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Cognizant Technology Solutions (NASDAQ:CTSH)

Q2 2014 Earnings Call

August 06, 2014 8:00 am ET

Executives

David Nelson - Vice President of Investor Relations and Treasurer

Francisco D'souza - Chief Executive Officer and Director

Gordon J. Coburn - President

Karen McLoughlin - Chief Financial Officer and Principal Accounting Officer

Analysts

Tien-tsin Huang - JP Morgan Chase & Co, Research Division

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

Bryan Keane - Deutsche Bank AG, Research Division

Darrin D. Peller - Barclays Capital, Research Division

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Steven Milunovich - UBS Investment Bank, Research Division

Moshe Katri - Cowen and Company, LLC, Research Division

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Charles Brennan - Crédit Suisse AG, Research Division

Brian L. Essex - Morgan Stanley, Research Division

Jason Kupferberg - Jefferies LLC, Research Division

Operator

Ladies and gentlemen, welcome to the Cognizant Technology Solutions Second Quarter 2014 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to David Nelson, Vice President, Investor Relations and Treasurer at Cognizant. Please go ahead, sir.

David Nelson

Thank you, and good morning, everyone. By now, you should have received a copy of the earnings release for the company's second quarter 2014 results. If you have not, a copy is available on our website, cognizant.com. The speakers we have on today's call are Francisco D'souza, Chief Executive Officer; Gordon Coburn, President; and Karen McLoughlin, Chief Financial Officer. 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. Please go ahead, Frank.

Francisco D'souza

Thank you, David, and good morning, everyone. Thanks for joining us today. I'll start the call today with the highlights of our second quarter results and our revised outlook for the rest of the year. I'll also take some time to put our results in the context of the broader industry trends that we're seeing, using as examples some significant transformational deals that have recently been awarded to us. I'll then pass the call on to Gordon to discuss our detailed operating results, and Karen will provide further details on our financial metrics and guidance.

For the second quarter, we delivered revenue of $2.52 billion, at the midpoint of our guidance range. Our non-GAAP operating margin, at 21%, was higher than our target range for the quarter and positions us well to absorb wage increases and promotions that take effect during the second half of the year. And in support of our continued confidence in the business, this morning, we announced an expansion of our existing share repurchase program to $2 billion. Karen will give you more details on this expansion shortly.

We delivered solid performance in the second quarter. But due to weaknesses in certain clients and longer-than-expected sale cycles for certain large integrated deals, we're adopting a more conservative stance for the remainder of the year and revising our revenue guidance to at least 14% for 2014 while maintaining our prior full year non-GAAP EPS of at least $2.54. More specifically, there are 2 main reasons for this revised guidance. First, as we've discussed with you in the past, we are seeing a trend in the market towards larger integrated deals. While these deals represent a strong source of revenue for Cognizant, certain deals took longer than expected to close, leading to delays in revenue ramp-up. And second, we continue to experience weakness in certain clients in North America and the U.K. that recently underwent leadership changes, a situation that we described to you last quarter. While we believe that our client relationships remain sound, we will not generate as much revenue in 2014 from some of these clients as we had previously expected. While I'm disappointed that our full year revenue growth will be below our prior expectations, we remain optimistic about the evolving market opportunity ahead of us.

I'd like to spend a few moments putting our results and outlook in the context of what we're seeing in the market, using some specific large important client situations as illustrations. We've spoken to you in past quarters about our clients' dual mandate to run better and run different. On one side of the dual mandate, our clients are under constant pressure to become more efficient in their current operations or to run better, and they continue to look to us to provide ever-greater levels of productivity in their core operations and legacy technology environments by combining multiple service areas, applying advanced automation and implementing best-in-class operations and Lean Six Sigma methodologies. Gordon will speak to you shortly about the details of 3 large deals of this nature that together represent approximately $3.5 billion in total contract value. The largest of these deals is with Health Net, a top 10 managed care organization in the U.S. We've signed a letter of intent with Health Net and expect to finalize the contract before the end of Q3. The Health Net deal alone represents around $2.7 billion in total contract value and is the single largest PCB deal in the history of Cognizant. This engagement builds on our long-standing relationship with Health Net for close to 10 years. Judging by our pipeline, we are seeing increased opportunity in these types of engagements and anticipate this to be a long-term trend. Winning and delivering these deals requires a broad range of integrated capabilities, in which we have been investing over many years: a strong consulting front end, solid client raising skills, deep domain knowledge and at-scale capabilities in technology and operations. And behind deals like these lies a deep sense of trust that our clients place in us, trust that comes from multiyear client relationships and deep levels of engagement within our clients' organizations.

On the other side of the dual mandate, our clients continue to drive -- the drive to adopt new digital technologies to gain competitive advantage or to run different. Where, in run better, we are seeing larger integrated services deals, our run different engagements tend to be sharply-focused, value-focused initiatives that often include the use of new SMAC or digital technologies to reshape aspects of our clients' businesses or industries. Quite often, these tend to be IP-driven, nonlinear, outcome-based engagements. For example, we were recently chosen by TransCelerate BioPharma Inc., an industry body with membership representation from 19 major pharmaceutical companies, to develop a first-of-its-kind, subscription-based platform that will transform the way pharmaceutical companies collaborate on clinical trials. TransCelerate's mission is to bring the global pharmaceutical R&D community together so as to accelerate and simplify the process of drug development. This shared investigator platform, built as an industry utility, will enable the pharmaceutical industry to bring standardization and consistency to clinical trials. In keeping with our past practice, we continue to invest in building our capabilities in new technologies and service areas as well as in new markets and geographies to meet our clients' evolving needs. Our initiatives in digital and SMAC technologies continue to show great traction and drive deeper engagement with our clients.

Let me close by saying that while we know that you are disappointed in our revised revenue outlook for the year, I can assure you that all of us at Cognizant are even more disappointed. But let me be clear, we believe that the market opportunity remains strong and that Cognizant is well positioned to capture a disproportionate share of the growth in the market over the coming years. A new report by ISG, a sourcing advisory group, indicates that demand in the market is at record-high levels. This is also reflected in our strong order pipeline. As part of our recent quarterly management meeting, our global leadership team assembled to take stock and review areas of the focus in view of our revised guidance for the year. Post these discussions, it's clear to us that we have the right strategy, and we remain confident in the long-term outlook of our business.

Our portfolio of services across the 3 horizons has never been stronger, and we continue to hire in large numbers. This quarter, we had a net addition of approximately 8,800 people to our company, our highest since the third quarter of 2011. The run better, run different dual mandate for our clients is more real than ever, and we will continue to push harder in the coming quarters to continue to be our clients' partner of choice.

With that, I'll now hand the call over to Gordon to share more about our performance and to Karen to provide financial details. I'll be back for the Q&A. Gordon?

Gordon J. Coburn

Thank you, Francisco. We're pleased to be able to speak with you today about 3 significant transformational deals, including an engagement with the largest total contract value, or TCV, in Cognizant history. But before I get into the details of these relationships, I want to first discuss our view on current market demand and our strategy to deliver long-term industry-leading performance. While our near-term 2014 revenue outlook of at least 14% growth is below our original expectations, we believe that these near-term, client-specific impacts we are experiencing are not a reflection of market environment or our approach to the broadening market. We remain confident in our strategy and long-term prospects.

Our commitment to industry-leading growth is something we take very seriously, and we believe that our 3 Horizon model is the right strategy to position us for industry-leading growth over the longer term. Given that overall market demand remains healthy and geographies beyond our traditional markets are underpenetrated and showing real signs of adopting our delivery model, it is more important than ever to continue investing to strengthen -- to further strengthen and differentiate our capabilities across our 3 growth horizons. Within Horizon 1, we're seeing a shift towards transformational deals, and we are strengthening our capabilities and client-value proposition for these opportunities. Within Horizon 2, which includes Business Process Services or BPS, consulting and IT Infrastructure Services, we believe that the market is still young, and we continue to invest in scale to compete and win deals based on our industry knowledge and ability to structure integrated solutions for clients. And finally, we're pleased with the revenue and mindshare traction we are gaining in our newer Horizon 3 businesses and services, where we have competitive offerings and differentiation with a strong opportunity to penetrate our top accounts.

For years now, we've been talking about the increasing importance of transformational deals that provide scale and leadership, and we have historically won a number of these deals, particularly in financial services and health care. With these deals, clients look to make large-scale changes to the way they operate significant parts of their businesses or IT organizations. The goal is to dramatically improve their performance in multiple areas of their business. Increasingly, these deals involve solutions integrating multiple service offerings.

Let me now speak about 3 examples of these types of deals. Combined, these 3 deals are expected to generate approximately $3.5 billion in TCV for us. We anticipate these deals will ramp over the duration of the contracts, with the expected incremental revenue in 2015 of at least $200 million. This morning, we are announcing the signing of a letter of intent for a multibillion engagement with Health Net, which provides and administers health benefits to approximately 5,800,000 members across the country. At a total contract value of $2.7 billion over 7 years, this engagement is significant from both a revenue and strategic perspective. Subject to contract finalization and applicable regulatory approval, Cognizant will provide end-to-end business services, including processing membership and claims as well as providing transformational IT and the underlying infrastructure services. Included within this deal is access to certain intellectual property related to the platform used to run the operation of a health care payer organization. We believe that this will allow us to play an even larger role in the health care industry ecosystem going forward. The business model resulting from this deal is expected to be a benchmark for the industry, enabling Health Net to improve its quality of service, reduce G&A spending and increase its agility in launching new products and participating in new markets.

Additionally, we recently won a multiyear transformational deal with a financial services company. This is a good example of how our long-term relationship with a client positioned us to win a large integrated deal covering all lines of business. Our track record in delivery gave the client confidence in our capabilities to leverage some synergies between IT and BPS and to be responsible for efficiently running their core processes, from the origination of new business to back-office support to maintaining critical systems. Providing a comprehensive solution will help not only to improve and streamline their core processes but enhance insight into their business.

Finally, we were selected by Vorwerk, a large European consumer goods manufacturing and direct sales company, to simplify, standardize and centralize the company's IT infrastructure. The transformed IT infrastructure environment will enable this client to achieve higher levels of business agility and service quality while sharpening its focus on its core competencies and driving down cost. Furthermore, this is a good example of how we are beginning to leverage the relationships of last year's C1 acquisition to further grow our business in Europe. These larger transformational opportunities are a testament to our ability to integrate multiple services, including our core IT services, as well as our Horizon 2 services at BPS consulting and IT infrastructure and often our SMAC capabilities.

Let me now turn to a detailed discussion of our Horizon 2 service lines. Our BPS practice had a solid quarter, gaining traction through several strategic wins as well as through the growth of existing project work and expanding into new divisions at existing clients. Capital markets and mortgage services demand in banking remained strong, as does underwriting in property and casualty insurance and claims processing and membership enrollment and revenue cycle management in health care.

Cognizant Business Consulting, or CBC, continued its pace of above-company average growth. As we've discussed in previous quarters, CBC is often a key factor in our ability to win and deliver results in these larger transformational deals. By incorporating consulting and advisory work upfront, we provide our clients with comprehensive and integrated solutions, thus helping them to transform their organizations. For example, CBC recently served as a retail client's digital platform partner in developing their roadmap to drive their digital transformation by launching offerings such as in-store ordering, multichannel fulfillment and mobile point-of-sale. CBC takes a business-led approach in formulating solutions and plays a key role in the implementation of these solutions.

IT Infrastructure Services had another strong quarter. We're well positioned in this growth market, as we are increasingly competing for comprehensive deals requiring the integration of end-to-end IT infrastructure management and application management. The engagement we mentioned earlier with Vorwerk is a good example of this type of win.

From an industry perspective, our Banking and Financial Services segment grew 3.4% sequentially and 16.2% year-over-year, driven primarily by strength in insurance, where there is a growing focus on end-to-end managed services. More broadly within BFS, underlying demand drivers from regulatory compliance, real risk time monitoring and fraud and trade surveillance support longer-term growth. Additionally, our financial services clients are looking to us to build and integrate SMAC solutions.

Growth in health care, which consists primarily of our payor, pharmaceutical and medical device clients, accelerated in the quarter, up 4.8% sequentially and 19.2% year-over-year. Within the pharmaceutical sector, several of our key pharmaceutical clients continue to work through the challenges associated with their drug pipelines and with the patent cliff, though we are beginning to see a steady pickup in demand. After a significant step-up in investments in 2013, many of our payor clients are taking a more cautious approach to incremental spending this year, especially associated with their activities with public and private health insurance exchanges. However, we're confident in the longer-term opportunities, given the significant disruption in the health care market that will continue to evolve over the coming years. The engagement with health care -- with Health Net will further enhance our ability to provide clients with both IT services and Cognizant-owned intellectual property platform-led solutions as they face these challenges.

Our retail manufacturing segment was relatively flat sequentially and up 11.4% year-over-year. In retail, continued pressure on discretionary spending among major clients has driven much of the softness in the quarter. Although revenue in manufacturing and logistics was soft in the quarter, we are seeing clients focus on both solutions that can drive operational efficiencies as well as embracing SMAC solutions in areas such as internet-enabled devices, with built-in intelligence to improve supply chain visibility and logistics operations and promote driver engagement through enhanced throughput.

Our other segment, which includes communications, information, media and entertainment and high tech, showed continued recovery, with 10.4% sequential growth and 20.8% growth year-over-year, primarily driven by increased traction with both communications and high technology companies, where we have seen a pickup in discretionary spending.

From a geographic standpoint, North America improved from a slow start at the beginning of the year, growing 5% sequentially and 15% year-over-year. Following a strong first quarter, revenue from Europe declined about 1% sequentially but grew 20.4% year-over-year. The slowdown was driven by the U.K., where we saw a 4.1% sequential decline in Q2. As Frank mentioned, the U.K. weakness came primarily from retail and financial clients which have experienced leadership changes. Continental Europe saw 4% sequential growth and 30.5% growth year-over-year, partially attributed to our 2013 acquisitions. We expect solid growth in the continent, and we anticipate that the structural shift towards larger multiyear outsourcing programs will continue to drive opportunities over the coming years.

The rest of world continued to show good growth, up 5.5% sequentially and 26.6% year-over-year. We added several new logos in the APAC region recently and remain encouraged by the growth prospects in that region.

Now let me turn the call over to Karen to provide details on our numbers.

Karen McLoughlin

Thank you, Gordon, and good morning, everyone. Second quarter revenue of $2.52 billion represented growth of 3.9% sequentially and 16.5% over Q2 2013. Non-GAAP operating margin, which excludes stock-based compensation expense and acquisition-related expenses, was 21%, above our target range of 19% to 20%, while our GAAP operating margin was 19.4% for the quarter. Non-GAAP EPS of $0.66 exceeded our previous guidance by $0.04.

Consulting and technology services and outsourcing services represented 52% and 48% of revenue, respectfully, for the quarter. Consulting and technology services increased 6.2% sequentially and 20.9% year-over-year. Outsourcing services increased 1.5% sequentially and 11.9% from Q2 a year ago.

During the second quarter, 35% of our revenue came from fixed-price contracts, and as expected, overall pricing was stable. We closed the quarter with 1,242 active clients and added 7 strategic customers, bringing our total number of strategic clients to 257.

As we discussed on the first quarter earnings call, we have accelerated the rate of share repurchase. In Q2, we repurchased 2.1 million shares for a total cost of $101 million. To date, we have repurchased approximately 34.1 million shares for a total cost of approximately $1.13 billion under the previous share repurchase authorization of $1.5 billion. Today, we are pleased to announce that the board has authorized a $500 million increase in share repurchase authorization, bringing the total repurchase authorization to $2 billion, of which $872 million is still unutilized.

Our fully diluted share count for the quarter was 612.2 million shares, a decrease of approximately 730,000 shares from the first quarter.

Our balance sheet remains very healthy. We finished the second quarter with approximately $4.13 billion of cash and short-term investments, up by approximately $264 million from the quarter ending March 31 and up by approximately $1.23 billion from the year-ago period.

During the second quarter, operating activities generated approximately $408 million of cash, financing activities were approximately a $93 million use of cash and capital expenditures were approximately $39 million for the quarter. Receivables were $1.8 billion, and we finished the quarter with a DSO, including unbilled receivables, of 76.7 days, up by approximately 1.5 days from the year-ago period. The unbilled portion of our receivables balance was approximately $298 million, up from $267 million at the end of Q1. We billed approximately 57% of the Q2 unbilled balance in July.

Let me now provide some color on our business and operating metrics for the quarter. As Francisco mentioned earlier, we ramped up hiring during the quarter, with approximately 8,800 net new hires, our highest net addition since Q3 2011, reflecting our long-term growth expectations for the company. Annualized attrition of 16.9% during the quarter, including BPO and trainees, was down by almost 200 basis points from the year-ago period. Total headcount at the end of the quarter was approximately 187,400 employees globally, of which approximately 175,500 were service delivery staff. 34% of our new hires were direct college hires, while 64% were lateral hires of experienced professionals. Utilization declined slightly on a sequential basis as we onboarded the 8,800 net new hires. Offshore utilization was approximately 74%. Offshore utilization, excluding recent college graduates who are in our training program, was approximately 82%, and on-site utilization was approximately 93% during the quarter.

I would now like to comment on our outlook for Q3 2014 and for the full year. As Francisco mentioned, while we are not where we expected to be in terms of revenue for the second half of the year, the overall services market remains strong, with tremendous opportunity for growth worldwide and across our regions and practice areas. However, given the weakness at certain clients and longer-than-anticipated sales cycles for certain large integrated deals, we are revising our full year revenue growth expectation to at least 14% growth, down from our previous expectations of at least 16.5% for the full year.

For the third quarter of 2014, we expect to deliver revenue of between $2.55 billion and $2.58 billion. During Q3 and for the second half of 2014, we expect to operate within our target non-GAAP operating margin range of 19% to 20% as we absorb the raises and promotions in the second half of the year. For the third quarter, we expect to deliver non-GAAP EPS of at least $0.63. Our non-GAAP EPS guidance excludes net nonoperating foreign currency exchange gains and losses, stock-based compensation and acquisition-related expenses and amortization. This guidance anticipates a share count of approximately 612 million shares and a tax rate of approximately 26%. Our full year non-GAAP EPS guidance is unchanged. We expect to deliver at least $2.54 for the full year. This guidance anticipates a full year share count of approximately 613 million shares and a tax rate of approximately 26%.

Now we would like to open the call for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from the line of Tien-tsin Huang with JP Morgan.

Tien-tsin Huang - JP Morgan Chase & Co, Research Division

Clearly, you cut your revenue outlook, looks like by, I guess, $220 million. I'm curious how much of that $220 million is due to the weakness in the client spend that you called out versus the longer sales cycles. And as a follow-up, do you expect that lower client spend to come back? Or has it been lost in, say, vendor consolidation or what have you?

Gordon J. Coburn

Tien-tsin, it's Gordon. The majority of it is the client-specific issues. The smaller piece of it is the longer sales cycle on the transformational deals, and it's a combination. Some of it is clients aren't spending quite as much as we expected on some projects we were anticipating, and some of it is delays in decisions, where clients -- at clients that had changes in leadership. So -- but certainly, it's more related towards client-specific issues at a handful of clients.

Tien-tsin Huang - JP Morgan Chase & Co, Research Division

Do you expect it to come back at some point, Gordon? And how broad-based was it? Are we talking about a handful of clients or something smaller?

Francisco D'souza

Tien-tsin, it's Frank. Look, I think -- we're talking about a small handful of clients, some of our larger clients. And in terms of the spend coming back, look, I think our relationships at across-the-board remain very, very healthy. But given where we are in the year, the dynamics of our business are such that if you don't start projects and ramp up in the early part of the first half of the year, then it's hard to make it up on the back end. But as we go into next year, look, I think we are positioned well with our client base, depending on where budgets come out and so on and so forth, those dynamics. I think we're well positioned to capture our fair share or an unfair share of what our clients are going to be spending and these same clients in the longer term.

Operator

We'll move on to the next question, which is coming from the line of Edward Caso with Wells Fargo.

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

Could you talk a little bit about the competitive framework here? It sounds like you're -- you and some of your competitors are starting to chase larger and larger transactions. And I'm wondering how much a greater role the advisors now play in it as opposed to your old model of penetrate and radiate. Sort of what's the framework here? And also, talk within the concept -- I know you said pricing was stable, but what's happening with total cost of ownership and what that implies for revenue growth?

Francisco D'souza

Yes, let me -- Ed, it's Frank. Let me talk about the first part, and I'll turn it over to Gordon for the second piece of your question. For several quarters now, we've been talking to you about this trend towards larger, more integrated services deals. And that's really driven at the fundamental level by the fact that increase -- there's an increasing body now of evidence and a track record at Cognizant at combining multiple service areas together, the traditional application development and application maintenance, IT infrastructure and BPO, allows us to combine those service areas together and create a way -- apply techniques like Lean Six Sigma, advanced automation and so on to drive even greater levels of productivity and efficiency. So as our clients face this dual mandate, which is very, very real, of how do I run my operations better in order to fund the investments that I need in order to run different, this trend towards larger integrated deals is something that we're seeing more and more of. I think in that context, the role of the advisors certainly is more pronounced than it had been in our traditional model. But I would also say that the traditional model is still very much the large piece of the business, where it's sort of a more land and expand kind of a model, where we win a client, tend to do some initial project and then expand from there. So that's still the big piece of our revenue growth. I just want to make that clear because we've spent a lot of time in our prepared comments in talking about these transformational deals, which is an important trend, but it's still a smaller part of the overall revenue mix.

Gordon J. Coburn

And it's Gordon. Your question about are people focused on price or rate card versus total cost of ownership, clearly, in most cases, it's total cost of ownership, particularly where intermediaries are involved. Because when you focus on total cost of ownership, you can have a win-win situation, which is the basis for long-term success. So the focus is on efficiency. It's on effectiveness. As Francisco mentioned, it's on automation. It's on process improvement. And as long as we can deliver a lower cost of ownership to the client, that's what they care about, rather than what the rate card is.

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

So does that imply sort of lower revenue growth for you, given this TCO pressure? You're basically less revenue per person.

Gordon J. Coburn

It's not less revenue per person because, if it's lower cost of ownership and I'm pulling the efficiency automation process improvement levers, I can do the work with less people. So yes, it can result to providing the same service with less people and, therefore, less revenue. But remember, that's on the run better side. And what clients are doing is they're freeing up those dollars and then investing them on the run different side. So as long as we can provide services on both sides of the house, that model works well for us.

Operator

Our next question is coming from the line of Bryan Keane with Deutsche Bank.

Bryan Keane - Deutsche Bank AG, Research Division

Just wanted to ask, the weakness in outsourcing, that's 2 quarters in a row. Just trying to figure out if something structurally is going on. I don't know if SaaS is having an impact; cloud, obviously, are the 2 themes that we see out there. Did that have any impact on the outsourcing business? And then just second question, just on wage hike expected, what percentage wage hike are you expecting in the third?

Karen McLoughlin

Sure. Bryan, it's Karen. I'll take the first part. I think Gordon's going to take the wage part of your question. So as you mentioned, the outsourcing growth has been a little bit slower in the first half of this year sequentially. In Q1, we talked about where we had seen a couple of clients who are actually redirecting revenue dollars from run better to run different, and that was the beginning of a bit of a shift that we had seen there. I think a little bit of that trend continued in Q2, where clients, as Gordon was just talking about, right, they're looking to optimize their spend, redirect investment dollars towards the run different and more transformational side of their business. But as we look out over the long -- the near term and the long term, there's actually a tremendous amount of growth for the outsourcing segment of our business. So keep in mind, outsourcing includes not just the application and maintenance side of the business but also the BPO and infrastructure services, which are continuing to grow faster than company average and certainly will for the foreseeable future. But also, if you think about the 3 transactions that we talked about this morning, that Gordon talked about with the Health Net transaction, the Vorwerk transaction and the financial services client, the vast majority of that revenue actually will be part of what we call the outsourcing segment because it includes application maintenance, infrastructure and BPO. So I think you will continue to see growth out of that segment moving forward.

Gordon J. Coburn

And on your question about wage inflation. First of all, our increases and promotions, a vast majority are effective July 1. We're going to be in line with the other leading players, so that translates into roughly 10% wage inflation offshore and on-site wage inflation in the lower single digits.

Operator

Our next question is coming from the line of Darrin Peller with Barclays.

Darrin D. Peller - Barclays Capital, Research Division

Look, I mean, your guidance obviously implies slower trends into the second half of the year. And when we still see some strength now in the financials and health care vertical, and you obviously call out some larger transformational deals like Health Net or others that you've won, I think it'd be helpful for the market if you can just provide a little more detail regarding the pipeline that you actually have now beyond just those 3 large deals, with respect to maybe geography verticals. And maybe give us a little confidence on whether or not the run rate of growth should be able to improve from what you're seeing in the second half, which is really roughly in the 10%, 11% range.

Gordon J. Coburn

Sure. So first of all, the larger transformational deals, the revenue largely kicks in next year, not in the second half of this year because, obviously, we have to get regulatory approvals in addition to all that. So that's -- helps drive next year. We are seeing -- we are pleased with the pipeline. You look at Horizon 2 as an example. We can now compete in larger deals. Because it was one of these things, you had to have scale to compete in larger deals. We now have the scale. So when I look at the pipeline, I don't just look at number of deals, but I look at the size of the deals, and the size is clearly materially larger. When I look at our traditional Horizon 1 businesses, clearly, Europe is a lot better than it had been. And that's a combination of the market's more open to it and, quite honestly, our execution has gotten better as we've done some acquisitions and as we've won some marquee names. We're picking up some traction in the Middle East. In the near -- in the short term, certainly, BFS and health care, we expect to be a bit soft. A little too early to know what that'll be for next year in sort of the core, less so the pipeline, but just take growth of the core existing customers. But I want to be -- and we tried to stress this on the earlier part of the call. This is not -- our adjustment in guidance is not due to the market. It's due to specific clients. And fortunately, sometimes, you are fortunate with what your specific clients are doing. And sometimes, you're unfortunate. This time -- many times, we've been fortunate in the past. This time, we've been unfortunate. But it is isolated to a relatively -- the majority of the impact is isolated to a relatively small number of clients. The overall market demand, we're actually feeling quite good about, as -- and I think you've seen that evidence from many of our competitors.

Darrin D. Peller - Barclays Capital, Research Division

All right. I mean, so given that -- those points, I mean, should we expect that the sort of pickup, the 2015 growth rates should look better? Only because if it's just a specific few clients, the core underlying organic story is still just pretty much unchanged. And it looks like you're adding some larger transformational business as well. And then lastly, these clients potentially could come back at some point.

Francisco D'souza

Look, I think -- it's Frank. I think the fundamentals of our industry remain very, very strong, right? Our thesis has been that we operate in a very large market that's highly fragmented, and it gives the opportunity for us to gain incremental share. And that -- those fundamentals still hold. And so I think we're very confident that, with our strategy of reinvesting in the business, there are still a lot of long-term growth opportunities. And in the long run, I think we can continue to drive industry-leading growth. It's too early for me to comment on 2015 specifically. As you know, we go through the cycle at -- towards the end of the year and in the early part of the subsequent year as clients go through the budgeting process and so on and so forth. But when I step back and just look at the overall situation, we're going through this big transition in the market in technology that's creating this dual mandate for our clients. We're still in a fragmented market. We are underpenetrated in key geographies around the world. I think those fundamentals remain strong and allow us to, if we continue to invest, to maintain industry-leading growth.

Operator

The next question is coming from the line of Joseph Foresi with Janney Montgomery Scott.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

It sounded like we saw some delays in project ramps in the back half of the year. What gives us confidence that, that doesn't continue on some of these new projects? And will you be taking over any assets on the new projects?

Gordon J. Coburn

So Joe, I'm assuming you're talking more about the larger transformational deals. It took a little longer just to get all our ducks in a row, and then you run into some year-end timing of when you start doing the work. So some of that did get pushed out from what we initially expected. On the -- we will be picking up some intellectual property as part of one of these deals, which we think we can leverage with other clients. So there will be some asset pickups as part of this in terms of intellectual property. And we're taking on some people who we think are going to be wonderful contributors on a long-term basis.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Okay. So maybe you could just give us some idea of like how the longer-term transformational deals differ from the traditional businesses that you normally do. And give us some idea of how that translates into revenues as we start to see larger pieces of this in your pipeline.

Gordon J. Coburn

I'm not sure it -- they differ materially from a revenue standpoint. As they start ramping up, we recognize revenue depending on the deal, if it's time and material or if it's fixed price. So I'm not sure the dynamics are any different, other than when do you start the ramp-up. The margin profiles, those will differ from client to client. Some are normal margin profiles from day 1. Others, you have an investment phase. But obviously, we can handle the -- we have the room for that within our existing margin ranges.

Operator

The next question is coming from the line of Steve Milunovich with UBS.

Steven Milunovich - UBS Investment Bank, Research Division

Regarding the client-specific issues, how much of those are due to leadership change versus customers not spending as much as you expected? And when you see leadership changes, what's your history there? Will the new leaders come in and decide to do something different? Or does it just turn out to be a delay of business?

Gordon J. Coburn

The answer is it's a combination. There are some cases where you have a new leader come in and they want to reevaluate overall IT priorities. Other times, they want to reevaluate their sourcing strategy. But normally, it's they just want to understand what they're spending money on. In other cases, it's situations where a client is just going to spend less money. And that's going to impact us as well. Or that their priorities of sourcing have changed. So it's -- when I look across the handful of clients where we've been impacted, it's no single answer, but it's -- it tends to be some combination of all those.

Steven Milunovich - UBS Investment Bank, Research Division

On the integrated deals, is it that the market is buying in a different way, or more that Cognizant is now able to provide a broader set of capabilities, and so you're seeing these larger deals and, therefore, some delays?

Francisco D'souza

I think it's probably -- it's -- the market is, I think, buying in a different way. Steve, I think that there is a growing recognition in the marketplace. And it's a position that we hold as well, that by combining service lines together, we can drive greater levels of efficiency and effectiveness for clients. And as you know, clients across the industries that we serve, we've been talking about this for some time, are under continued pressure to drive ever-greater levels of productivity, efficiency, effectiveness. That's what we call the run better part of the dual mandate. And so creating these large integrated deals is just a natural outcome of that. In parallel with that, since we recognized this trend several years ago, we've been building out the core individual service lines that are required to service these large integrated deals. And largely, those are the traditional Cognizant application development and application maintenance service line, the IT Infrastructure service line and the BPS service line, and all of that wrapped with a consulting layer that Cognizant Business Consulting provides. So we feel like we're well positioned. Our capabilities, the ones that we've invested in over the last few years, really enable us to play in these large integrated deals.

Operator

We'll move on to the next question, which is coming from the line of Moshe Katri with Cowen and Company.

Moshe Katri - Cowen and Company, LLC, Research Division

This is a follow-up regarding the large deals. You indicated that you're going to take some assets. Will there be a margin impact from those deals? Anything unusual there? I think that's going to be helpful if you provide some color on that. And then, obviously, you've expanded your share buyback program. On the flip side of it, what's the logic for not introducing a symbolic dividend payment sometime this year?

Gordon J. Coburn

Sure. Let me take the first question of, on the larger deals, is there a margin impact. Each -- with these large deals, both the 3 that we talked about here and others, the margin -- the characteristics are a little bit different on each one. Some, it's sort of normal margins or steady margins from day 1. Others, there are an investment period. But let me be clear, the ones where there are investment period, we can handle those within our existing margin profile because they are also larger deals that are coming out of the investment period. So as long as you kind of have these things staggered, you're fine. So we're comfortable with that. But the margin -- the timing of the margin will differ from deal to deal. On capital structure, as we've been saying for a while, we think the right answer for us is to focus on share repurchases. And if you look historically, we've been a -- we've looked at relative valuation of Cognizant to the market in terms of deciding how aggressive to be. And even in Q2, we picked up the pace of acquisition -- of share repurchases from Q1. Obviously, we're signaling that we can -- we expect to continue to do share repurchases with the expansion of the program. We do not have any plans near term to focus on a dividend. Because a dividend, once you start doing it, obviously, you want to continue doing it. And this is still a very dynamic market. We think we're going to end up being a clear leader in the market, and we want to make sure we have the flexibility to do that as acquisitions may come up or other things may come up. So we don't want to box ourselves in, and that's why we think share repurchases are the right way to go, because it gives us more flexibility. And obviously, even before today, share repurchases were accretive to earnings.

Operator

The next question is coming from the line of Glenn Greene with Oppenheimer.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Just a couple real quick. But maybe just coming back to the client-specific issues, just to be clear, are these just kind of delays in decision-making? Or has there sort of been a reallocation or a cut in either the technology or offshore budgets of the clients for this year? Just trying to -- wanted to understand that a little better.

Francisco D'souza

I think it's a little bit of both, frankly, Glenn. What's happened is, as Gordon said, sometimes, we're seeing clients reassessing priorities, shifting dollars from, say, run better to run different kinds of initiatives. And other times, it's just been just straight delays, frankly, where projects get pushed out. And as I said earlier, when that happens, just given the calendarization and the timing of things during the year, it becomes difficult to, essentially, to catch up in the year.

Gordon J. Coburn

Also, we do see a client here and there where they have a real budget gap that they have to close, which goes against overall industry trends. But it does impact that particular client, and we've seen that as well.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

And Gordon, maybe you could help us. I mean, you obviously -- it's a pretty big cut for the back half, a little over $200 million in revenue. The degree of conservatism you're thinking about into the back half, to just sort of like, well, if you're going to cut, cut hard? But I just want to understand how you're thinking of the back half.

Gordon J. Coburn

I think our thinking about it is similar to what you just described.

Operator

The next question is coming from the line of Charles Brennan with Crédit Suisse.

Charles Brennan - Crédit Suisse AG, Research Division

It's actually coming back to the idea of 2015, if we can. I know you don't want to give some specific guidance, but the guidance for the back half of 2014 is for slowing momentum. It's something like 12% growth in the third quarter falling to something like 8% in the fourth quarter. That gives us a fairly weak exit run rate. Are you confident that Q4 is the low point of the growth cycle? And then as we look at 2015, you're obviously going to be facing some tough comps in the first half. Is it going to be one of those hockey-stick years, where we're relying on the second half to deliver the growth?

Gordon J. Coburn

So let me caveat my comments with we've not gone through the budget cycle with clients, and we clearly don't want to get ahead of ourselves and talk about 2015. But we -- the issues we face this year are not market demand issues, and you're seeing that from our competitors. They are client-specific to us. When we look at those that are client-specific to us, we think a lot of the -- many of those challenges wash out of the system by the end of this year. So I don't think we have the headwinds from those specific clients as we go into next year, or at least in aggregate. But obviously, we want to go through the planning cycle with the other 900 and -- or other 1,000 clients before we have a full view on 2013. Certainly, we're pleased that we have some stuff under our belt now with these transformational deals that we've won. And certainly, we've been winning other stuff, just doesn't rise to the size that were talked about on the call.

Charles Brennan - Crédit Suisse AG, Research Division

And just why doesn't lower spend in the second half annualize in the first half of next year? Are you assuming that spend comes back? Or are you assuming that business wins overcompensate for it?

Gordon J. Coburn

In the term -- use the term business wins, not just new logos but growth of existing accounts. Essentially, we have an anchor of a handful of accounts that are offsetting really quite healthy growth at the vast majority of our accounts. And we -- and that anchor doesn't continue to decline as we go into next year, is our belief. But once again, we haven't done the planning yet on what the other 1,000 clients will do. That will be part of the budget process.

Operator

The next question is coming from the line of Brian Essex with Morgan Stanley.

Brian L. Essex - Morgan Stanley, Research Division

I just want to dig in a little bit to the mix of revenue attributable to renewals. How is that this year relative to last year? And what are those conversations like with your customers? And I understand that some of your peers have been very competitive, particularly on the outsourcing front, and just want to get a sense of when it comes for -- it comes time for renewal, you indicated pricing is stable. But how are you able to maintain that stable pricing in that environment?

Francisco D'souza

Yes, I think -- this is Frank. Let me -- Brian, let me just step back and say, first of all, that I think there are different kinds of renewal circumstances and situations. And I think, as I said earlier, the vast majority of our business continues to be what I think of as the traditional model in which we've operated, where we tend to have preferred vendor status with a client and we win projects incrementally as the clients identify new work. Now sometimes, that's renewal work. For example, we might be doing an engagement -- a maintenance engagement that comes up, and then the client renews it. That tends to be one renewal cycle. And generally speaking, those fall under the overall sort of master agreement that we have with the client. Those master services agreements will sometimes come up for renewal once every several years. And the competitive dynamics there have largely remained unchanged, I think, over several years. There's nothing remarkable about that. So that's what I consider to be the normal cycle of our business. On top of that, we're seeing this trend towards larger deals. And I think we are benefiting from this trend towards larger deals. There, what's happening is that the client is either taking a traditional, what I would consider to be a more legacy kind of contract, usually that's in infrastructure, and moving it to a global services model and then combining that with applications and/or with BPO to create these integrated deals. In those cases, the competitive dynamics are such that we're able to drive a lot of additional value by combining those together. We have a very, very strong process historically of understanding what the levers are that we can pull in each of those circumstances and translate that into, as Gordon said earlier, lower total cost of ownership for the client. In those cases, the competitive dynamics are such that the advisors play a little bit of a stronger role. And oftentimes, as is the case in some of the big transactions that we announced today, the scope of those larger deals includes some current scope that Cognizant is already executing. So in a sense, it becomes a renewal, but a much larger renewal because you take the existing scope of work that we might already be executing for the client, you add a lot more around it to create a much larger deal. So that's sort of a second kind of renewal circumstance. So I don't know if that gives you some color around how these renewals are playing out. But overall, we feel good about our competitive position and our ability to win in those circumstances.

Brian L. Essex - Morgan Stanley, Research Division

Okay. And just want to touch real quick on attrition. Unless we misheard it, it looked like it spiked in the quarter, and I think some of your peers are having similar issues. Maybe if you can comment on what's being done to address attrition and how that might impact the, I guess, seasonal increase in promotional and salary increase spend that you're seeing going into the back half of the year.

Gordon J. Coburn

Sure. So going from Q1 to Q2, we always see an increase in attrition -- or almost always. The reason why is we pay out our bonuses in March. So people who are waiting for their bonuses who are planning to leave would leave, plus you have people going back for higher education. So we're down about 2 points from second quarter of last year. Still running a little bit higher than we want but certainly in better shape than we -- much better shape than we were last year. That's one reason, obviously, why we gave salary increments at the higher end of the industry, because we wanted to send a strong message to our people about the -- at Cognizant, they can have terrific careers and great growth paths. So we'll continue to watch it. But the key things we're doing is a lot of efforts around employee engagement that we started when we saw a spike last year, and that has helped things. We've given healthy increments, which we think will help things. So continue to keep an eye on it, but the trend is actually -- seasonally adjusted trend is actually going in the direction that we want. Not fully there, but certainly, we've made good progress.

Operator

Our final question is coming from the line of Jason Kupferberg with Jefferies.

Jason Kupferberg - Jefferies LLC, Research Division

I appreciate some of the comments around what appears to be conservatism for the back half. But obviously, it's the second straight quarter where it seems like we've been caught off guard a bit by clients' spending plans. So I'm just wondering if this is causing you to rethink, on a kind of more structural basis, any of your internal budgeting and forecasting processes as well as how you might translate the output of those processes to the formal guidance that you give to the Street.

Francisco D'souza

Jason, I think, look, we've -- we're taking a long, hard look at all of our internal processes to understand if we need to adjust how we think about our own forecasting and then, as you said, translating that into the guidance that we provide. I think the reality is that we're going through a somewhat of a transition in the marketplace, as I've said several times over the last quarters, where you have these big technology shifts going on. And that's leading to some -- I think it's leading to 2 things, right? One is great opportunity for us. I feel really optimistic about how we're positioned and the opportunities that are available to us in the marketplace. It also leads to a more dynamic market, a much more dynamic demand environment with shifting client priorities. And that makes it a little difficult to get clear longer-term fixes on exactly where we are in terms of revenue and so on and so forth. We'll continue to do everything we possibly can to strengthen our internal processes and to give you and the rest of our investors a clear -- as clear a picture as we can. That's been our historical approach. At this point, I don't see sort of fundamental internal operational issues that would require us to retool the way we forecast or anything like that fundamentally. But we continue to look at that just all the time and look at how we, ourselves, can run better and run different, just as we explain that to our clients.

Jason Kupferberg - Jefferies LLC, Research Division

And just a very quick follow-up on that. The 2 points of growth -- or at least 2 points, I guess, of growth that you're expecting, you -- renew deals to add to next year's growth rate. I mean, would you characterize the degree of conservatism around those 2 points of growth the same way you would the degree of conservatism for the back half of 2014? Or is it still just a little bit early to really know what those -- what the ramp on those deals is going to look like? Because it seems like that could end up being a very significant swing factor in determining whether or not next year's growth rate could potentially accelerate a little bit versus this year's growth rate.

Gordon J. Coburn

Yes. I think the ramp is fairly clear, based on the assumption of timing of when it starts next year, and we've been a little bit conservative on the timing just to play it safe. Obviously, as we've said in our press release, the Health Net deal is subject to contract finalization and applicable regulatory approvals, which -- so we've got to get through that process. But we've been a bit conservative in terms of when the ramp actually starts.

Francisco D'souza

All right. Well, thanks, everybody, for joining us today and for your questions. We appreciate your time, and we look forward to speaking with you again next quarter.

Operator

Thank you. This concludes today's Cognizant Technology Solutions Second Quarter 2014 Earnings Conference Call. You may now disconnect.

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Source: Cognizant Technology Solutions' (CTSH) CEO Francisco D'souza on Q2 2014 Results - Earnings Call Transcript

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