Cognizant Technology Solutions (CTSH) Q4 2011 Earnings Call February 8, 2012 8:00 AM ET
Ladies and gentlemen, welcome to the Cognizant Technology Solutions Fourth Quarter 2011 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to David Nelson, Vice President, Investor Relations and Treasury at Cognizant.
Thank you, operator, and good morning, everyone. By now, you should have received a copy of the earnings release for the company’s fourth quarter 2011 results. If you have not, a copy is available on our website, cognizant.com. The speakers we have on today’s call are Francisco D’Souza, Chief Executive Officer; and Gordon Coburn, President, both of which are slightly under the weather, recovering from colds. And we’re also delighted to have with us Karen McLoughlin, our new Chief Financial Officer.
Before we begin, I would like to remind you that some of the comments made on today’s call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company’s earnings release and other filings with the SEC.
I would now like to turn the call over to Francisco D’Souza. Please go ahead, Francisco.
Thank you, David, and good morning, everyone. Thanks for joining us today. This morning, I’m joined by Gordon Coburn, our newly appointed President; and Karen McLoughlin, our newly appointed CFO. As we announced this morning, Gordon and Karen have taken expanded roles within Cognizant, which I will talk about shortly. I’m pleased to announce the solid fourth quarter results for Cognizant that kept very strong 2011 performance. Our revenue grew nearly 4% sequentially, and nearly 27% over the year-ago quarter to $1.66 billion. This brings full year revenue to $6.12 billion, more than 33% growth over 2010, once again demonstrating the strength of our value proposition, the depth of our client relationship, and the exceptional execution of our strategy.
As I look back on 2011, I’m proud of Cognizant’s many accomplishments. First, we continue to have track record of industry-leading growth. 33% growth is all the more significant when considered against the backdrop of an economy that was more volatile than we expected at this time last year. Europe grew slower than expected during the back half of 2011, but demand throughout other geographies remain solid, fueling strong annual results, and reinforcing confidence in our approach and our value proposition.
Second, we strengthened our client relationships by delivering on our unique value proposition that bears intimate domain expert client teams with a robust seamless global delivery network. Throughout 2011, we added 317 new clients and increased the number of strategic clients by 25 to 191, the largest increase in our history. Strong results from our recently concluded third-party annual customer satisfaction survey showed that clients continued to see high levels of service quality even as we scale. And perhaps most significantly, 13 accounts contributed more than $100 million in 2011 revenue, illustrating the depth of our client relationships.
Third, we, again, hired and retained an outsized share of the talent marketplace. We grew our team by more than 33,000 this year and closed the fourth quarter with an attrition rate just over 10%, amongst the lowest in our industry. The fact that associates see Cognizant as a great place to work and to build long-term careers is reflected in record-high satisfaction scores from our third-party annual employee survey. Fourth, we stayed true to our reinvestment strategy by maintaining stable operating margins, and reinvesting in the business. Our approach of distributing investments across 3 horizons strengthened an already robust services portfolio. As a result, we are well-aligned to help clients with the dual mandates of simultaneously reducing costs and innovating for growth and competitiveness.
Within our Horizon 1 services, offerings such as application development and maintenance, testing and packaged application services, our emphasis has been on driving ever-greater levels of productivity for clients through best-in-class methodologies and a more aggressive move to variable pricing models, so-called managed services. We also continue to strengthen our offerings with tuck-under acquisitions such as Zaffera, which bolsters our SAP capabilities.
Within our Horizon 2 offerings, we have achieved critical mass across consulting or CBC, Business Process Outsourcing or BPO and IT Infrastructure Services or ITIS. Our focus is now on scaling them across industries and clients. Our business consulting ranks have grown to over 2,900 consultants that are increasingly working with senior members of the CXO suite to deliver large-scale, end-to-end transformational programs.
Within BPO, we executed on our strategy of focusing on vertical processes that require deep domain and functional knowledge, and then benefit from the integration of consulting, IT and BPO services. This included enhancing our mortgage processing capabilities through our acquisition of CoreLogic’s India operations. And within ITIS, we continue to win and manage a growing pipeline of large deals, launching one of the biggest projects in practice history with a European investment bank and beginning an end-to-end infrastructure outsourcing program for a retailer with more than 1,000 facilities in over 75 cities.
And finally, within Horizon 3, we are seeding investments in emerging offerings, the clear foundation for our long-term growth. Though these practices remain in the infancy, we saw strong traction amongst clients. This was partially a result of the mind share that we have captured through our thought leadership campaign that highlight the changing nature of the Future of Work. I’ll speak more about Horizon 3 shortly.
Before moving move on, I’d like to take a moment to thank our associates around the world for their contributions to making 2011 another stellar year for Cognizant. We could not continue to deliver strong results quarter-after-quarter without their support.
I’d now like to shift gears and turn to our outlook for 2012. Two weeks ago, I attended the World Economic Forum in Davos, and I had an opportunity to speak with and hear from global leaders in government and business. While there was universal acknowledgment that helps challenges lie ahead, the overall tone was optimistic. As we look to our future, we share that sense of optimism. While the macro environment, especially in Europe, will remain volatile in the coming months, our optimism stems from our strong conviction that our value proposition is more relevant than ever. As clients seek a partner who can drive cost savings and innovation on one integrated platform, they are increasingly turning to us.
In North America, our largest market, recent economic data has been encouraging. Close examination of that data shows that while overall unemployment remains high in the U.S., it is only 4% for those with a college degree. This is creating an acute talent shortage that will only be exacerbated by the growing intensity with which clients use technology. Our ability to provide clients with global access to talent is a key enabler of their competitiveness, and will be a long-term driver of our business.
At the same time, we continue to be strong advocates of immigration and education reform as solutions for long-term U.S. competitiveness. In Europe, the protracted volatility is more concerning. While some clients have slowed their pace of discretionary spending for the short-term, they continue to seek out cost savings. In addition, shrinking populations in many European countries create a talent gap that is arguably more intense than that of the U.S. We have seen some European financial institutions relocating technology and operations activities to geographies such as in Asia-Pacific in order to address these issues. This trend will fuel our growth in those regions.
Europe remains attractive over the long term, especially as economic pressures create additional demand for our services. The demand is reflected in the 14 new logos we signed across the U.K. and Continental Europe in Q4 and a growing pipeline of work at existing clients. As an example, we recently signed a multimillion euro contract with a large European multinational to provide a broad range of IT services. This global strategic partnership will see increasing scope of IT services over time.
When we look at spending patterns for 2012, we continue to see normal budget cycles in North America and Europe. Our view remains that 2012 IT and operations budgets will remain flat with a slight upward bias in the U.S. as the recovery continues. While we expect long-term prospects for our European business to be strong, we have assumed that growth could remain muted during 2012. In light of these assumptions, we are confident in our ability to deliver revenue of at least $1.7 billion for the first quarter of 2012 and at least $7.53 billion for the full year, an annual growth rate of at least 23%.
Our success in 2012 will rely on strong execution in 3 areas. First, we will strengthen our Horizon 1 and Horizon 2 offerings by expanding their reach across clients, industries and geographies. Second, we will invest heavily in Horizon 3 offerings to stay ahead of changing client needs and to build a strong foundation for future growth and third, we will continue to scale our operating model and expand our senior leadership team.
Let me briefly touch on each of these 3 areas. Offerings from Horizon 1 and 2 will continue to deliver the lion’s share of Cognizant’s revenue and revenue growth in 2012. In each of these core areas, the global delivery model remained under-penetrated. When combined with a relentless economic pressure to continuously lower costs, we see robust expansion of an addressable market where we have routinely captured market share.
Turning to Horizon 3. We will continue to invest in emerging opportunities that keep Cognizant on a trajectory of long-term market-leading growth. While these offerings are unlikely to have a material revenue impact in 2012, they represent areas of high importance for our clients where we will differentiate ourselves.
Horizon 3 investments will fall into 3 broad areas. First, our investments in new markets. This involve adapting our global delivery model around existing offerings to serve new industries, including targeted areas of government and new geographies such as Latin America. Second, our investments in services around the new IT architecture, namely, Enterprise Analytics and cloud mobile and social computing. And third, our investments in new delivery models, primarily nonlinear models that are based on proprietary intellectual property and allow us to decouple revenue and headcount, most notably with the investments in platform-based, business process solutions, where we leverage our people and a multi-tenant technology platform to process clients’ transactions.
And finally, we recognize that our continued success depends on scaling the business and managing with equal vigor and discipline across all 3 horizons. In recognition of this imperative, this morning, we announced an expansion of our management team of which you have no doubt already read. Gordon Coburn, our long-time Chief Financial and Operating Officer had promoted to President. Gordon will work closely with Raj Metha, who’s been promoted to Group Chief Executive of Industries and Markets, overseeing our industry vertical teams; and Chandra Sekaran, who has been promoted to Group Chief Executive of Technology and Operations, overseeing our service lines that span across industry groups. Together, Gordon, Raj and Chandra will oversee all aspects of our current business operations. Each is a tremendously accomplished Cognizant veteran, who has been with the company for well over a decade. I have the utmost confidence in their continued success.
Karen McLoughlin, an 8-year veteran of Cognizant has been promoted to Chief Financial Officer. Karen has most recently led our financial planning and analysis team, a group that she architected and built during her time here. In addition, Karen has spearheaded critical transformation initiatives that have contributed materially to the efficiency and effectiveness of our operations. This includes the role she has recently played, leading the team responsible for the execution of our Cognizant 2015 program, an enterprise-wide initiative that is examining every aspect of our business to ensure continued success as our clients’ most trusted partner.
Malcolm Frank, who joined Cognizant in 2005, has been promoted to Executive Vice President of Strategy and Marketing. During his tenure, Malcolm has made extraordinary contributions to Cognizant’s position as a Tier 1 provider. An industry-recognized thought leader, Malcolm has been the Chief Architect of our corporate strategy and built an award-winning marketing approach that he has — that has made Cognizant’s success possible.
I will retain the role of Chief Executive Officer and continue to oversee Cognizant’s strategic direction with a special focus on our long-term growth agenda. Specifically, I’ll lead group comprised of a few senior executives responsible for working hand-in-hand with our core business to develop profitable, sustainable and scalable new offerings around the Horizon 3 areas I outlined earlier.
Over time, our goal will be to increase the share of revenue that Cognizant derives from recently introduced offerings and to increase the proportion of clients that consume those offerings. I will now turn the call over to Gordon Coburn, our new President, to review our detailed financial and operating metrics; and Karen, our new CFO, who will take you through 2012 guidance. After which, we’ll open up the floor to questions and I’ll end with a few closing remarks. Gordon?
Gordon J. Coburn
Thank you, Francisco, and good morning to everyone. 2011 was a great year for us. We grew over 33%, while maintaining stable margins and a healthy balance sheet. While we did not see any budget flush in Q4, we saw a broad-based growth across industries and service lines through the quarter.
During the fourth quarter, we experienced continued growth in our financial services segment, which includes our practices in insurance, banking and transaction processing. This segment grew 3.7% on a sequential basis and 22.6% year-over-year. It represented 40.9% of revenue for the quarter. For the full year, this segment grew over 29%. Q4 growth within financial services was driven by ongoing traction for IT infrastructure services and high-end BPO services such as securities processing, board operations and underwriting and claims processing, and continued ramp-up in regulatory work including initial development assignments in addition to consulting.
Healthcare continued its growth during the quarter with 6.3% sequential growth and 34.7% year-over-year. This segment represented 27.5% of revenues. For the full year, healthcare grew almost 38%. The continued solid growth within this segment was driven by reform-related work including ICD-10 and consumerization of health plans. Ramp-up of pharmacy benefit, management providers and initial traction in Horizon 3 offerings such as business process as a service, cloud-based CRM and mobile technology.
Retail manufacturing and logistics continued its growth during the quarter and grew 2.8% sequentially and 30.9% year-over-year. It represented 19.2% of revenues. For the full year, this segment grew over 40%. Demand within this segment was driven by ramp-up of transformation projects and large strategic accounts as well as growing demand for services such as e-commerce integration.
The remaining 12.5% of revenue came primarily from other service-oriented industries of communications, entertainment, media and high technology, which as a group, grew 1.3% sequentially and 20.1% year-over-year. For the full year, this segment grew 26%. Application development represented 51% of revenue and application management, 49% for the quarter. Development grew 30.9% year-over-year and 4.3% sequentially. Management grew 23.1% year-over-year and 3.5% sequentially. We saw fairly balanced growth between development and management as clients expanded outsourcing projects to address their 2012 savings objectives. For the full year, application development represent 51% of revenue and grew 41%, while application management represent 49% of revenue and grew 26%.
During the quarter, 79.8% of revenue came from clients in North America. Europe was 16.5% and 3.7% of revenue came from our clients in Asia Pacific, the Middle East and Latin America. For the quarter, North America grew 6.1% sequentially and 31.1% year-over-year. For the year, North America grew 34%. For the quarter, all of Europe declined 5.6% sequentially and grew 8.8% year-over-year. For the year, Europe grew 28%. Continental Europe declined 8% sequentially on Q4 and the United Kingdom declined 4.2%. European revenue was negatively impacted by currency movements of approximately $8.6 million compared to the third quarter. On a constant-dollar basis, Europe declined 2.7% sequentially and grew 8.6% year-over-year. The macroeconomic issues in Europe continued to result in some volatility and constraints on discretionary spending, particularly in life sciences and financial services.
As expected on a sequential basis, our pricing was flat during the fourth quarter as most of our 2011 price increases were reflected in our run rate coming into the quarter. We closed the quarter with over 785 active customers, and a number of accounts which we consider to be strategic increased by 6. This brings our total number of strategic clients to 191. We continue to see a trend towards our newer strategic clients, embracing a wider range of Cognizant services at an earlier stage in the relationship.
Turning to costs. On a GAAP basis, cost of revenues exclusive of depreciation and amortization, was approximately $971 million and included $4.1 million of stock-based compensation expense. The increase in cost of revenues is primarily due to additional staff both on-site and offshore required to support our revenue growth. We increased our technical staff by over 7,200 during the quarter and ended the quarter with over 132,000 technical staff.
Fourth quarter SG&A, including depreciation and amortization, was $385 million on a GAAP basis and included approximately $21.9 million of stock-based compensation expense. Our GAAP operating margin was 18.5% for the quarter and our non-GAAP operating margin, which excludes stock-based compensation expense, was 20.1%, slightly above our target range of 19% to 20%. The average rate of the rupee was 50.7 in Q4 versus 45.7 in Q3. $225 million of rupee-denominated operating expense cash flow hedges were settled in Q4. This resulted in a $14.3 million loss, which was recognized in operating expenses. We further extended our India rupee expense hedging program with over $3.5 billion in outstanding hedges of our rupee expenses, which will mature each month through 2015 at an average rate of approximately 50.9. We have $10.9 million of interest income. In addition, we had $4 million of other nonoperating income. This included a net foreign exchange gain of $3.8 million.
Our GAAP tax rate for the quarter was 25.7% and for the full year, 24.4%. Our diluted share count for the quarter was 308.8 million shares, down slightly from Q3, primarily due to the full quarter impact of the share repurchase we made in late Q3. During the fourth quarter, we repurchased 40,000 shares at an average price of $60 for a total cost of $2.4 million. Within our currently authorized $600 million repurchase program, we have purchased approximately 5.6 million shares at a cost of $380 million.
Turning to the balance sheet. Our balance sheet remains very healthy. We finished the quarter with over $2.4 billion in cash and short-term investments. During the fourth quarter, operating activities generated $285 million of cash. Finance activities generated $21 million of cash. This was comprised of net proceeds of $23.7 million related to option exercises and related tax benefits as well as our employee stock purchase program, partially offset by expenditures of $2.4 million towards our share repurchase program.
We spent approximately $124.6 million on capital expenditures during the quarter. Our full year capital expenditures for 2011 was approximately $290 million, slightly above our original expectations of $285 million. During 2012, we expect our capital expenditures to total approximately $370 million.
Based on our approximately $1.3 billion receivables balance on December 31, we finished the quarter with a DSO including unbilled receivables of 73 days, unchanged from the third quarter, and up slightly from 71 days in the fourth quarter of last year. The unbilled portion of our receivables balance is approximately $140 million, down from $163 million at the end of Q3. Approximately 66% of the Q4 unbilled balance was billed in January.
32.3% of our revenues came from fixed-price contracts during the fourth quarter and 31.7% during the full year. Net headcount increased by over 7,300 people during the quarter. 56% of gross additions for the quarter were direct college hires, while 44% were lateral hires of experienced professionals. We ended the quarter with over 137,700 employees globally. During 2011, we added over 33,700 employees globally. One of our goals for 2011 was to achieve an improved balance between college hirings and lateral hires. I’m pleased to report that we were successful in achieving this goal, with 48% of our 2011 hires coming from campus.
Attrition in the fourth quarter was 10.1%, lower than Q3 attrition of 13.4%. Our attrition rate for Q4 was the lowest since the first quarter of 2003, barring the first quarter of 2009, which was the aftermath of the financial crisis. As we have discussed in the past, there’s no consistent methodology in the industry to report attrition. We have historically reported attrition by annualizing the turnover, which occurs within the quarter, including both voluntary and involuntary. Our attrition statistics include all departures, including BPO and employees in our training program.
Utilization decreased slightly on a sequential basis during Q4. Offshore utilization was approximately 68%. Offshore utilization, excluding recent college graduates who were in our training program, was approximately 80%. On-site utilization remain flat at about 94% during the quarter.
Our operational focus for 2011 was centered around our ability to scale our people, processes and infrastructure to support the increasing complexity of our business and to capitalize on opportunities that the market presented. We made significant progress against these goals through the year, particularly in the area of talent management and community relations, which we expect to build on further in 2012.
On prior earnings calls, we highlighted various initiatives to sharpen and enhance our employee value proposition. These efforts resulted in the highest employee satisfaction scores in our history during 2011. Our associates believe that we are winning the war for talent and are proud to work for us. They see value in the long-term opportunities our industry-leading growth offers for them. The relevance of our employee value proposition is also reflected in our Q4 attrition rate of 10%, among the lowest in the industry.
We continue to be regarded as the #1 employer of choice in India for graduates of top business and technical schools and enjoy top placement at every one of the schools we targeted. Our university campus — our U.S. Campus Recruiting Program, which kicked off in 2010, has yielded dividends as our first-class is now serving our clients in various parts of the country. We’ve expanded the program to add 3 additional undergraduates institutions and 7 more business schools. Our next class starts work next month. We have also launched similar programs in the United Kingdom and Continental Europe. We accomplished all these while actively giving back to the communities in which we live and operate. In India, our grassroots Outreach program started by associates in 2007 logged more than 80,000 volunteer hours, a 200% increase over 2010. This is now being replicated globally in Argentina, China, the Philippines, the U.K. and the United States.
This year in the United States, we unveiled our Making the Future campaign, an education-based initiative designed to promote programs that supports stem education. We believe that stem education can have a long-term impact on the economic development in the U.S. through a promotion of innovation and a concept of creating and building.
Before I turn the call over to Karen McLoughlin, our new CFO, to discuss our 2012 outlook, I’d like to wrap up by saying that I am excited about my new role at Cognizant. As I move into the President role, I do so with confidence that we have a world-class financial organization in place. Karen is an outstanding finance professional, with a deep understanding of the importance of a CFO being tightly aligned and involved in the business, and she has a solid knowledge of the Cognizant business.
With Karen reporting to me in her new role, I plan to stay actively involved with our ongoing investor communications programs, and look forward to seeing many of you at future investor events. I’d like to now make a hand off to our new CFO as I turn the call over to Karen for discussion of our 2012 guidance.
Thank you, Gordon, and good morning, everyone. I am very excited about the opportunity to serve as Cognizant’s new CFO, and look forward to meeting many of you over the coming months through our investor Outreach programs. I would now like to comment on our growth expectations for Q1 and for the full year 2012.
For the first quarter of 2012, we are projecting revenue of at least $1.7 billion. For the full year 2012, we expect to continue delivering industry-leading revenue growth. Based on current conditions and client indications, we are projecting revenue of at least $7.53 billion, which represents full year growth of at least 23%.
During Q1 and for the full year, we expect to operate within our target operating margin range of 19% to 20%, excluding the impact of stock-based compensation expense. Therefore, we are currently comfortable with our ability to deliver in Q1 GAAP EPS of $0.79 and non-GAAP EPS of $0.85, which excludes estimated stock-based compensation expense of $0.06. This guidance anticipates a Q1 share count of approximately 310 million shares and a tax rate of approximately 25%. Our guidance excludes any nonoperating FX gains or losses.
For the full year 2012, we expect our GAAP EPS to be at least $3.43 and our full year non-GAAP EPS to be at least $3.69, excluding $0.26 of estimated full year stock-based compensation expense. This guidance anticipates a full year share count of approximately 312 million shares and a tax rate of approximately 25%. It also excludes any nonoperating FX gains or losses.