Cognizant Technology Solutions Q3 2007 Earnings Call Transcript

Cognizant Technology Solutions (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

Presentation

Operator

I would like to welcome everyone to the Cognizant Technology Solutions third quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn today’s call over to Scott Hoffman from Financial Dynamics. Please go ahead, sir.

Scott Hoffman

Thank you, operator and good morning everyone. By now you should have received a copy of the company’s third 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, Scott and good morning, everyone. Thank you all for joining us today for Cognizant’s third quarter 2007 earnings call. This morning I’ll provide an overview of our third quarter results and discuss the key drivers of our financial and operating performance. I will also discuss our recent announcement regarding our intention to acquire marketRx. Finally I’ll provide you with some color around clients’ 2008 spending expectations based on client feedback from our recently concluded customer conference.

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

We had a strong third quarter, which featured healthy continued growth across our vertical industries segments, service offerings and geographies. Our third quarter reflects the results of several key company-wide strategic initiatives, which we laid out at the start of the year.

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

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

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

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

The strongest drivers of our growth in the quarter were fueled by investments we have made recently to capture opportunities for future growth. Our third quarter performance also speaks to our track record of operational excellence. Our strong bottom line results during the quarter once again demonstrated our ability to quickly pull operating levers to offset macroeconomic pressures on our cost structure and maintain our operating margin targets.

Looking at our third quarter results in detail, we once again exceeded expectations generating $558.8 million in revenue, which represent an 8% sequential increase from the second quarter and an increase of 48% from the third quarter of 2006. GAAP EPS was $0.32 for the quarter compared to $0.27 last quarter, and $0.20 for the year ago quarter. These results are adjusted for the 2:1 stock split that we completed in October.

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

Towards the end of the third quarter, Cognizant’s Board of Directors declared a 2:1 stock split on our capital stock in the form of a stock dividend. In addition, the Cognizant board of directors authorized a share repurchase program of up to $100 million of the company’s common stock over the next 12 months. This stock split recapitalization and share repurchase program underscored the board’s confidence in the fundamental of our business and the company’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 industry sector expertise that distinguishes us from the competition. We continue to benefit from our investments in cultivating this expertise across an expanding range of industries, including life sciences, retail manufacturing and logistics and financial services.

During the quarter, the number of accounts that we consider to be strategic -- which means 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 five, bringing our total number of strategic clients to 102. As we have said in the past, we believe that the majority of our strategic accounts still have considerable growth potential and we expect these relationships will expand further as the needs of our customers evolve and as we continue to expand our range of solution offerings.

Growth in our healthcare business segment was driven by the strong momentum of our life sciences practice, where we continue to expand wallet share amongst the world’s top global pharmaceutical and biotechnology companies. Revenue from life sciences customers increased 16% sequentially, and 61% year over year. The accelerated growth in our life sciences practice came as a result of clients broadening their relationships with Cognizant to cover our full spectrum of service offerings in IT infrastructure services, BPO and consulting.

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

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 continues to perform well with 12% sequential revenue growth during the quarter, 56% growth year over year. The retail sector in particular continues to show significant potential as retailers continue to invest in systems and applications to be more competitive in the marketplace. Large retailers are looking to Cognizant to leverage the cost advantage and the broad capabilities that we bring to the table, both in the packaged and custom application areas. To address the increased demand, we have strengthened our retail consulting capabilities and built key partnerships with retail software product vendors.

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

Another prominent driver of our third quarter performance was the strong return on our investments to expand and globalize the company, which was another key theme for the company in 2007. European revenues increased 24% sequentially and 92% year over year, compared to the third quarter of 2006. Our European clients now contribute approximately 17% of total company revenue, compared to about 13% in the same quarter of 2006. The significant increase in percent of revenues from Europe is a significant accomplishment for the company, given our goal of globalization.

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

For example, in the UK we have seen significant growth in testing services, especially in the BFS segment. To give you an illustration, over the past three months we have built a testing team of approximately 120 consultants for a leading financial services institution in the United Kingdom. Similarly, we are seeing demand in Europe for our advanced solutions practice, BPO, IT Infrastructure Services, ERP and CRM service lines.

As a consequence, we are making necessary investments to take advantage of this increased demand by building management and delivery teams for each of the service lines in Europe both on the continent and also in the UK.

The strong growth of our horizontal services was not limited only to Europe during the quarter. We saw strong growth during the quarter across our portfolio of horizontal services. Infrastructure management, testing, ERP and CRM all grew well in excess of the company average. Data warehousing and business intelligence grew 77% year over year or 16% sequentially and represents another strong example of our endeavor to establish distinctive capabilities in each of our service lines.

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

Consistent with our acquisition strategy, we also recently announced our intention to strengthen our global life sciences BPO and analytic offerings with the acquisition of marketRx for $135 million in cash, which we expect to close during the fourth quarter. MarketRx is one of the largest and fastest-growing independent offshore analytics businesses providing services to global companies in the pharmaceutical, biotechnology and medical devices market segments.

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

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

Secondly, we believe there is significant potential to cross sell marketRx analytic services offerings to clients in our other industry verticals, building on the success of our vertical BPO strategy. Finally, the addition of marketRx’s expertise represents a growth opportunity for Cognizant’s core technology services, since we expect to see synergies with our existing business intelligence and data warehousing and CRM services.

Before I comment on our outlook for the business going into 2008, it’s important to note that we achieved strong performance in the third quarter while continuing to execute on the process we outlined in the first quarter to address the macroeconomic challenges facing our industry.

Specifically, we followed through on our plan to increase utilization in order to offset Rupee appreciation, wage hikes and taxes over the course of the year. We delivered approximately 30 basis points of sequential margin expansion and our earnings results exceeded expectations as we further extend our track record of effectively managing our business while investing to further differentiate Cognizant in the eyes of our customers.

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

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

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

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

Moving forward, we are confident that our rigorous customer centric focus will continue to drive demand for our services over the long term. An example of our commitment to collaborating with our clients is our customer conference, Cognizant Community. Last week we concluded our eighth annual event in North America and the largest to-date. The conference is significant for two reasons: first, attendance at this year’s community exceeded 300 with Cognizant customers representing 149 companies from every vertical industry we served.

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

Secondly and of equal importance, Cognizant Community enables us to gain qualitative and quantitative insights into our customers initial IT spending plans for the year ahead. As part of Community, we conducted a formal survey to assess our clients’ budget plans and spending priorities for 2008. More than 150 community attendees -- CIOs, CEOs, VPs of IT and other senior decision makers -- responded to the survey representing a broad cross-section of Cognizant clients in banking, financial services, insurance, health care, life sciences, retail, manufacturing and the telecommunications 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 the likely impact to their offshoring budgets in the event of a decline in overall IT budgets; only 19% of the respondents said that an overall IT budget reduction would meaningfully impact their offshore spending plans in 2008.

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

Finally, amongst the financial services customers that completed the survey, about 90% do not expect their IT outsourcing budgets to decline in 2008. On the whole, the survey gives us further confidence in the growth prospects for Cognizant in 2008.

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

Gordon Coburn

Thank you, Francisco and good morning to everyone. I would like to provide some additional information on the third quarter and then discuss our financial expectations for the remainder of the year. Revenue for the third quarter exceeded our prior guidance and expectations due to continued strength in Europe, strong year-over-year growth in our retail manufacturing and logistics segment, as well as health care, and all three 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 broad range of services and industries. Our core businesses remain 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 almost $79 million year over year and represented 47% of revenue for the quarter. Health care grew $43 million and represented 23% of revenues. Retail manufacturing logistics grew by over $31 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 almost $29 million compared to the third quarter of last year.

During the quarter, financial services grew 43% year over year and 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 driven by 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 our information and media operation as well as technology and communications.

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

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

We added approximately 55 new customers during the third quarter. We closed the quarter with active customer base of 445. During the quarter, the number of strategic accounts which we consider to have the potential to ramp up to at least $5 million or more than $50 million in annual revenue increased by five, bringing the total number of strategic clients to 102.

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

The increase in cost of revenues was due to additional technical staff both 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 second quarter of this year. We increased our technical staff by 3,100 during the quarter and end of the quarter we were approximately 45,800 technical staff. This is a net increase of close to 13,600 technical staff from September 30, 2006.

Third quarter SG&A including depreciation and amortization expenses was $140.4 million on a GAAP basis up from $100.3 million in the third quarter of 2006. GAAP SG&A expense in Q3 of 2007 included roughly $4.8 million of equity-based compensation expense. As a percentage of revenue SG&A including depreciation and amortization expenses was down as we continue to leverage 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-GAAP basis, which includes the impact of $9.2 million of equity-based compensation expense, operating income for the third quarter was $110.3 million, up almost 45% from last year. Our GAAP operating margin was 18.1% for the quarter and our non-GAAP operating margin for the quarter was 19.7%, in line with our target range of 19% to 20%.

During the quarter, operating income continued to be impacted by appreciation of the Indian Rupee. The average rate for the Rupee was approximately 40.4 in the third quarter versus 41.1 in the second quarter of 2007.

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

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

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

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

Our collection of trade receivables improved slightly from the third quarter of 2006. Based on our $428.5 million balance in September 30th, we finished the quarter with a DSO including unbilled receivables of 71 days, compared to 72 days for the same period last year. During the third quarter, excluding unbilled receivables our DSO was approximately 61 days. The quality of our receivables portfolio remained very strong.

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

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

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

Turnover, included both voluntary and involuntary, was slightly below 17% annualized during the third quarter. Third quarter attrition was 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 that our employees receive appropriate rewards, recognition and personal and professional growth opportunities across their entire life cycle with Cognizant. We believe this reduced attrition is a result of those efforts.

As we discussed in the second quarter, as part of our strategy to offset the impact of the appreciation of the Indian Rupee, we are increasing the company’s utilization levels due to scale economies and historically heavy over investment in bench resources, we were able to successfully further increase our utilization rates during the third quarter. Onsite utilization increased slightly to around 87% for the quarter. Offshore utilization excluding recent college graduates who are in our training program during the quarter, was approximately 68%. Including trainees, offshore utilization was approximately 58% for the quarter. We had close to 5,000 unbilled people in our training program at the end of the quarter, which positions us well from a staffing perspective as we enter 2008.

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

For the fourth quarter of 2007, we’re projecting revenue of $590 million to $595 million. As Francisco mentioned earlier, we are seeing very positive comments from our clients regarding the planned 2008 spend on offshore outsourcing. However, we are not seeing a year end budget flush as we experienced in the prior few years. 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 far in excess of 90% of our fourth quarter revenue guidance.

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

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

Assuming no further material appreciation of the Rupee, our guidance assumes that we will continue to be in the upper half of our targeted 19% to 20% non-GAAP before the impact of equity-based compensation range for the fourth quarter. With this expected level of revenue growth, and our expected operating margins, we are currently comfortable with our ability to delivering the fourth quarter GAAP EPS of $0.31 and non-GAAP EPS of $0.34 excluding equity compensation expense of approximately $0.03.

This guidance includes the anticipation of a Q4 share count of approximately 307 million shares, a tax rate of 16.4% and an operating margin 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, we currently 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 guidance includes anticipation of a full year tax rate of 15.6%, a share count of approximately 304.7 million shares and an operating margin in the upper half of our guidance range.

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

In conclusion, we are very pleased with our strong growth in Q3 and are quite optimistic about our market position for the future. We believe that we understand the margin related issues currently facing the industry and that we have taken appropriate short-term and long-term actions to manage these issues while continuing to invest in long-term growth.

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

Question-and-Answer Session

Operator

Your first question comes from Adam Frisch - UBS.

Adam Frisch - UBS

In reading the release, both of you went out of your way to speak very positively and favorably about the ‘08 growth outlook, which I found comforting. I am wondering how we should connect the dots between the slowdown we’ve seen through ‘07 and especially what we are seeing, and I know the year-over-year comps are tough in the fourth quarter but 3Q came in a little bit light as your stock is reflecting this morning. How do we connect the dots here in terms of the slowdown that we are seeing in ‘07? Does that continue into ‘08 or were there certain actions in the second half of the year, which don’t necessarily make them 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 you look at the third quarter, the growth across our segments was actually quite healthy, as Gordon mentioned, healthcare grew 10% sequentially. Retail manufacturing and logistics grew 12% sequentially. Europe was very strong at 24% sequentially. Financial services grew 7% sequentially.

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

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

Gordon Coburn

I think Francisco hit the key thing. If you look historically some fourth quarters we saw very nice sequential growth. Other fourth quarters were a little bit weaker due to customers not pulling projects or launching projects early. Clearly this year we aren’t not seeing that budget flush, but we also think 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 hearing from our clients at this point despite some of the economic headwinds, clients are 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 credit crunch mean for the 2008 budgets? What we are hearing so far now that we have some quantitative data from our clients is we were hearing that some of the economic 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% and maybe a little bit slower; is that the kind of growth we should expect going forward? Can we actually see a rebound or somewhat of an acceleration as we head out of fourth quarter?

Gordon Coburn

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

Adam Frisch - UBS

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

Gordon Coburn

That was a pleasant surprise. In Q3 the discretionary spending was strong despite some of the macroeconomic activity. What that says is clients still want to get work done and to get it done they are moving it offshore.

Adam Frisch - UBS

Were there any company or more likely customer-specific issues in the quarter here where maybe a ramp-up didn’t happen as fast or someone 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 of revenues, are these kind of things sustainable and should we expect this to continue in the future? Was it part of a utilization increase or was it a one-time thing in the third quarter?

Gordon Coburn

No. I do not view that as one time. Clearly, there are scale efficiencies in SG&A. Our goal is to continue to stay in that, excluding option expense, in the 19% to 20% margin range. We still have leverage we can pull if needed but as we have demonstrated in the third quarter, the levers that we pulled kicked in nicely and we’re feeling pretty good about our ability to 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 any specific vertical or verticals and maybe top ten clients? Then also focusing on the budget cycle that’s going on right now, we are hearing that the decisions on ‘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 early December and now we’re talking about January. Is this something that you are hearing 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. Francisco will talk about the budgets. The question on the budget flush or lack of budget flush in any one industry, the answer is no. It’s across the board. It’s clearly not something that’s specific to financial services. When I look across all of our segments, it’s fairly consistent.

Francisco D’Souza

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

Moshe Katri - Cowen

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

Gordon Coburn

Really no surprises there. Onsite sequentially, we were up a little bit. Offshore was flat but that’s more as BPO is ramping up so if you just took IT, we would have been up a little bit. So we were tracking right where we are 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 your customer 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? Were there particular pressures that are unique and similarly for those that said overall that IT reduction budget reduction would reduce offshore again, can you characterize why?

Gordon Coburn

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

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

That sort of ties if you will to comments we made earlier about our strategic customers and the number of customers that we think are mature in that they’ve moved significant portions of the work that they can move offshore. That number in our case is relatively low and that reflects in these statistics as well.

Anthony Miller - Arete

Did you run a similar survey this time last year? And if so how 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 - Credit Suisse

I’m just trying to understand, you are not seeing a budget flush at the end of this year but you feel confident about 2008. Why wouldn’t you 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 telling us. They are saying that this year they don’t have the extra money in their 2007 budget but as they are planning and starting to lock down their budgets or get further into the budget process for 2008, that part of the way they are making their budgets work for next year is to further leverage offshoring.

In prior years sometimes you would see people start a development project this year instead of wait to January 1, or try to finish one up earlier because people just had more dollars left over. What we’re hearing this year, they have stuff ready to go, but they have to wait for their new budget dollars to become available.

Bryan Keane - Credit Suisse

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

Gordon Coburn

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

Bryan Keane - Credit Suisse

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

Francisco D’Souza

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

Bryan Keane - Credit Suisse

Any idea how fast the industry is supposed to grow next year?

Gordon Coburn

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

Operator

Your next question comes from Joseph Foresi - Janney Montgomery Scott.

Joseph Foresi - Janney Montgomery Scott

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

Gordon Coburn

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

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

Joseph Foresi - Janney Montgomery Scott

A second question here, it sounds like what you’re seeing is less 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 way that you guys plan on maybe compensating for a potential slowdown and if so what are the areas of growth that you would target in order to continue to keep the business moving forward?

Because of our strategy of heavily reinvesting in the business, we are already investing in multiple areas at once, both service line expansion, geographic expansion, domain expertise. So I think we’ll continue that strategy. Obviously if there’s a major recession, that’s going to impact everyone. The good news is based on what clients are saying now, it seems fairly clear to us that cutting offshore is not going to be at the top of their list.

Joseph Foresi - Janney Montgomery Scott

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

Gordon Coburn

For the fourth quarter, we expect marketRx to close as we get further into the latter part of the quarter. So the impact on Q4 will be fairly small and we have a small amount of revenue built in. Obviously we get the 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 an annualized basis in terms of revenue, recent growth and profitability?

Gordon Coburn

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

Ashish Thadhani - Gilford

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

Gordon Coburn

Obviously, we don’t give our salary increases until April. How much we give will depend largely on what other tier one players give, because we 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 hopeful that wage increases in 2008 will be less than 2007, but a little too early to know for sure as we get into the first quarter, we should start to probably get a better flavor on that.

Operator

Your next question comes from Ed Caso - Wachovia Capital Markets.

Ed Caso - Wachovia Capital Markets

Any initial thoughts on the tax rate for 2008?

Francisco D’Souza

Ed, did you say 2008 or 2009?

Ed Caso - Wachovia Capital 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 on excluding the one timers, we are at 16.4% for this year. So, certainly my model for next year, I’m assuming, will be around 16.4% again. I am sure it will be a little less or a little more, but that would be our best guess.

Ed Caso - Wachovia Capital Markets

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

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 those were down 1 percentage point from the second quarter, which is a trend that obviously has been going on for a long time as the size of our customer base grows.

Ed Caso - Wachovia Capital Markets

One last one on the H1B, as I see this legislative proposal to maybe push up the fee to $5,000 per application from $1,500. I don’t know if you knew where that stood and how important are the H1Bs and are you changing the 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 and more US based hiring as we get bigger, so we don’t have the utilization risks. So, we continue to increase our US hiring. Certainly, it is important to leverage the visa programs to bring over where the specific skill sets that we can’t find here as well as some of the knowledge of the onsite offshore model. Obviously, we prefer the fees don’t go up, but given the size of our corporation I’m not sure if the fees goes up a little bit it won’t materially change anything.

Operator

Your next question comes from George Price - Stifel Nicolaus.

George Price - Stifel Nicolaus

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

Francisco D’Souza

We obviously looked into that in detail. There’s nothing really specifically going there. We just look at that as the ups and downs in the business. Insurance, as you know, has been growing very well for us over a long period of time now. The insurance segment is one where we have a very good position in the marketplace. So, I wouldn’t attribute that at this point to anything beyond just the ups and downs of the business.

George Price - Stifel Nicolaus

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

Gordon Coburn

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

George Price - Stifel Nicolaus

Gordon, did you say 304.7 million shares for the fourth quarter.

Gordon Coburn

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

Operator

Your final question comes from Julio Quinteros - Goldman Sachs.

Julio Quinteros - Goldman Sachs

The 2008 outlook, maybe approaching it a little bit differently from more of a bottoms up perspective. If we look at headcount growth for 2007, right now we’re looking for about 42% headcount growth to finish the year of 55,000. Thinking about that into 2008 from a utilization perspective, or pricing perspective, and the levers that normally drive this business, why would we not see kind of the normal trend that we’ve seen over the last two or three years where headcount growth is one of the most important leading 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 faster than revenue. Now, we’re taking utilization up a bit. As we’ve gotten scale efficiencies, we came to understand that we were sub-optimized a little bit running as low a utilization as we did. So we’ve come up several points this year. I would expect we’ll go up a little bit more next year even if the Rupee doesn’t move just because it’s the right thing to do operationally. So, I think that’s driven by some the natural scale efficiencies in utilization. We’ll be coming out of the year with a very healthy bench of freshers who are in the training 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. It would seem like anything below a 40% growth rate would be a little bit conservative, or am I thinking about that incorrectly?

Gordon Coburn

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

Julio Quinteros - Goldman Sachs

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

Gordon Coburn

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

Julio Quinteros - Goldman Sachs

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

Gordon Coburn

The big piece of that is because the efficiency action primarily 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 our bonus 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 you mentioned D&A as well, was there anything with D&A, no, that’s actually out 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 for closing remarks.

Francisco D’Souza

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

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

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