Cognizant Technology Solutions Q3 2007 Earnings Call Transcript

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 |  About: Cognizant Technology Solutions Corporation (CTSH)
by: SA Transcripts

Cognizant Technology Solutions (NASDAQ:CTSH)

Q3 2007 Earnings Call

November 5, 2007 10:00 am ET

Executives

Scott Hoffman - Financial Dynamics

Francisco D’Souza - President, CEO

Gordon Coburn – CFO, COO

Analysts

Adam Frisch - UBS

Moshe Katri - Cowen

Anthony Miller - Arete

Bryan Keane - Credit Suisse

Joseph Foresi - Janney Montgomery Scott

Ashish Thadhani - Gilford

Ed Caso - Wachovia Capital Markets

George Price - Stifel Nicolaus

Julio Quinteros - Goldman Sachs

Operator

I would like to welcome everyone to the Cognizant TechnologySolutions third quarter 2007 earnings conference call. (OperatorInstructions) I would now like to turntoday’s call over to Scott Hoffman from Financial Dynamics. Please go ahead,sir.

Scott Hoffman

Thank you, operator and good morning everyone. By now youshould have received a copy of the company’s third quarter 2007 earningsrelease. If you have not, please call our offices at 212.850.5600 and we’ll besure to get a copy sent to you.

The speakers we have on the call today are FranciscoD’Souza, President and Chief Executive Officer; and Gordon Coburn, ChiefFinancial and Operating Officer of Cognizant Technology Solutions.

Before we begin, I would like to remind you that some of thecomments made on today’s call and some of the responses to your questions maycontain forward-looking statements. These statements are subject to the risksand uncertainties as described in the company’s earnings release and otherfilings 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, Scott and good morning, everyone. Thank you allfor joining us today for Cognizant’s third quarter 2007 earnings call. Thismorning I’ll provide an overview of our third quarter results and discuss thekey drivers of our financial and operating performance. I will also discuss ourrecent announcement regarding our intention to acquire marketRx. Finally I’llprovide you with some color around clients’ 2008 spending expectations based onclient feedback from our recently concluded customer conference.

I am joined on our call today by our Chief Financial andOperating Officer, Gordon Coburn, who will take you through our financial andoperating results in greater detail in a few moments.

We had a strong third quarter, which featured healthycontinued growth across our vertical industries segments, service offerings andgeographies. Our third quarter reflects the results of several key company-widestrategic initiatives, which we laid out at the start of the year.

First, we are making the necessary investments to buildtruly distinctive capabilities in each of the markets that we serve.

Second, we continue to globalize, both on the supply and onthe demand sides of our business.

Third, we are committed to maintaining an environment atCognizant where the best talent in the world can thrive.

Finally, we are focused on building the infrastructure processesand intellectual capital to allow us to continue to scale the business.

The strongest drivers of our growth in the quarter werefueled by investments we have made recently to capture opportunities for futuregrowth. Our third quarter performance also speaks to our track record ofoperational excellence. Our strong bottom line results during the quarter onceagain demonstrated our ability to quickly pull operating levers to offsetmacroeconomic pressures on our cost structure and maintain our operating margintargets.

Looking at our third quarter results in detail, we onceagain exceeded expectations generating $558.8 million in revenue, whichrepresent an 8% sequential increase from the second quarter and an increase of48% from the third quarter of 2006. GAAP EPS was $0.32 for the quarter comparedto $0.27 last quarter, and $0.20 for the year ago quarter. These results areadjusted for the 2:1 stock split that we completed in October.

Our GAAP operating margin was 18.1%, and our non-GAAPoperating margin, which excludes stock-based compensation expense, was 19.7% atthe upper end of our target range of 19% to 20%.

Towards the end of the third quarter, Cognizant’s Board ofDirectors declared a 2:1 stock split on our capital stock in the form of astock dividend. In addition, the Cognizant board of directors authorized a sharerepurchase program of up to $100 million of the company’s common stock over thenext 12 months. This stock split recapitalization and share repurchase programunderscored the board’s confidence in the fundamental of our business and thecompany’s future prospects.

Now, I’d like to discuss the drivers of our revenue growth.One of the most important growth drivers continues to be the deep industrysector expertise that distinguishes us from the competition. We continue tobenefit from our investments in cultivating this expertise across an expandingrange of industries, including life sciences, retail manufacturing andlogistics and financial services.

During the quarter, the number of accounts that we considerto be strategic -- which means they have the potential to generate between $5million and $40 million or more in annual revenue for Cognizant over the long term-- increased by five, bringing our total number of strategic clients to 102. Aswe have said in the past, we believe that the majority of our strategicaccounts still have considerable growth potential and we expect theserelationships will expand further as the needs of our customers evolve and aswe continue to expand our range of solution offerings.

Growth in our healthcare business segment was driven by thestrong momentum of our life sciences practice, where we continue to expandwallet share amongst the world’s top global pharmaceutical and biotechnologycompanies. Revenue from life sciences customers increased 16% sequentially, and61% year over year. The accelerated growth in our life sciences practice cameas a result of clients broadening their relationships with Cognizant to coverour full spectrum of service offerings in IT infrastructure services, BPO andconsulting.

In addition, we are also starting to see a trend ofincreased adoption of the global delivery model by customers in the medicaldevices area. Our core knowledge of healthcare, life sciences and biotech isvery applicable to the medical devices segment and gives us an advantage inthat market. Today, we count amongst our customers most of the top 20pharmaceutical companies and many of the top 10 biotech and medical devicescompanies.

Our recently announced intention to acquire marketRx will,among other dimensions, strengthen our presence in the life sciences industry.I will speak about marketRx in more detail in a few moments.

Our retail manufacturing and logistics practice also continuesto perform well with 12% sequential revenue growth during the quarter, 56%growth year over year. The retail sector in particular continues to showsignificant potential as retailers continue to invest in systems andapplications to be more competitive in the marketplace. Large retailers arelooking to Cognizant to leverage the cost advantage and the broad capabilitiesthat we bring to the table, both in the packaged and custom application areas.To address the increased demand, we have strengthened our retail consultingcapabilities and built key partnerships with retail software product vendors.

Finally, I wanted to highlight the healthy growth wecontinue to see in financial services despite market concerns related to the sub-primemortgage market. Revenue from financial services client 7% sequentially and 43%year over year. Over the last several years we have established a financialservices market leadership position and we continue to win business across ourwell-diversified client base because of the depth and breadth of domainexpertise that we bring to the world’s top banking financial services andinsurance companies. While our financial services clients continue to managethrough the sub-prime related issues, the impact on their spending with Cognizantto date has been insignificant. We will continue to monitor the situation inBFS in light of the situation emanating from the sub-prime mortgage market.

Another prominent driver of our third quarter performancewas the strong return on our investments to expand and globalize the company,which was another key theme for the company in 2007. European revenuesincreased 24% sequentially and 92% year over year, compared to the thirdquarter of 2006. Our European clients now contribute approximately 17% of totalcompany revenue, compared to about 13% in the same quarter of 2006. Thesignificant increase in percent of revenues from Europeis a significant accomplishment for the company, given our goal ofglobalization.

Over the past several quarters, we’ve been expanding ourgeographic footprint in Europe as European companieshave continued to aggressively adopt offshore strategies. More recently we havefocused our investments in Europe on building outservice offering capabilities in areas such as BPO, ERP, testing,infrastructure management and CRM. These investments are showing results.

For example, in the UKwe have seen significant growth in testing services, especially in the BFSsegment. To give you an illustration, over the past three months we have builta testing team of approximately 120 consultants for a leading financialservices institution in the United Kingdom.Similarly, we are seeing demand in Europe for ouradvanced solutions practice, BPO, IT Infrastructure Services, ERP and CRM servicelines.

As a consequence, we are making necessary investments totake advantage of this increased demand by building management and deliveryteams for each of the service lines in Europe both onthe continent and also in the UK.

The strong growth of our horizontal services was not limitedonly to Europe during the quarter. We saw strong growthduring the quarter across our portfolio of horizontal services. Infrastructuremanagement, testing, ERP and CRM all grew well in excess of the companyaverage. Data warehousing and business intelligence grew 77% year over year or16% sequentially and represents another strong example of our endeavor toestablish distinctive capabilities in each of our service lines.

Our standing as a distinctive data warehousing and businessintelligence service provider was further validated when we were recentlyawarded the Best of the Best Award from Computerworld Magazine at their 2007 BestPractices in Business Intelligence conference. Cognizant was recognized in theinnovation and promise in business intelligence category for the work we did inthe area of business intelligence as a service for one of our key clients. Thisis the third consecutive year in which Computer World has recognized Cognizantfor our expertise in data warehousing and business intelligence.

Consistent with our acquisition strategy, we also recentlyannounced our intention to strengthen our global life sciences BPO and analyticofferings with the acquisition of marketRx for $135 million in cash, which weexpect to close during the fourth quarter. MarketRx is one of the largest andfastest-growing independent offshore analytics businesses providing services toglobal companies in the pharmaceutical, biotechnology and medical devicesmarket segments.

MarketRx has a unique delivery model comprised of high endknowledge processing outsourcing services delivered through an innovative,software-based platform. MarketRx is a high growth business that we expect willenable Cognizant to simultaneously accomplish several of the strategicobjectives which I laid out earlier.

First, it will extend our position in providing value-addedout sourcing services to life sciences biotechnology and medical devicescompanies. MarketRx expands our domain capabilities and broadens our serviceofferings to address all areas of the life sciences value chain, from researchand development and manufacturing to sales and marketing operations, marketRxwill bring an impressive client base to Cognizant, representing a total of 75life sciences customers including all of the largest 20 pharmaceuticalcompanies and four out of the top five biotech companies.

Secondly, we believe there is significant potential to crosssell marketRx analytic services offerings to clients in our other industryverticals, building on the success of our vertical BPO strategy. Finally, theaddition of marketRx’s expertise represents a growth opportunity forCognizant’s core technology services, since we expect to see synergies with ourexisting business intelligence and data warehousing and CRM services.

Before I comment on our outlook for the business going into2008, it’s important to note that we achieved strong performance in the thirdquarter while continuing to execute on the process we outlined in the firstquarter to address the macroeconomic challenges facing our industry.

Specifically, we followed through on our plan to increaseutilization in order to offset Rupee appreciation, wage hikes and taxes overthe course of the year. We delivered approximately 30 basis points ofsequential margin expansion and our earnings results exceeded expectations aswe further extend our track record of effectively managing our business whileinvesting to further differentiate Cognizant in the eyes of our customers.

To accommodate our expectations for future growth, we addeda net of 3,300 employees during the quarter bringing our total employee base toapproximately 49,000 worldwide at the end of September. We also recentlycrossed an important milestone when we hired our 50,000th Cognizant associate.

We are on track to end the year with our previously statedgoal of approximately 55,000 employees around the world, which underscores ourcommitment to investing in our people and infrastructure ahead of demand.Employee attrition decreased slightly from the second quarter to 16.7%, whichrepresents a significant 370 basis point decline from the year ago quarter.

We are comfortable with the progress that we made inreducing our attrition rates through an innovative combination of engagementinitiatives with our associates as we outline on previous earnings calls. As Isaid earlier, we remain committed to maintaining a environment at Cognizant inthe world where the best talent can thrive.

During the quarter, we also continued to make progress onour previously announced infrastructure expansion program across India.In addition, once completed our acquisition of marketRx will enable us toexpand Cognizant’s global delivery platform into northern Indiawhere marketRx has based its delivery operations in the New Delhi region.

Moving forward, we are confident that our rigorous customer centricfocus will continue to drive demand for our services over the long term. Anexample of our commitment to collaborating with our clients is our customerconference, Cognizant Community. Last week we concluded our eighth annual eventin North America and the largest to-date. The conferenceis significant for two reasons: first, attendance at this year’s communityexceeded 300 with Cognizant customers representing 149 companies from everyvertical industry we served.

The event enables us to strengthen our relationships withour clients and engage in substantive discussions about the common issues,challenges and opportunities that they face in their businesses and the rolethat outsourcing plays in helping them achieve their business objectives andultimately strengthen their companies.

Secondly and of equal importance, Cognizant Communityenables us to gain qualitative and quantitative insights into our customersinitial IT spending plans for the year ahead. As part of Community, weconducted a formal survey to assess our clients’ budget plans and spendingpriorities for 2008. More than 150 community attendees -- CIOs, CEOs, VPs of ITand other senior decision makers -- responded to the survey representing abroad cross-section of Cognizant clients in banking, financial services,insurance, health care, life sciences, retail, manufacturing and thetelecommunications verticals.

The survey yielded several illuminating data points. First,despite the uncertainty in the market about the economic outlook for 2008, 92%of our clients do not expect their overall IT budgets to decline going into 2008.

Second, we asked respondent to provide us with a view of thelikely impact to their offshoring budgets in the event of a decline in overallIT budgets; only 19% of the respondents said that an overall IT budgetreduction would meaningfully impact their offshore spending plans in 2008.

Thirdly, outsourcing budget growth is expected to outpaceoverall IT budget growth in 2008, with 90% of respondents citing continuedgrowth in offshore development spending.

Finally, amongst the financial services customers thatcompleted the survey, about 90% do not expect their IT outsourcing budgets todecline in 2008. On the whole, the survey gives us further confidence in thegrowth prospects for Cognizant in 2008.

Now, I will turn the call over to Gordon to walk you throughour financial and operating results in greater detail.

Gordon Coburn

Thank you, Francisco and good morning to everyone. I wouldlike to provide some additional information on the third quarter and thendiscuss our financial expectations for the remainder of the year. Revenue for thethird quarter exceeded our prior guidance and expectations due to continuedstrength in Europe, strong year-over-year growth in ourretail manufacturing and logistics segment, as well as health care, and allthree of our industry verticals within our other business segment.

Quarterly revenue grew 8% sequentially and 48% year over year.As the quarter proceeded, we continued to see healthy volume growth across a broadrange of services and industries. Our core businesses remain vibrant and ourpipeline is robust.

During the quarter, our financial services segment, whichincludes our practices in insurance, banking and transaction processing, grewby almost $79 million year over year and represented 47% of revenue for thequarter. Health care grew $43 million and represented 23% of revenues. Retailmanufacturing logistics grew by over $31 million representing approximately 15%of revenues for the quarter.

The remaining 15% of our revenues came primarily from otherservice-oriented industries of telecom, media and technology, which grew byalmost $29 million compared to the third quarter of last year.

During the quarter, financial services grew 43% year over yearand 7% sequentially. Health care grew 49% year over year and 10% sequentially.Retail manufacturing and logistics grew 56% year over year, and 12%sequentially. Growth in our retail manufacturing logistics segment was drivenby several newer retail clients, which we have won and are now ramping up.

Our other business segment grew 54% year over year and 5%sequentially. Growth in the other segment benefited from strong growth in ourinformation and media operation as well as technology and communications.

For thequarter, we saw healthy demand for our entire service offering.Application management represented 51% of revenues and application developmentwas 49%. Both services continued to grow significantly in Q3. Applicationmanagement grew 45% year over year and 6% sequentially. Application developmentgrew 52% year over year and 11% sequentially due to strong discretionaryspending during the quarter.

During the quarter, 82% of revenues came from clients in North America. Europe was approximately 17% oftotal revenue. The remaining 1% of revenue came from the Asian market. AsFrancisco mentioned, our European business grew 24% sequentially and 92% year overyear as we continue to invest in that region.

We added approximately 55 new customers during the thirdquarter. We closed the quarter with active customer base of 445. During thequarter, the number of strategic accounts which we consider to have thepotential to ramp up to at least $5 million or more than $50 million in annualrevenue increased by five, bringing the total number of strategic clients to102.

Turning to costs, on a GAAP basis, cost of revenuesexclusive of depreciation and amortization increased 52% for the quarter, ascompared to the third quarter of 2006. Third quarter cost of revenues includedapproximately $4.3 million of equity-based compensation expense.

The increase in cost of revenues was due to additionaltechnical staff both onsite and offshore required to support our revenue growthas well as the impact of the strengthening Rupee and wage increases that wereaffected in the second quarter of this year. We increased our technical staffby 3,100 during the quarter and end of the quarter we were approximately 45,800technical staff. This is a net increase of close to 13,600 technical staff fromSeptember 30, 2006.

Third quarter SG&A including depreciation and amortizationexpenses was $140.4 million on a GAAP basis up from $100.3 million in the thirdquarter of 2006. GAAP SG&A expense in Q3 of 2007 included roughly $4.8 millionof equity-based compensation expense. As a percentage of revenue SG&Aincluding depreciation and amortization expenses was down as we continue toleverage our scale efficiencies.

GAAP operating income for the quarter increased 47% to$101.1 million from $68.8 million in the third quarter of 2006. On a non-GAAPbasis, which includes the impact of $9.2 million of equity-based compensationexpense, operating income for the third quarter was $110.3 million, up almost45% from last year. Our GAAP operating margin was 18.1% for the quarter and ournon-GAAP operating margin for the quarter was 19.7%, in line with our targetrange of 19% to 20%.

During the quarter, operating income continued to beimpacted by appreciation of the Indian Rupee. The average rate for the Rupeewas approximately 40.4 inthe third quarter versus 41.1 inthe second quarter of 2007.

Interest income for the third quarter increased to $7.9million compared to $4.8 million in the third quarter of 2006. Interest incomeincreased due to higher global cash and short-term investment balances, as wellas an increase in short-term interest rates. We had a $2.6 million foreignexchange gain during the quarter.

Our GAAP tax rate for the third quarter was 13.9%. Duringthe quarter, we had a favorable settlement of certain tax uncertainties. Inaccordance with FIN 48, results of this settlement were required to berecognized as a discreet item during the quarter. Assuming no further discreetitems for the remainder of the year, we expect our fourth quarter tax rate tobe [16.4%], and our full year tax rate to be approximately 15.6%.

Turning to the balance sheet, our balance sheet remainedhealthy. We finished the quarter with over $809 million of cash and short-terminvestments, up over $273 million from September 30, 2006 and $99 million from June of this year. During thequarter, operating activities generated over $129 million of cash. Financeactivities -- primarily the exercise of stockoptions and related tax benefits -- generated approximately $18 million ofcash. These amounts were partially offset by almost $40 million in capital expenditureswith the final [inaudible] of approximately $12 million related to our 2005acquisition of Fathom Solutions.

In addition, we’ve generated approximately $2 million ofcash due to currency translation adjustments. For 2007, we continue to expectto spend up to $180 million in capital expenditures, the substantial majorityof which is related to the construction program and equipping of additionaldevelopment facilities to support our growth as we had previously announced.

Our collection of trade receivables improved slightly fromthe third quarter of 2006. Based on our $428.5 million balance in September30th, we finished the quarter with a DSO including unbilled receivables of 71days, compared to 72 days for the same period last year. During the thirdquarter, excluding unbilled receivables our DSO was approximately 61 days. Thequality of our receivables portfolio remained very strong.

Our unbilled receivables balance was approximately $56.4million at the end of the third quarter, up almost $14 million or 32% from September 30, 2006, and up less than $2million for Q2 of this year. Approximately 56% of our September 30th unbilledbalance was billed in October.

During the third quarter, over 24% of our revenue came from fixedpriced contracts, consistent with both the second quarter of this year and thethird quarter of 2006. When we look at the mix by solution type during thethird quarter, 30% of our development revenue and 18% of our maintenancerevenue came from fixed priced contracts during the quarter.

Turning to headcount, at the end of the third quarter ourworldwide headcount including both technical, professionals and support stafftotaled approximately 48,900. This represents a net increase of 3,300 peopleduring the quarter, and 14,500 since September 30, 2006. Approximately 70% of our Q3 hires were recent collegegraduates who will enter our training program, and the remainder were lateralhires of experienced IT professionals. During the fourth quarter, we expect toadd a significant number of new employees including many recent collegegraduates who will be entering our training program.

Turnover, included both voluntary and involuntary, wasslightly below 17% annualized during the third quarter. Third quarter attritionwas over 300 basis points lower than our attrition in the third quarter of 2006.As discussed previously, we have launched a global initiative to ensure thatour employees receive appropriate rewards, recognition and personal andprofessional growth opportunities across their entire life cycle withCognizant. We believe this reduced attrition is a result of those efforts.

As we discussed in the second quarter, as part of ourstrategy to offset the impact of the appreciation of the Indian Rupee, we areincreasing the company’s utilization levels due to scale economies andhistorically heavy over investment in bench resources, we were able tosuccessfully further increase our utilization rates during the third quarter.Onsite utilization increased slightly to around 87% for the quarter. Offshoreutilization excluding recent college graduates who are in our training programduring the quarter, was approximately 68%. Including trainees, offshoreutilization was approximately 58% for the quarter. We had close to 5,000 unbilledpeople in our training program at the end of the quarter, which positions uswell from a staffing perspective as we enter 2008.

I’d now like to comment on our growth expectations for theremainder of the year. The investments we are making are producing results;they’re allowing us to differentiate ourselves in the marketplace both in termsof winning and growing clients and expanding our service offerings.

For the fourth quarter of 2007, we’re projecting revenue of $590million to $595 million. As Francisco mentioned earlier, we are seeing verypositive comments from our clients regarding the planned 2008 spend on offshoreoutsourcing. However, we are not seeing a year end budget flush as weexperienced in the prior few years. We continue to have significant revenuevisibility due to our high level of recurring revenue and long-term nature ofour customer relationships. In fact, today we have customer commitments for farin excess of 90% of our fourth quarter revenue guidance.

For the full year 2007, based on the strong demandenvironment for offshore services and the favorable experience on ramp-up rates,we are pleased to increase our guidance to between $2.125 billion and $2.13billion, a $15 million plus increase from our prior guidance given in earlyAugust. This revised guidance represents a growth of approximately 49% and anincrease of over $700 million in revenue compared to 2006.

As has been typical in past years, we expect a majority ofour growth for remainder of 2007 will come from the ramp-up of clients we havewon over the past few years.

Assuming no further material appreciation of the Rupee, ourguidance assumes that we will continue to be in the upper half of our targeted19% to 20% non-GAAP before the impact of equity-based compensation range forthe fourth quarter. With this expected level of revenue growth, and ourexpected operating margins, we are currently comfortable with our ability todelivering the fourth quarter GAAP EPS of $0.31 and non-GAAP EPS of $0.34excluding equity compensation expense of approximately $0.03.

This guidance includes the anticipation of a Q4 share countof approximately 307 million shares, a tax rate of 16.4% and an operatingmargin in the upper half of our historical guidance range of 19% to 20%excluding the cost of equity compensation.

For the full year 2007, based on current business trends, wecurrently project GAAP EPS to be $1.14 and full year non-GAAP EPS to be $1.24,excluding equity compensation expense of appropriately $0.10. This guidanceincludes anticipation of a full year tax rate of 15.6%, a share count ofapproximately 304.7 million shares and an operating margin in the upper half ofour guidance range.

Please note that our GAAP EPS guidance for the fourthquarter and full year assume no P&L impact from the recently enacted fringebenefit tax on the exercise of stock options in India.The accounting treatment for this new tax has yet to be finalized by theaccounting industry.

In conclusion, we are very pleased with our strong growth inQ3 and are quite optimistic about our market position for the future. Webelieve that we understand the margin related issues currently facing theindustry and that we have taken appropriate short-term and long-term actions tomanage these issues while continuing to invest in long-term growth.

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

Question-and-AnswerSession

Operator

Your first question comes from Adam Frisch - UBS.

Adam Frisch - UBS

In reading the release, both of you went out of your way tospeak very positively and favorably about the ‘08 growth outlook, which I foundcomforting. I am wondering how we should connect the dots between the slowdownwe’ve seen through ‘07 and especially what we are seeing, and I know the year-over-yearcomps are tough in the fourth quarter but 3Q came in a little bit light as yourstock is reflecting this morning. How do we connect the dots here in terms ofthe slowdown that we are seeing in ‘07? Does that continue into ‘08 or were therecertain actions in the second half of the year, which don’t necessarily makethem the right points to extrapolate next year’s growth trends on?

Francisco D’Souza

I think you have to look at a couple of things. When youlook at the third quarter, the growth across our segments was actually quitehealthy, as Gordon mentioned, healthcare grew 10% sequentially. Retailmanufacturing and logistics grew 12% sequentially. Europewas very strong at 24% sequentially. Financial services grew 7% sequentially.

Now its interesting, if you parse out financial services alittle bit, between financial services and insurance, what happened in thethird quarter in financial services or our BFSI segment if you will, is thatthe financial services piece actually grew considerably faster than 7% andinsurance actually grew slower than the 7%. We actually saw strength in the corefinancial services sector as well.

So overall if you look at the pieces of the business, theyare all growing quite well in the third quarter. As you look out to the fourthquarter as Gordon said, what’s really going on there is that unlike in prioryears, we are just not seeing the budget flush that we saw in prior fourthquarters.

Gordon Coburn

I think Francisco hit the key thing. If you look historicallysome fourth quarters we saw very nice sequential growth. Other fourth quarters werea little bit weaker due to customers not pulling projects or launching projectsearly. Clearly this year we aren’t not seeing that budget flush, but we alsothink that actually sets us up fairly well on a sequential basis for next year.

In our mind, the most important thing is what we’re hearingfrom our clients at this point despite some of the economic headwinds, clientsare saying they want to keep increasing outsourcing in 2008. The big question,if you go back six, eight, ten weeks ago, was what did all of this creditcrunch mean for the 2008 budgets? What we are hearing so far now that we havesome quantitative data from our clients is we were hearing that some of theeconomic issues may yet turn out to be a positive factor for us.

Adam Frisch - UBS

Hitting the trend line topic, I appreciate your color there,but I think the critical point here now is the trend lines that we are seeing,especially in the fourth quarter of growth at the top end being around 40% andmaybe a little bit slower; is that the kind of growth we should expect goingforward? Can we actually see a rebound or somewhat of an acceleration as wehead out of fourth quarter?

Gordon Coburn

Obviously the year-over-year comparable for the quarter istough in the fourth quarter. We are not ready to give guidance for 2008 as wehave done always in the past. We want to finish the planning cycle with ourclients so when we put out numbers we will have a great deal of confidence inthem. So a little too early to know exactly what the numbers will be for 2008 butcertainly qualitatively, we are hearing quite positive things from our clients.

Adam Frisch - UBS

[Management] has slowed sequentially but developmentactually accelerated. So that’s also I guess that’s a positive sign in termswhat your clients are thinking. Not what you would normally expect you get onnegative expectations out there on macro spending.

Gordon Coburn

That was a pleasant surprise. In Q3 the discretionaryspending was strong despite some of the macroeconomic activity. What that saysis clients still want to get work done and to get it done they are moving itoffshore.

Adam Frisch - UBS

Were there any company or more likely customer-specificissues in the quarter here where maybe a ramp-up didn’t happen as fast orsomeone decreased spending where that impacted the overall rate?

Gordon Coburn

A little bit there, but nothing that stands out.

Adam Frisch - UBS

The factors driving down the SG&A expense as percent ofrevenues, are these kind of things sustainable and should we expect this tocontinue in the future? Was it part of a utilization increase or was it a one-timething in the third quarter?

Gordon Coburn

No. I do not view that as one time. Clearly, there are scaleefficiencies in SG&A. Our goal is to continue to stay in that, excludingoption expense, in the 19% to 20% margin range. We still have leverage we canpull if needed but as we have demonstrated in the third quarter, the leversthat we pulled kicked in nicely and we’re feeling pretty good about our abilityto match costs; so that is not at the top of our priorities to focus on.

Operator

Your next question comes from Moshe Katri - Cowen.

Moshe Katri - Cowen

The budget flush comment, is that coming out from anyspecific vertical or verticals and maybe top ten clients? Then also focusing onthe budget cycle that’s going on right now, we are hearing that the decisionson ‘08 spending budgets have been pushed out from the typical, I don’t know,you guys typically hear about this towards the end of November and earlyDecember and now we’re talking about January. Is this something that you arehearing as well and will that impact funding for projects in Q1 of next year?Thanks.

Gordon Coburn

Well, let me take the first part of the question. Franciscowill talk about the budgets. The question on the budget flush or lack of budgetflush in any one industry, the answer is no. It’s across the board. It’sclearly not something that’s specific to financial services. When I look acrossall of our segments, it’s fairly consistent.

Francisco D’Souza

With respect to the budget cycle, Moshe, as I said, we’vejust come back from the customer conference. I didn’t hear anything although wedidn’t specifically ask the question during the formal part of the survey.Nothing that I heard qualitatively tells me that budget cycles are gettingelongated beyond the normal process. The normal process at clients is that youstart to get some clarity in November and December but in reality most clientsdon’t lock down their budgets until the earlier and middle part of the firstquarter, so nothing that I heard at the customer conference suggested thatgoing to go longer than that.

Moshe Katri - Cowen

Gordon, can you comment on pricing during the quarter onsiteversus offshore?

Gordon Coburn

Really no surprises there. Onsite sequentially, we were up alittle bit. Offshore was flat but that’s more as BPO is ramping up so if you justtook IT, we would have been up a little bit. So we were tracking right where weare planning on average realized rate up about 2% for the year.

Operator

Your next question comes from Anthony Miller - Arete.

Anthony Miller -Arete

I’m just interested in those statistics you gave from yourcustomer forum when you said, 92% do not expect an overall IT budget to decline,19% say budget reduction would may increase would not reduce offshore spending.For the 8% who do expect their overall IT budget to decline going into ‘08,what would characterize them? Where they in a particular industry sector? Werethere particular pressures that are unique and similarly for those that said overallthat IT reduction budget reduction would reduce offshore again, can you characterizewhy?

Gordon Coburn

We looked at that. It’s hard to draw conclusions. Thereasons are all over the place. You have a few people for example, that mighthave had an unusually high investment year in 2007 and just naturally budgetswill go down in 2008. I can think of aclient or two that has done that. Then you just have some clients who look atthings and say, given if our overall IT spending were to decline, that wouldhave a proportionate impact on our offshore spending. That tends to be the moremature clients who have moved a substantial amount of their work offshore.

For the clients who are less mature with off shoring, youtypically tend to find that a budget cut will incent them to move work offshorea little bit more aggressively. But when there isn’t that opportunity to dothat because they’ve moved a lot of their work already offshore, then an acrossthe board budget cut will have the impact of potentially reducing the spendingboth offshore as well.

That sort of ties if you will to comments we made earlierabout our strategic customers and the number of customers that we think aremature in that they’ve moved significant portions of the work that they canmove offshore. That number in our case is relatively low and that reflects inthese statistics as well.

Anthony Miller -Arete

Did you run a similar survey this time last year? And if sohow did the results compare?

Gordon Coburn

I know. We did not do a formal survey last year.

Operator

Your next question comes from Bryan Keane - Credit Suisse.

Bryan Keane - CreditSuisse

I’m just trying to understand, you are not seeing a budgetflush at the end of this year but you feel confident about 2008. Why wouldn’tyou be nervous about 2008 as the budget flush isn’t coming this year?

Gordon Coburn

I think it’s really based on what our clients are tellingus. They are saying that this year they don’t have the extra money in their2007 budget but as they are planning and starting to lock down their budgets orget further into the budget process for 2008, that part of the way they are making theirbudgets work for next year is to further leverage offshoring.

In prior years sometimes you would see people start adevelopment project this year instead of wait to January 1, or try to finishone up earlier because people just had more dollars left over. What we’rehearing this year, they have stuff ready to go, but they have to wait for theirnew budget dollars to become available.

Bryan Keane - CreditSuisse

If you look at the revenue by geography, obviously Europegrew exponentially but North America didn’t grow quiteas fast. I have it at about 5.6% sequentially; that’s slower than we’ve seen inthe past. Was there anything in particular in North Americathat slowed the revenue sequentially?

Gordon Coburn

Really nothing. There was no one item. Nothing specific.

Bryan Keane - CreditSuisse

Finally, obviously we’re all going to be waiting for 2008and beyond. I don’t know, Francisco, is there any kind of long-term growth rateor revenue growth rate you think the company can maintain over the next threeyears that we can kind of target?

Francisco D’Souza

What we’ve said in the past and what we continue to becomfortable with is that given the investments we’re making in the businessthat we can continue to grow the business faster than the industry and fasterthan our key competitors and I’m comfortable with that.

Bryan Keane - CreditSuisse

Any idea how fast the industry is supposed to grow nextyear?

Gordon Coburn

There are a lot of statistics out there and the industrywill grow probably slower than our competitors. So that’s one that fleshes outas we go along. When we think about our strategy of keeping our margins alittle bit lower than our competitors, which we’ve done for years andreinvesting that back into relationship management, the customer experience,domain expertise. We feel the best measure for ourselves and we hope the wayinvestors think about measuring our strategy as successful is are we growingfaster that our key competitors? That’s something on a full year basis obviouslywe have been doing for a while and based on what we see, we believe that willcontinue.

Operator

Your next question comes from Joseph Foresi - JanneyMontgomery Scott.

Joseph Foresi -Janney Montgomery Scott

I wonder if you could talk a little bit about the change in methodologythat we’re seeing involving guidance. Typically we see a number and then obviously a freeze associated withit. Is that just sort of a quarterly change? Or has there been a change in thethought process in giving guidance?

Gordon Coburn

That is really two things. One, because we had our client eventlast week, we released the earnings a couple days later than normal and thereforewe have our October results in already so we have a better sense of where weare and we had a couple analysts who were getting fairly aggressive. So wewanted to make sure that people didn’t have unrealistic expectations for Q4. Sowe wanted to set more of a boundary for this quarter.

Obviously when you start a year and you have 11 months aheadof you, I would expect we’ll probably go back to our old language as we getinto next year.

Joseph Foresi -Janney Montgomery Scott

A second question here, it sounds like what you’re seeing isless of a budget flush but you’re confident of spending toward next year.Assuming that it’s not the picture that you’re seeing right now, is there a waythat you guys plan on maybe compensating for a potential slowdown and if sowhat are the areas of growth that you would target in order to continue to keepthe business moving forward?

Because of our strategy of heavily reinvesting in thebusiness, we are already investing in multiple areas at once, both service lineexpansion, geographic expansion, domain expertise. So I think we’ll continuethat strategy. Obviously if there’s a major recession, that’s going to impacteveryone. The good news is based on what clients are saying now, it seemsfairly clear to us that cutting offshore is not going to be at the top of theirlist.

Joseph Foresi -Janney Montgomery Scott

Lastly, just curious as to what the impacts you’re expectingfrom the recent acquisition next quarter on the top line.

Gordon Coburn

For the fourth quarter, we expect marketRx to close as weget further into the latter part of the quarter. So the impact on Q4 will befairly small and we have a small amount of revenue built in. Obviously we getthe full impact for Q1.

Operator

Your next question comes from Ashish Thadhani - Gilford.

Ashish Thadhani -Gilford

Do you have anything more specific for marketRx on anannualized basis in terms of revenue, recent growth and profitability?

Gordon Coburn

Yes. On a full year basis marketRx will be a $40 millionplus business in 2007. Profit margins excluding all of the purchase accountingstuff for 2008, we would expect it to beroughly in line with company average. It’s a business that’s obviously growingand we bought it not for any cost synergies, they already are a veryefficiently-run business. We think there are some meaningful revenue synergiesthat we would certainly hope to capture as we go into 2008.

Ashish Thadhani -Gilford

There has been some talk of salary moderation attributed toCognizant management. Could you elaborate on your expectations for next year?

Gordon Coburn

Obviously, we don’t give our salary increases until April. Howmuch we give will depend largely on what other tier one players give, becausewe certainly will make sure that we’re competitive with our tier one players,but we certainly will not be seeking to gain any advantage there. We’re hopefulthat wage increases in 2008 will be less than 2007, but a little too early toknow for sure as we get into the first quarter, we should start to probably geta better flavor on that.

Operator

Your next question comes from Ed Caso - Wachovia CapitalMarkets.

Ed Caso - WachoviaCapital Markets

Any initial thoughts on the tax rate for 2008?

Francisco D’Souza

Ed, did you say 2008 or 2009?

Ed Caso - WachoviaCapital Markets

2008.

Gordon Coburn

2008, I would not expect any material change from the 16.4%.So this year, full year will be 15.6%, because we had one timers, but onexcluding the one timers, we are at 16.4% for this year. So, certainly my modelfor next year, I’m assuming, will be around 16.4% again. I am sure it will be alittle less or a little more, but that would be our best guess.

Ed Caso - WachoviaCapital Markets

I didn’t hear it if you did, your top account percentage ofrevenue?

Gordon Coburn

The top five customers in the third quarter represented 24%of revenue, and the top ten customers represented 34% of revenue. Each of thosewere down 1 percentage point from the second quarter, which is a trend thatobviously has been going on for a long time as the size of our customer basegrows.

Ed Caso - WachoviaCapital Markets

One last one on the H1B, as I see this legislative proposalto maybe push up the fee to $5,000 per application from $1,500. I don’t know ifyou knew where that stood and how important are the H1Bs and are you changingthe way the model works and maybe address some of the tightness in H1B market.

Gordon Coburn

Certainly, our business model has enabled us to do more andmore US basedhiring as we get bigger, so we don’t have the utilization risks. So, wecontinue to increase our UShiring. Certainly, it is important to leverage the visa programs to bring overwhere the specific skill sets that we can’t find here as well as some of theknowledge of the onsite offshore model. Obviously, we prefer the fees don’t goup, but given the size of our corporation I’m not sure if the fees goes up alittle bit it won’t materially change anything.

Operator

Your next question comes from George Price - StifelNicolaus.

George Price - StifelNicolaus

Just going back to the comments on the financial servicesvertical and you noted Frank, that insurance was actually the slower growingcomponent as opposed to the other financial services area that people might bemore concerned about. Why did insurance grow slower? Did something happen at aparticularly large client, or can you give us a little bit more color aroundthat?

Francisco D’Souza

We obviously looked into that in detail. There’s nothingreally specifically going there. We just look at that as the ups and downs inthe business. Insurance, as you know, has been growing very well for us over along period of time now. The insurance segment is one where we have a very goodposition in the marketplace. So, I wouldn’t attribute that at this point toanything beyond just the ups and downs of the business.

George Price - StifelNicolaus

When you’re talking about budgets, flattish budgets lookinginto next year overall, do you have an overall view on this year? Where I’mgoing with the question is, just based on what you maybe saw this year for yourview of what overall budgets did this year, even if they are still going to beflattish and maybe up a little bit, the growth is probably going to be down sayfrom this year and I’m just trying to understand the confidence in that, you losethat multiplier effect even given the offshore component maybe increasingwithin those budgets.

Gordon Coburn

Just to be clear on the survey for next year, we are 92% ofthe clients said budget is not declining, but that doesn’t mean they are allflat. So, we would expect that overall IT budgets are growing a little bit fornext year. How much compared to this year? Our sense is that becomes more of arounding error. I’m not sure there are any dramatically different trends thatwe’re ever seeing at this point.

George Price - StifelNicolaus

Gordon, did you say 304.7 million shares for the fourthquarter.

Gordon Coburn

Our guidance is based for the full year 304.7 million, forthe fourth quarter 307 million.

Operator

Your final question comes from Julio Quinteros - GoldmanSachs.

Julio Quinteros -Goldman Sachs

The 2008 outlook, maybe approaching it a little bitdifferently from more of a bottoms up perspective. If we look at headcountgrowth for 2007, right now we’re looking for about 42% headcount growth tofinish the year of 55,000. Thinking about that into 2008 from a utilizationperspective, or pricing perspective, and the levers that normally drive thisbusiness, why would we not see kind of the normal trend that we’ve seen overthe last two or three years where headcount growth is one of the most importantleading indicators that we have for revenue growth into ‘08?

Gordon Coburn

Sure. That’s an important question. For a couple years,Julio, we’re trying to take utilization down. We actually grew headcount fasterthan revenue. Now, we’re taking utilization up a bit. As we’ve gotten scaleefficiencies, we came to understand that we were sub-optimized a little bitrunning as low a utilization as we did. So we’ve come up several points thisyear. I would expect we’ll go up a little bit more next year even if the Rupeedoesn’t move just because it’s the right thing to do operationally. So, I thinkthat’s driven by some the natural scale efficiencies in utilization. We’ll becoming out of the year with a very healthy bench of freshers who are in thetraining program and obviously, we do as much lateral hiring as we need.

Julio Quinteros -Goldman Sachs

So if your headcount growth finishes in the 42% range,utilization is going up, pricing is probably flat to up next year as well. Itwould seem like anything below a 40% growth rate would be a little bitconservative, or am I thinking about that incorrectly?

Gordon Coburn

We haven’t given guidance for next year, and it all dependson how much lateral hiring we do. But as Francisco and I said, we are certainlyhearing positive things from our customers.

Julio Quinteros -Goldman Sachs

Let me try for a different perspective. On the keycompetitors Satyam, TCS, Infosys on average are expected to grow about 30% nextyear. Some of these guys are double the size that you guys have. Does seemslike a sustainable growth rate at least for the next 12 months for the keycompetitors of the industry?

Gordon Coburn

Let me be clear, we would certainly expect to grow fasterthan our key competitors. We don’t see that we’re about to fall off a cliff byany stretch of the imagination based on what we know today.

Julio Quinteros -Goldman Sachs

Finally on the margins, the gross margin sequentially itlooked like it was down from where you were last quarter, typically June is thetrough. Can you just give us the kind of the breakdown of what drove the grossmargins from June into September, on a basis point perspective if possible?

Gordon Coburn

The big piece of that is because the efficiency actionprimarily utilization really kicked in and we’re getting the benefit from it.We are sharing that with our employees through higher bonuses. So, we took ourbonus accruals up in the third quarter. We committed to our employees to do it,if they could generate the [inaudible].

Julio Quinteros -Goldman Sachs

The Rupee, we know what that did. Anything else? I think youmentioned D&A as well, was there anything with D&A, no, that’s actuallyout of that line. Okay.

Gordon Coburn

The Rupee wasn’t that. It was the Rupee a little bit,actually the Rupee and the bonuses, those are the two.

Operator

I’d like to turn the call back over to management forclosing remarks.

Francisco D’Souza

Thank you very much, everyone again for joining us on thecall today. In conclusion I just would like to say that we’re pleased with ourstrong financial performance during the third quarter. Moving forward, wecontinue to closely manage the business model to generate long-term value forour shareholders while investing in further differentiating Cognizant in the eyesour customers.

We’re confident that our focused investment strategy and ourability to capitalize on the most strategic opportunity for future growth willcontinue to translate into strong financial and operating results. We lookforward to talking to you again next quarter. Thank you.

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