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Cognizant Technology Solutions Corporation (NASDAQ:CTSH)

Q2 2007 Earnings Call

August 1, 2007 10:00 am ET

Executives

Scot Hoffman - Financial Dynamics

Francisco D'Souza - President and CEO

Gordon Coburn - Chief Financial and Operating Officer

Analysts

Julio Quinteros - Goldman Sachs

Rod Bourgeois - Sanford C. Bernstein

Ed Caso - Wachovia Securities

Julie Santoriello - Morgan Stanley

Mark Scuntows - Piper Jaffray

Ashwin Shirvaikar - Citigroup

Joseph Vafi - Jefferies & Co.

Presentation

Operator

Good morning. My name is Cynthia and I will be your conference operator today. At this time, I would like to welcome everyone to the Cognizant Technology Solutions' Second Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Hoffman at Financial Dynamics. Please go ahead sir.

Scot Hoffman

Thank you, operator, and good morning, everyone. By now, you should have received a copy of the company's second quarter 2007 earnings release. If you have not, please call our offices at 212-850-5600, and we'll be sure to get a copy sent to you.

The speakers we have on the call today are Francisco D'Souza, President and Chief Executive Officer; and Gordon Coburn, Chief Financial and Operating Officer of Cognizant Technology Solutions.

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, Francisco.

Francisco D'Souza

Thank you, Scot, and good morning, everyone. Thank you all for joining us today for Cognizant's second quarter 2007 earnings call. This morning I'll provide an overview of our second quarter results and discuss the key drivers of our financial and operating performance. I am joined on today's call by our Chief Financial and Operating Officer, Gordon Coburn who will take you through our financial and operating results in greater detail.

I am pleased to report that the steadfast execution of our long-term strategy has enabled us to surpass an annualized $2 billion revenue run rate during the quarter, just six quarters after surpassing the $1 billion annualized revenue run rate in the fourth quarter of 2005. Our rapid achievement of this milestone is a testament to the strong fundamentals of our business, the success of long-term strategy, our dedication to client satisfaction and our commitment to delivering value to our shareholder.

Cognizant's tremendous growth was also recently recognized by Business Week, which once again named Cognizant's among the InfoTech 100, Business Week's annual ranking of the top technology industry performers. Cognizant outpaced all of its industry competitors in this year's InfoTech 100 and placed ninth overall on the fastest growing sub list, with a 62% year-over-year revenue growth rate for the 12-month period measured by Business Week.

These achievements were a result of our approach and culture of partnering with our customers every day to build stronger businesses and deliver a tangible return on their IT investments. Our ability to maintain these results oriented client-centric culture while scaling the business rapidly, essential to our ability to maintain industry leading growth which was again evident in our second quarter results.

Turning to our second quarter financial results in more detail. We once again exceeded our internal forecast and our guidance generating $516.5 million in revenue, an increase of 12% sequentially and 53% from the second quarter of 2006. As in recent quarters, our strong performance this quarter was the result of broad-based growth across our business.

As we've said in the past, we believe that the majority of our strategic accounts still have considerable growth potential and this was evident in the growth of our largest client relationships during the quarter. Revenue from our top five clients grew by 9% sequentially, and revenue from our top 10 clients grew by 11% from the first quarter. We expect these relationships will expand further as the needs of our customers evolve over the long-term and we continue to expand the range of solution offerings that help strengthen our customers businesses.

We also generated significant new business potential during the quarter, increasing our number of active clients to over 430. In addition, the number of accounts that we consider to be strategic, which means that they have the potential to generate between $5 million and $40 million or more in annual revenue for Cognizant over the long-term, increased by 5 during the quarter bringing our total number of strategic clients to 97. Strategic clients spanned broadly across industries, banking and financial services, healthcare and retail, as well as geographies including the U.S. and Europe.

Revenue growth across all of our business segments were strong including growth in our two largest segments, financial services and healthcare. Revenue from our financial services segment customers increased 13% sequentially and 49% year-over-year, as we continue to leverage on leadership position in the market and deep domain expertise that we bring to the world's top banking, financial services, and insurance companies.

We had a very strong second quarter in our Healthcare Segment, growing 62% over the second quarter of last year, and adding two strategic clients.

Turning to the cost side of the business, GAAP EPS was $0.54 for the quarter, up 46% from the year ago quarter. Non-GAAP EPS, which excludes stock-based compensation expense, was $0.59 compared to $0.41 in the second quarter of 2006. We achieved this strong performance while proactively addressing several challenges facing the entire offshore outsourcing industry.

During the quarter, we executed on the plan we outlined on our last conference call to offset anticipated pressure on our cost structure stemming from the Indian Rupee's appreciation, as well as seasonal wage increases. We addressed these headwinds through a combination of increasing utilization of our stock by approximately 2%, as well as taking advantage of SG&A scale efficiency saving.

As a result of better utilization and other scale efficiencies, our operating margin for the second quarter, excluding equity-based compensation expense, was a solid 19.4%, slightly above our guidance for the quarter and well within our historical target range of 19% to 20%, which also excludes equity-based compensation expense.

The successful execution of our plan demonstrate our flexibility to quickly pull operating leverage to effectively offset macro economic headwinds to enable us to meet our financial and operating targets.

Our execution in the quarter also underscores our focus on delivering consistently strong bottom-line results, while upholding our commitment to reinvesting in the future growth of the company.

On the operational side of our business during the quarter, we continued to make investments in our people and infrastructure. We added a net of over 2,000 employees during the quarter, bringing our total employee base to approximately 45,500 worldwide. Employee additions during the quarter were low compared to historical levels given our goal of increasing utilization from Q1 levels. During the second half of the year, we expect to return to a more normalized pattern of hiring and are on track to end 2007 with our previously stated goal of approximately 55,000 employees.

This is consistent with our expectations and intention to increase utilization throughout the year and manage the business within our target operating margin range of 19% to 20%, excluding equity compensation expense.

Employee attrition increased slightly to 17%, which is consistent with seasonal trends and attrition for the second quarter. This increase was due primarily to the seasonal tendency for certain employees to leave during the second quarter to pursue higher education. We continue to monitor employee attrition closely and take necessary short and long-term steps to manage it.

In terms of infrastructure, as demand for our services escalate throughout the world and our client base grows, we are focusing on building infrastructure to capitalize on these growth opportunities. As we announced this morning, Cognizant's board of directors has approved plans to make an additional $100 million investment in our previously announced infrastructure expansion program across India. This brings our total real estate investment platform to $300 million. Gordon will provide more details on this initiative later in the call.

Before turning the call over to Gordon, I would now like to comment briefly on some broader industry trends and highlight the investments that we are making to drive our ongoing growth.

First, we continue to see broad based demand for our services including our newer service offerings. This is evidence of Cognizant's ability to expand our relationships with our customers and to bring innovative new services to our markets.

Our growth platform continues to expand across industry verticals driven by the investments we've been making and cultivating market leading expertise in each of the industry segments we serve. In our core business segments of financial services and healthcare, we continue to demonstrate a market leading position. For instance, in June Cognizant was named to the Healthcare Informatics 100, a list of the industry's leading healthcare IT solutions and services providers based on revenue growth. Cognizant has been named to this distinguished list for several years and this year we move to the top 20, affirming our leadership in this key industry.

Similarly in financial services, our growth continues to be strong as we continue to make investments to solidify our position in that industry segment. We have been able to effectively extend our financial services practice to Europe, where we are now doing work for 11 strategic clients in the financial services area.

During the second quarter, we also experienced growth across our range of horizontal service offerings, with particularly strong performance in ERP, data warehousing and business intelligence, testing and infrastructure management. As an example, our testing group has experienced remarkable growth and today we are an acknowledged leader with over 6,000 career test professionals serving more than 200 customers, driven by our ability to provide best-in-class solutions, such as enterprise level managed care centers.

We are also seeing very strong demand for our testing offering in Europe, where we have engaged with several large banking, financial services, insurance, and retail customers.

Second, as we've said in the past, European clients continue to aggressively adopt offshoring strategies and as a result we continue to see strong returns on our investments in expanding and globalizing our business. European revenues grew 17% sequentially and 79% from the second quarter of 2006, driven by expansion of our business with European companies and when two of our strategic clients wins during the quarter are well [defined].

Growth was particularly strong in continental Europe year-over-year, demonstrating that the investments we would be making in expanding our business across Europe are paying off for us. Our success in Europe was also evident in attendance at our annual Cognizant community event in Europe during the second quarter, which brings together clients and prospective clients to discuss the benefits, challenges and opportunities of global service delivery. [Again] on this year, more than doubled from last year and consistent of CIO level leaders, representing a broad range of industries along with an impressive assortment of Europe's leading companies.

Another key trend that we've been observing is the willingness of clients to engage Cognizant much earlier in the life cycle to play a role in defining solutions, not just implementing them. This is a trend which Cognizant is particularly well positioned to capitalize on given our historical strong investment in our front-end client facing team. Cognizant's ability to engage in a consultative fashion very early in the life cycle is validation of these investments and allows us to build deeper and longer lasting relationships with clients.

Last quarter, I talked about our domain consulting group within banking, which is comprised of experts across nine industry sub-sectors. Our success in financial services is increasingly driven by our NBAs and industry experts who enable us to capitalize on the demand for higher value consulting services. Our strategy is to invest in replicating that consulting business model within our other business areas.

Telecommunications is an example of a newer vertical in which we are focused on replicating our consulting model. The success of this strategy is evident in our strong revenue growth and expanding list of market clients.

Revenue in the second quarter increased by 29% from last quarter and 73% compared to the second quarter of 2006. This growth is a result of the successful acquisition and integration of Fathom Solutions, a telecom consulting firm that strengthened our communications and domain consulting capabilities.

Since the acquisition of the business two years ago, our combined offering has attracted major industry players who choose Cognizant for our unique ability to integrate high end consulting capabilities with efficient global delivery. They are also attracted by our thorough leadership in next generation industry issues that can help take their businesses to the next level.

By using the same domain experts drive both consulting service work and the ensuing systems implementation, Cognizant becomes a full life-cycle solution partner with the upstream ideas and know-how and the downstream accountability for implementing an effective solution. For example, we recently partnered with a major U.S. telecom provider to lead an evaluation of every major system within their new strategic platforms that enables triple play, Voice-over-IP, IPTV and high speed data offerings. Cognizant's analysis focused on determining functional and technical readiness for future phases of new IP service introductions, which we are now entrusted to implement.

The success of our consulting model is not limited only to our industry vertical areas. In many of our horizontal service offerings we are observing the same trend of clients willing to engage Cognizant much earlier in the life cycle. For example in our data warehousing business intelligence and performance management business, we are seeing demand for a range of consulting services including business case development, IT strategy, government and their performance management.

Our customers see us as a partner who recommends practical and implementable strategies and solutions. They also see us as a partner who is willing to engage across the lifecycle from upfront consulting to implementation and post-implementation to measure deliver against originally outlined results and objectives. We have built specific business benefit assessment tools to help our customers attract their ROI as related to their strategy.

Finally, as the growth of the industry places demands on the talent equal system in India, we continue to find innovative ways to enhance our ability to attract and retain talent. Our efforts to hire entry level engineers from campuses have produced strong results this recruiting season. The key message that resonates with newly graduated engineers is one of cost per year growth resulting from the rapid growth of Cognizant as a company.

We are reaching deep into the educational ecosystem in order to secure our position as an employer of choice. Through a formal program we bring together the principals, deans, and placement directors of the more than 150 campuses from where we recruit. We use this forum to discuss collaboration opportunities in areas such as curriculum development, employability enhancement, and faculty-industry linkage programs. This forum has helped us engage very closely with academic institutions and policy makers at the highest levels.

We continue to push forward with programs designed to enhance employability of recent graduates. In addition to our work with finishing schools such as 3-Edge, we work closely with NASCOM initiated programs. We are also working with the IIT's and NIT's to support their finishing school initiatives.

Further, as part of the consortium formed by the Confederation of Indian Industry CII, a premier trade body, Cognizant is working closely with the University of Madras to define the curriculum for soft skills that will be taken to science colleges under the aegis of this university. Such programs and many more institution-specific initiatives have helped us to secure slot one or slot two in the majority of the over 150 campuses that we target for recruiting, thereby considerably improving our average slot rating this year and allowing us to increase the average number of offers made per college in 2007.

Likewise, on business school campuses, Cognizant continues to enjoy a premier position for recruiting, competing with global strategy consulting organization, investment banks and FMCG enterprises. In many premier B-school campuses Cognizant is considered the first choice amongst students aspiring to join the IT industry. Cognizant has a solid reputation because of the career options that we provide to B-school graduates in business consulting, business analysis, opportunity assessment, relationship management and corporate development.

As an example, the Indian School of Business is one such premier business school in India with academic alliances with the Kellogg's School of Management at north, Western University, Wharton School at the University of Pennsylvania and the London Business School.

At the Indian School Business this year, Cognizant had 35 accepted offers, the highest number of acceptances ever for any company in the history of the Indian School Business.

And finally, in terms of continuing education of our existing associates, we continue to push forward with innovative programs that further our goal of establishing market leading positions in the markets that we serve. For example, in the area of life sciences, we recently entered into an association with Manipal University to offer a two-year Master of Science Degree in Clinical Research and Regulatory Affairs, for associates in our life sciences practices.

A leading private university in Southern India, Manipal University, also runs one of the country's most successful hospital chains. This is the first of its kind industry academia lead program designed for professional interested in pursuing their careers in the life science industry, in the fields of clinical research, medical writing, clinical data management, drug development, buyer statistics and regulatory affair. Cognizant has been working actively with the university to design the course, bring together the best in industry knowledge, key studies and experience of Cognizant professionals. Cognizant will also help deliver some of the modules of this course.

With those comments, I would like to conclude by saying that overall we are very pleased with our performance for the second quarter, which was driven by growth across all dimensions of our business, vertical industry segments, service areas and geographies and we continue to confident in our growth strategy for 2007 and beyond.

Now, I will turn the call over to Gordon who'll walk you through our financials in greater detail. Gordon?

Gordon Coburn

Thank you, Francisco, and good morning to everyone. I would like to provide some additional information on the first quarter and then discuss our financial expectations for the third quarter, as well as full year 2007.

Revenue for the second quarter exceeded our prior guidance and expectations due to continued strength in Europe, strong year-over-year growth in our healthcare segment, as well as all three of the industry verticals within our other segment.

Quarterly revenue grew 12% sequentially, 53% year-over-year. As the quarter proceeded we continued to see healthy volume growth across the broad range of services and industries. Our core business remains vibrant and our pipeline is robust.

During the quarter our Financial Services segment, which includes our practices in insurance, banking and transaction processing, grew by over $80 million year-over-year and represented 47% of revenue for the quarter.

Healthcare grew over $45 million and represented 23% of revenues, retail, manufacturing and logistics grew by almost $25 million, representing approximately 15% of revenues for the quarter. The remaining 15% of our revenues came primarily from other service-oriented industries of telecom, media and technology, which grew by over $29 million compared to the second quarter of last year.

During the quarter, financial services grew 49% year-over-year, and over 13% sequentially. Healthcare grew 62% year-over-year, about 8% sequentially. Retail, manufacturing and logistics grew 48% year-over-year, and 11% sequentially.

Growth in our retail, manufacturing and logistics segment was driven by several new retail accounts that we have won and are now ramping up, including the previously announced transaction with Kimberly-Clark. And our other segment grew 60% year-over-year and 17% sequentially. Growth in the other segment benefited from strong growth in our information and media operations, as well as technology and telecommunications.

For the quarter, application management represented 52% of revenues, and application development was 48%. Both services continued to grow significantly in Q2. Application management grew 57% year-over-year and 11% sequentially. Application development grew 50% year-over-year and 14% sequentially, reflecting a healthy demand environment for our entire services offerings.

During the quarter, 84% of revenue came from clients in North America. Europe was approximately 15% in total revenue. The remaining 1% of revenue came from the Asian market. Our European business grew 17% sequentially and 79% year-over-year for the quarter, as we continue to invest in that region.

We added approximately 66 new customers during the quarter. We closed the quarter with an active customer base of over 430. During the quarter the number of accounts, which we considered to be strategic and have the potential to become significant revenue sources for us in the future, increased by five, bringing our total number of strategic clients to 97.

Turning to costs, on a GAAP-basis, cost of revenues exclusive of depreciation and amortization increased 55% in the quarter compared with the second quarter of 2006. Second quarter cost of revenues include approximately $4.8 million on equity-based compensation expense. The increase in cost of revenues was due to additional technical staff, both the onsite and offshore required to support our revenue growth as well as the impact of the strengthening rupee and wage increases that were affected in the Q2. We increased our technical staff by 1,900 during the quarter and ended the quarter with approximately 42,700 technical staff. This is a net increase of close to 15,000 technical staff from June 30, 2006.

Second quarter SG&A including depreciation and amortization expense was $133.5 million on a GAAP basis, up from $87.8 million in the second quarter of 2006. GAAP SG&A expense in Q2 2007 included approximately $4.7 million of equity-based compensation expense. As a percentage of revenue SG&A including depreciation and amortization was down slightly as we're able to leverage our scale efficiencies.

GAAP operating income for the quarter increased 49% to $90.7 million from $60.7 million in the second quarter of 2006. On a non-GAAP basis, which excludes the impact of $9.5 million of equity based compensation expense, operating income for the second quarter was $101 million up almost 49% from last year. Our GAAP operating margin was 17.6% in the quarter and our non-GAAP operating margin for the quarter was 19.4%, in line with our target of 19% to 20%.

During the second quarter operating income was negatively impacted by the significant appreciation in the Indian Rupee. The average rate for the Rupee was approximately 41 in the second quarter versus 44 in the first quarter of 2007 and 45 in the second quarter of 2006. Interest income for the second quarter increased to $6.5 million compared to $3.9 million in the second quarter of 2006. Interest income increased due to a higher global cash balance for the short-term investments as well as increase in short term interest rates. We had a $530,000 foreign exchange gain during the quarter.

Our GAAP tax rate for the second quarter was 15.7%. During the quarter we had a favorable settlement of certain tax uncertainties. In accordance with FIN48, the results of this settlement were required to be recognized as a discreet item during the quarter. This reduced the second quarter tax rate from our normalized tax rate of 16.4% to 15.7%. Assuming no further discreet items in the second half of this year, we expect our second half tax rate to be 16.4% resulting in a full year tax rate of approximately 16.3%.

Turning to the balance sheet, our balance sheet remains very healthy. We finished the quarter with over $710 million of cash, and short-term investments up over $240 million from June 30th of last year, and up over $37 million from March of this year. During the second quarter, operating activities generated over $52 million of cash, financing activities, primarily the exercise of stock options, and related tax benefits generated approximately $26 million of cash. These amounts were partially offset by over $42 million of capital expenditures. In addition, we generated approximately $670,000 of cash due to currency translation adjustments.

For 2007, we continue to expect to spend approximately $180 million in capital expenditures, a substantial majority of which is related to the construction and equipment for additional development facilities to support our growth, as we announced.

Today we also announced a $100 million expansion of our current construction program in India, bringing the total value of the program to over $300 million. This program now encompasses the construction of approximately 4.5 million square feet across five cities; all of the construction is planned for Special Economic Zones to allow us to participate in tax holidays well into the future.

In addition, we are opportunistically leasing facilities with SEZ status. So far this year, we have leased over 800,000 square feet of space in Special Economic Zones, all of which will become available for use by year end.

Our collection and trade receivables improved slightly from the second quarter of 2006 based on our $403.6 million balance on June 30. We finished the quarter with a DSO including unbilled receivables of 71 days compared to 72 days for the same period last year. During Q2, excluding unbilled receivables, our DSOs was approximately 61 days. The quality of our receivables portfolio remained strong. Our unbilled receivables balance was approximately $54.7 million at the end of the second quarter, up about $16 million or 43% from June 30 of last year, and up about $8 million from Q1 of this year. Approximately 54% of our June 30 unbilled balance was billed in the month of July.

During the second quarter overall, 24% of our revenue came from fixed-price contracts, down from 25.3% in the first quarter of this year, and down from 25.2% in the second quarter of 2006. When we look at the mix by solution type during the second quarter, 29% of our development revenue and 20% of our maintenance revenue came from fixed-price contracts during the quarter.

Turning to headcount, at the end of the second quarter our worldwide headcount, including both technical professionals and support staff, totaled approximately 45,550. This represents a net increase of approximately 2,100 people during the quarter and 15,900 people since June 30th of last year. Slightly less than 50% of our Q2 hires are recent college graduates who will enter our training program. The remainder where lateral hires of experienced IT professionals.

Turnover, including both voluntary and involuntary was approximately 17% annualized during the second quarter. As discussed previously, we've launched the global initiative to ensure that our employees receive appropriate rewards, recognition, and personal and professional growth opportunities across their entire lifecycle at Cognizant.

Q2 attrition was roughly in line with the second quarter attrition in both 2004 and 2005. It was about 2 percentage points higher than attrition in the second quarter of 2006. As you will recall, we experienced lower than normal attrition in the first half of 2006 and then a spike in the third quarter of last year.

As we discussed back in May, as part of our strategy to offset the impact of appreciation of the Indian Rupee, we are increasing the company's utilization level. Due to scale economies and historical heavy overinvestment in bench resources, we were able to successfully begin to increase our utilization rates during the second quarter. During the second quarter we executed according to our plans towards this goal.

Onsite utilization increased slightly to over 85% for the quarter. Offshore utilization, excluding recent college graduates who were in our trainee program at the end of the quarter, was approximately 68%, as many of our full 2006 trainees graduated from our trainee program. Including trainees, offshore utilization was approximately 56% for the quarter. We had well over 4,300 unbilled people in our training program at the end of the quarter.

I would now like to comment on our growth expectations for the third quarter of 2007, as well as the full year. The investments we are making are producing results. They are allowing us to differentiate ourselves in the marketplace, both in terms of winning and growing new clients and expanding our service offerings. This has resulted in stronger than expected results for Q2, and provides us with a strong foundation for continued growth in 2007.

For the third quarter of 2007, we are projecting revenue of at least $550 million. This represents more than 45% year-over-year growth. We continue to have significant revenue visibility due to our high-level of recurring revenue and long-term nature of our customer relationships. In fact, today we have customer commitments for well over 90% of our third quarter revenue guidance.

For the full year 2007, based on the strong demand environment for offshore services and our favorable experience in ramp up rates, we are pleased to increase our guidance to at least $2.110 billion, a $40 million increase from our prior guidance given in early May. This revised guidance represents growth of at least 48% and an increase of more than $685 million compared to 2006. As it has been typical in past years, we expect the vast majority of our growth in 2007 will come from the ramp up of clients we've won over the past few years.

Assuming no further material appreciation of the Rupee, our guidance assumes that we will continue to be near the midpoint of our targeted 19% to 20% non-GAAP, which is before the impact of equity compensation range for operating margin for the year and for the third quarter.

With this expected level of revenue growth and our expected operating margins, we are currently comfortable with our ability to deliver in Q3 GAAP EPS of $0.56 and non-GAAP EPS of $0.62, excluding equity compensation expense of $0.06. This guidance includes the anticipation of the Q3 share count of approximately 153 million shares, a tax rate of 16.4%, and an operating margin towards the middle of our historic guidance range of 19% to 20%, excluding the cost of equity compensation.

For the full year 2007, based on current business trends, we currently project GAAP EPS to be at least $2.20, and full year non-GAAP EPS to be at least $2.40, excluding equity compensation expense of approximately $0.20. This guidance includes the anticipation of a full-year tax rate of 16.3%, a full-year share count of approximately 152.7 million shares and an operating margin towards the middle of our guidance range.

Please note that our GAAP EPS guidance for the third quarter and full year assumes no P&L impact from the recently enacted fringe benefit tax on the exercised stock options in India. The accounting treatment for this new tax is yet to be finalized by the accounting industry.

In conclusion, we were very pleased with our industry-leading revenue growth in Q2 and are quite optimistic about our market position for the future. We believe that we understand the margin related issues currently faced by the industry and are taking the appropriate short-term and longer-term actions to manage these issues.

We would now like to open the call for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Julio Quinteros from Goldman Sachs.

Julio Quinteros - Goldman Sachs

Hey guys, good morning. Real quickly, just to get a couple of things out of the way here. How much mortgage exposure do you guys have in your BFSI segment as a percentage of revenue?

Gordon Coburn

In terms of subprime mortgages, it's negligible. Overall mortgage -- that I have to check on. But very well exposure to subprime mortgage.

Julio Quinteros - Goldman Sachs

Okay, great. And then looking at the model, the way that it shaped up for the quarter, obviously we're expecting utilization to go up. How much further can you take utilization from current levels, in other words how much is less in terms of cushion from utilization? And then can you walk us through pricing for the quarter as well?

Gordon Coburn

Starting with utilization, as we said last call, our goal is to take utilization up around four points or so, because of the way they are averaging works for the quarter takes two quarters to get there. So, we still have a more increasing utilization plan and that's obviously baked into our headcount guidance and that's just simply a fact of the next two quarters to pull through the impact. In terms of -- what was the other question, pricing?

Julio Quinteros - Goldman Sachs

Yeah, pricing.

Gordon Coburn

Pricing is coming right where we had expected. For the full year we expected it to be about 2%, on an apples-to-apples basis compared to last year. Sequentially we had a very modest increase in pricing, year-over-year we were only about 2%.

Julio Quinteros - Goldman Sachs

Okay, great. And then just the four percentage points, I think there was a little bit of confusion last quarter. I just want to make sure I understand. When we think four percentage point increase, are you talking offshore blended including, excluding, just to make sure, we have the right number here?

Gordon Coburn

So that's global.

Julio Quinteros - Goldman Sachs

Global total including trainees.

Gordon Coburn

Yeah.

Julio Quinteros - Goldman Sachs

Got it, great. Thanks guys.

Operator

Your next question comes from Rod Bourgeois from Bernstein.

Rod Bourgeois - Sanford C. Bernstein

Hey guys, nice to see all the growth here continuing. I wanted to ask about specifically the CapEx outlook with all the plans to expand the facilities. Presumably a lot of the movement into the Special Economic Zone is geared towards optimizing the tax rate after the tax savings expire in March '09. Can you talk about what these investments and facilities in Special Economic Zones might do to your sort of capital expenditures compared to the run rate that we've seen in recent history?

Gordon Coburn

Sure, whether the SEZs existed or not, the company would still be doing constructions if the economics are better than renting. This expansion does not impact our 2007 CapEx budget. As said, we still look at that to be $180 million, haven't worked out 2008 yet. But if you look over the last couple of years as a percentage of revenue it still remains fairly constant. So, that's probably as good an assumption as any at this point.

Rod Bourgeois - Sanford C. Bernstein

Okay, great. There has been a lot of attention focused on the headcount kind of growth outlook in recent periods here. I wanted to ask a scenario -- you guided up again on revenues, if the revenue growth outlook continues to improve and you are able to take you revenue growth guidance up again later in the year, would you then be in a position to take your headcount growth guidance up to 7.9 or do you have enough headcount in place right now to hit a range that goes even higher than where your current revenue growth guidance resides?

Gordon Coburn

With 55,000 people we certainly do look at more revenues than we have got into. Even with our increasing utilization we will still be well below the industry. So they are sort of two separate things. Would we need to take headcount now -- can just obviously know. Would we want to? Maybe yes, maybe no, but when we look at end of the year, was about 55,000 well that gives us room to meet demand this year and positions us quite well for next year.

Rod Bourgeois - Sanford C. Bernstein

Okay, and then --

Gordon Coburn

And as far as, just finish the talk on -- quite obviously large because we have been running so low historically, you just have a lot of buffer in there.

Rod Bourgeois - Sanford C. Bernstein

Right and then with the expansion plan. I mean do these Special Economic Zones and the related investments, does that have implications for the type of headcount growth you are planning for the 2008 timeframe or is it too early to give a read on that? Just presumably with all this investment being planned, you've got some idea of the type of headcount you're hoping to achieve in 2008?

Gordon Coburn

A lot of this construction, some of it starts to come online at beginning 2008, but some of it doesn't come online until late 2008, early 2009. So it's sort of a constant process continuing to expand, but the fact that we've expanded the program clearly means that as we look into the future in 2008-2009 and beyond, we still see a lot of runaway in terms of growth opportunities.

Rod Bourgeois - Sanford C. Bernstein

Okay. And then just to complete all this thought. I'm assuming that your continued plans to take utilization up -- I'm assuming you're still arguing that the higher utilization will not create any trade-off with respect to your growth rates?

Gordon Coburn

At the level that we're targeting to take it up to, we're very comfortable that it does not impact our ability to deliver services and once again that comes back to -- we have been running quite low large scale efficiencies with bench resources, and even with where we are increasing utilization too, we're still -- we still have room, you'll still be below industry standards.

Rod Bourgeois - Sanford C. Bernstein

Alright, thanks guys very much.

Operator

Your next question comes from Ed Caso with Wachovia Securities.

Ed Caso - Wachovia Securities

Good morning, congratulations on another great set of numbers here. I think you haven't talked much about your BPO business. Can you give us a sense of percent of revenue growth rates, focus areas, what the demands are for the future?

Francisco D'Souza

Yeah, Ed, it's Frank. We continue to make good progress on the BPO business. We've -- I think a call or two ago I spoke about -- I gave examples of some clients who we're winning there. As I've said in the past we are focused on what we think of as vertical BPO, industry-specific BPO or what we're calling V-BPO.

And so we're making good progress. We're pleased there with the progress we're making in that business and also looking at the synergies between our IT business and our BPO business.

In terms of the specifics that you asked for, I think a couple of things. Right now revenue for our BPO business is relatively small. It's also important to remember that revenue per head in the BPO business is significantly lower than it is in the IT business. And so, the BPO business today is not a material, significant part of the overall revenue stream.

Ed Caso - Wachovia Securities

Great. Gordon, can you remind us, your goal on the short run for two quarters is to raise global utilization 4 points. How many more points of flexibility do you have beyond that?

Gordon Coburn

We certainly have flexibility beyond that. The question becomes at what point does it start to create a skills mismatch. Yeah, I think we still probably have a little bit of room, bit down to four points. We are kind of growing at an unprecedented rate, so it's more of an art than a science to know what point you hit that skills mismatch. Again, what we know is like we have four points, we are not at that point yet. If you keep going at some point you head it. But we're pretty comfortable with how the model is working and as we're taking utilization up so far this quarter, it's actually been a good thing for the business. We probably realize we probably have let it get a little bit lower than it needed to be.

Ed Caso - Wachovia Securities

Can you talk a little bit about H1Bs? How you get in the lottery, any issues there? How you are thinking about scenarios long-term?

Gordon Coburn

As you know, a lot more applications were filed than visas issued. We certainly understood the process and filed our visas appropriately and received the visas we need to run our business. We continue to monitor the situation. Washington, obviously [excluded] with the immigration legislation, EDAP and then slowing down. So, we will continue to keep an eye on it.

Ed Caso - Wachovia Securities

Okay. Thank you.

Operator

Your next question comes from Julie Santoriello with Morgan Stanley.

Julie Santoriello - Morgan Stanley

Thanks, good morning. I wanted to ask a little bit about the tax rate going forward. Are they part of the construction plans or really all-round I am eluding to SEZs. So, what kind of tax rate do you think we can expect post March of 2009? Can you completely offset some of the exploration with SEZ activity or how much might you be able to offset?

Gordon Coburn

You are absolute right, Julie. Obviously, we are building some SEZs and we're leasing stuff in SEZs. As I mentioned we recently signed leases for almost 800,000 square feet of leased SEZ space, so it's a combination of leasing and building. Really the way the rules work are you cannot move any existing volume from the old passed programs to the new. So, whether our tax rate will jump by 2009 will depend on two factors, how fast does the business grow between now and the end of 2009, and how much of that growth can I put into Special Economic Zones. We'll have a better feel for that later on this year when we start to understand what 2008 looks like and we will start to give a range for the tax rate in 2009. But, I would certainly expect the material increase in the tax rate in 2009, because vast majority of my existing volume starts to become fully taxed.

Julie Santoriello - Morgan Stanley

So, it would be fair for us at this point to look at a tax rate that is somewhere between the 16% now and 32% or so kind of global rate?

Gordon Coburn

We haven't given any guidance, and the range is so wide, I am not sure it has been that helpful for people. Yeah, obviously it will be more than 16% now. When we were fully taxed they didn't recognize the benefit of tax holidays, we were at 37%. Obviously, we not could be at either of those extremes.

Julie Santoriello - Morgan Stanley

Okay. And a question on the consulting business, basically you mentioned some good tractions there. Can you give us an update on the number of people you have now in consulting? And just a little bit more on the strategy there, should we be looking towards specific consulting related revenues from Cognizant or is the consulting practice more geared towards just driving the rest of the services?

Francisco D'Souza

Yes. We've taken the very deliberate approach of putting our consulting business, if you will, into the core businesses. We think that that's an effective way to drive the business. It's an effective way to grow consulting practice. But also that really creates tight integration between the consulting business and the rest of the business, if you will. So, I don't try to sort of look at consulting revenues as split about separately. What I will say is that we're seeing good traction and a lot of interest from clients, as I said during the earlier part of this call, engaging us upfront, understanding, helping us, inviting us to help understand and frame the business problem before, than engaging us on the downstream work as well.

Julie Santoriello - Morgan Stanley

Does that have more positive margin implications?

Francisco D'Souza

I think it's neutral, I think from a margin perspective -- but I think it certainly has significant implications in terms of our relationships with clients, the depth of our relationships with clients. The kind of dialogue we're having and then of course, the ability to drive downstream revenues.

Julie Santoriello - Morgan Stanley

Okay, thanks. And just lastly, any discussion internally on hedging strategies or plans to put a more formal program in place?

Gordon Coburn

As you Julie -- today we don't hedge at all. Am I looking at it, it doesn't make any sense. Yeah, I am looking at it, no near term decisions. In my mind the only way it would make sense is if I could get hedge accounting since I have the hedges reached mark-to-market each quarter probably that doesn't create a lot benefit for shareholders. So, we are looking at it but, no near term plan, certainly [noting]. It does clear whether all the pieces work for the instrument that we will need.

Julie Santoriello - Morgan Stanley

Okay. Thank you.

Gordon Coburn

Thanks.

Operator

Your next question comes from Mark Marostica with Piper Jaffray.

Mark Scuntows - Piper Jaffray

Good morning, it's [Mark Scuntows] for Marostica. Just a question on the SG&A line. Could you just be a little bit more specific on the scale of interest that gained here than whether we can expect to see these year-over-year gains through the rest of the year?

Gordon Coburn

There is a broad range of stock. As we transition more to our own facilities that's going to have scale efficiencies -- the scale efficiencies for communications and some of the marketing related activities and back office activities. So, the scale efficiencies is a question of when do you lever those, and when don't you. One of the ways we run the businesses, we target our operating margin and we look at SG&A, that's something we can accelerate or decelerate depending where cost of goods sold come in.

Mark Scuntows - Piper Jaffray

Okay. And then just one other question as it relates to attrition. Could you just remind us of what the components where that 20% spike that you had last year and sort of how that compares to where we are, hope for where we will be in 3Q this year?

Gordon Coburn

[You know, bill] through is now where we will be in the third quarter, because August is a tentative swing month, but third quarter last year was unusual in terms of spiking to 20%. And then as we have been running actually well below normal for the first half of last year, spiked up in the third quarter and then started to come back down. Part of it may have been that in 2006 we tried to sort of set the market on wages by indicating or keeping wage increases modest, others didn't fall in that lead, so we ended up a little bit behind market last year on wages. That may have caused that third quarter spike, obviously we fixed that this year so there wasn't any one item that caused it.

Mark Scuntows - Piper Jaffray

Okay. So just looking at the last three quarters you guys upticked year-over-year. Is that trajectory sort of expected if you look out over the next couple of quarters or should that reverse itself?

Gordon Coburn

It's a little difficult to predict, what I'd like you to assume. Are we still running a little bit higher than I'd like? Absolutely, yes. Are we running -- but it's only a little bit higher. One that concerned me was third quarter last year when there was a significant spike, now we're running a point two points higher which has got noise in my mind.

Mark Scuntows - Piper Jaffray

Okay, great. Thanks.

Operator

Your next question comes from Ashwin Shirvaikar with Citigroup.

Ashwin Shirvaikar - Citigroup

Thank you. Thank you for the fabulous results as well hopefully makes it clear there is more to revenue growth than headcount growth. I wanted to talk about the growth of your European business. Are you assigned to strategic clients there, is there something different European clients look for than U.S. clients could delve into that?

Francisco D'Souza

Yeah, it's Frank. I think that the -- I would point to a couple of things that we are doing in Europe. That I wouldn't say different but requires us to focus in a different way in Europe, because of particularly language issues and differences across continental Europe. We are having to build out local teams in each of the countries in Europe in which we are operating. And so that's probably the first, we can't rely obviously on English as the language of business in these countries even tough many of our multi-national clients operate in English, you still need to have a local language capability in each of the countries. So, that requires us to invest -- that requires us to build local teams in each of these countries and really get the local team deeply integrated with the rest of Cognizant, in our global delivery models so on and so forth.

The other thing that we are seeing to some extent in Europe, which is somewhat different than in perhaps other parts of the world, is that we tend to see interest in applications, development and system integration work, perhaps earlier than in other parts of the world where you might see a lead with application maintenance in the U.S., it tends to be a little bit more focused on application development than Europe. And that sometimes has to do with the labor laws and other regulations in Europe, which limit or prevent the displacement of existing workers in Europe.

Ashwin Shirvaikar - Citigroup

Okay. And I guess last question. As you line up client requirements that are strongest today with your capabilities, do you feel a need to over-invest in any particular areas, either organically or through acquisition or do you think you are pretty well set and set for the next 12 to 18 months?

Francisco D'Souza

Yeah. Our acquisition program is ongoing. We are always looking out there to see where there are strategic fits. We've said that we continue to look for acquisition that will extend our capabilities in really three areas. We are looking for acquisitions that are complimentary in terms of the industries that we serve. Looking to deepen our industry expertise I talked about, consulting as an increasing area of interest and so we're looking for acquisitions in the industries that we serve that can add that capability.

The second axis that we're looking for in terms of acquisitions and continue to always keep our eyes open for our technology based acquisitions. Good example of that was the acquisition we did some years ago of Aces that got us into the CRM space. And the third is, the third screen we use is geographic screen. So, we're continuing to look at acquisitions in markets in Europe that would extend or deepen our presence in the markets that we want to serve in Europe.

Ashwin Shirvaikar - Citigroup

Okay. Thank you and congratulations once again.

Gordon Coburn

Thanks Ashwin. And operator, we have time for one more call.

Operator

Your final question comes from Joseph Vafi with Jefferies & Co.

Joseph Vafi - Jefferies & Co.

Hi guys, great results. Good morning. Just one real question, but first a housekeeping, did I miss what the salary hike was for the year that you had in the quarter?

Gordon Coburn

Yeah, the salary increases affected the beginning of the second quarter. We averaged about 16% in India and very low single-digits on onsite.

Joseph Vafi - Jefferies & Co.

Okay, very good. So, the real question is now that we've taken the salary hikes for the year, we have some utilization levers coming and assuming that Rupee stay stable here in Q3, is there anything I'm missing here? Should we not have the capacity to have higher margins in Q3 if those three things have occurred and/or are stable at this point?

Gordon Coburn

No, I'm not sure I've set that expectation. However, we have promotions in October and our promotion cycle has always been twice a year, so you have some cost impact from that. And we don't want to disrupt our long-term investments, so as I said our goal is to be around midpoint of our range.

Joseph Vafi - Jefferies & Co.

Okay. So, just given some normal business development expenses that we're going to see in the quarter, but otherwise it seems like salary hikes weren't too big and there is clearly leverage off those moving forward and…

Gordon Coburn

Yeah, the big things for the year are under our belt. And the big negative things in the year under our belt, those all head in Q2. But, we are very committed to and it's still early in the game we're offshoring and so we're committed to investing for the long-term. And given where the Rupee has moved, we think that the midpoint of our range is the right thing in terms of balance of short-term and the long-term.

Joseph Vafi - Jefferies & Co.

Great, thanks so much.

Gordon Coburn

Thanks, Jeff.

Francisco D'Souza

Well, thank you everyone again for joining us on our call today. In conclusion, we're very pleased with our strong financial performance in the second quarter and our success in maintaining our operating targets, while reinvesting in the growth of the business. Moving forward, we are confident that the steadfast execution of our strategy and our commitment to expanding our global platform will continue to drive our industry leading growth. We look forward to talking to you all again next quarter. Thank you.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.

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Source: Cognizant Technology Solutions Q2 2007 Earnings Call Transcript
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