in Q2 that was the first quarter since 2007 where development, which uses a proxy for discretionary spending, grew at the same pace sequentially as maintenance. That trend continued in Q3. Q4 will that trend continue or not will depend on do people kick off the new projects or not. We’ve been a little bit more conservative with our assumptions on development spending in Q4 because that is obviously more discretionary.

Joseph Foresi - Janney Montgomery Scott

Was there a large project in the third quarter that maybe began and ended or is it just continuous work?

Gordon Coburn

The strength in Q3 had nothing to do with one project or one customer. As we indicated, it was across all of our industries, it wasn’t one industry driving this, it was across all the industries and geographies so it was quite broad based.

Joseph Foresi - Janney Montgomery Scott

As we exit this year and head into next year you’ve seen sort of a baseline level of maintenance work maybe in the March quarter and if I understand it correctly you’ve seen some discretionary pickup in the last three quarters. Is it your thought that with budgets finalizing that maybe we would be building off that base heading into 2009 and that incremental revenue would be based on what you’re going to see on the discretionary side?

Gordon Coburn

There’s a timing question in here of when will budgets be finalized and how big will the budgets finally be. As Francisco mentioned, given we still are in a difficult economic environment we are being conservative on our assumptions about when budgets get finalized and the lumpiness that results while people are going through the budget process.

Operator

Your next question comes from George Price - Stifel Nicolaus & Company

George Price - Stifel Nicolaus & Company

From the margin perspective I recognize what you said regarding the back into your standard margin range. If we look around a little bit, look at how some of your offshore competitors have at least maintained their margins at pretty good levels, seeing some surprising improvement say from IBM for example even in their outsourcing business. I’m wondering given where the business is trending and inflecting here do you think the 20% level could be a more reasonable consistent level give the pace of the acceleration of the revenues to let you invest and yet have a somewhat higher margin level?

Gordon Coburn

We’re still in the early innings of this whole trend towards globalization and especially as we’re moving up the food chain with our consulting capabilities with our ITIS capabilities and overlapping more and more with the multi-nationals. We have tremendous market opportunities left so we’re in this for the long term and our strategy is to invest for the long term so we grow materially faster then any of our competitors, that’s how we measure success.

We do not measure success on increasing our margin. Our goal is to maintain our margins at 19% to 20% and take every dollar above that to reinvest in differentiating ourselves from the rest of the market and as a result growing the top line faster then the other major players in the market.

George Price - Stifel Nicolaus & Company

Segwaying to some of the multi-nationals, have you seen any changes in what they’re doing competitively? Are they reacting any differently given pressures from the macro downturn particularly the more successful M&Cs out there Accenture and IBM?

Francisco D’Souza

I wouldn’t characterize the competitive nature to be any different as a result of the macro economic environment. Beyond the trends that we’ve been talking about for some quarters now with them increasingly using the offshore and global delivery model in their deals and so on. I don’t see a significant change in the last one or two quarters.

I think that place where we continue to be successful is in terms of creating a truly integrated global delivery network using our Cognizant 2.0 platform which allows us not just to provide essentially talent in different parts of the world but to stitch that talent together into a seamless global cohesive team and we find that to be a very strong and very compelling value proposition in the marketplace both when compared to our traditional India based competitors and the multi-nationals.

George Price - Stifel Nicolaus & Company

Given the CapEx push outs this year can you maybe give us a sense of how that might play out in terms of CapEx next year? I don’t know if you gave the percent of employees in India if you could give that that’d be helpful?

Gordon Coburn

We’re still going through the planning process for next year. Certainly I would expect that we’ll initiate an additional round of construction. How bit and the timing of that not quite sure. In terms of the onsite/offshore mix very small change this quarter. We moved onsite by about 30 basis points compared to last quarter.

Operator

Your last question comes from Ashwin Shirvaikar – Citigroup

Ashwin Shirvaikar – Citigroup

Does your guidance include any UBS India contribution?

Gordon Coburn

To be very clear, no it does not. We expect that acquisition to only close at the end of the year so Q4 does not include UBS revenue. We don’t expect any material impact from it.

Ashwin Shirvaikar – Citigroup

As you look at your cash buildup, to follow up on that last question, any commentary on M&A beyond UBS India or some of your India based competitors have done things like special dividends and stuff like that, any commentary there?

Gordon Coburn

Our strategy is unchanged. We continue to look at the smaller tuck under acquisitions. Those have been very successful for us. We’re thrilled with the ones that we’ve done this quarter. We think they add very targeted and meaningful capabilities to the company so we’ll continue to look at those. Other then what we’ve previously announced there are no other plans at this point.

Francisco D’Souza

Let me close by saying that we are absolutely delighted with our performance during the third quarter. Despite a very difficult operating period in the economic environment, Cognizant remains an industry leading provider thanks to our business model, our continual reinvestments, our operating efficiency and the strength and passion of our people. Thank you all for joining us today and we look forward to speaking to you again next quarter.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Cognizant Technology Solutions Corp. Q3 2009 Earnings Call Transcript
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