The Hindu Business Line : `The biggest challenge is managing growth'

IT was the perfect occasion to have a conference call with the Chief Financial Officer of Cognizant Technology Solutions. On February 10, the Nasdaq-listed Cognizant was the first company to get off the blocks with its earnings guidance for calendar year 2005. Given its predominantly India-centric operations, Cognizant's revenue guidance of 44 per cent and per share earnings growth of 37 per cent has literally set the pace for frontline Indian software peers to follow.

In a call from the US, Gordon Coburn, CFO, Cognizant Technologies, spoke to eWorld on the variables that influenced the guidance and the trends that underpin a robust year ahead for the sector. Just hours before the call with us, Coburn was selected as one of "America's Best CFOs" for the technology sector by the Institutional Investor magazine. He joined an elite group of CFOs selected in 62 industries based on responses from over 1,000 portfolio managers and analysts from brokerage houses.

Looking at the guidance of 44 per cent revenue growth for 2005, what are the criteria and variables that you have reckoned for the guidance?

The three pillars of our growth in 2005 will be: offering a broader range of services adjacent to our core capabilities, servicing a broader range of industries, and expanding our geographic footprint.

In the last two years, we have expanded the range and scope of services that we offer to our clients. Traditionally, clients have offshored application maintenance and relatively simple development projects; now, we're seeing our clients entrust us with more complex development work. They are also moving work in the areas of IT infrastructure services, business-technology consulting and vertical BPO. This has resulted in enhancing our ability to penetrate our clients' IT budget much deeper than we have done historically.

The second pillar is the broad range of industries that are engaging offshore strategically. Now healthcare — both managed care and pharmaceutical companies — too has started using offshore strategically. Especially in the last 6-9 months, manufacturing, retail and logistics companies have embraced offshore rapidly and we are one of the big beneficiaries of this trend.

The third pillar is that Europe has woken up to the reality of strategic offshoring. Although the UK has been a little ahead of the curve, we are seeing significant growth opportunities in Continental Europe and are quite optimistic of growth there.

Cognizant makes significant investment in SG&A, about 23 to 25 per cent of revenue. Now that you have consistently been posting industry-leading growth, would you continue to spend such a high percentage or would you push up the margins by reducing SG&A spend?

Our philosophy is to plough back into business anything in excess of 20 per cent of our operating margins. With clients looking to do a broader range of work offshore, they are looking for an offshore partner that has deep industry expertise, business and analytical skills, as well as a good geographic presence.

It's our belief that during this period of "hyper-growth" for the industry, the key is to maintain a steady margin and re-invest back into the business to win new customers and ramp up existing customers as opposed to reducing SG&A spend.

One of the reasons why we're growing faster than any of our comparable peers in the industry is because we're making such re-investments, which allows us to be very successful in winning new clients, and more importantly, to ramp up client engagements faster. Our strategy is clearly to reinvest in our business at a level that keeps us in the 19-20 per cent operating margins.

Last calendar year 2004, you started the year with 40 per cent revenue guidance and ended reporting about 60 per cent. So is this guidance for 2005 conservative?

Our business mix is predominantly application maintenance and application development. We have good visibility for application maintenance, which is growing steadily at over 45 per cent on a year-on-year basis for the past 7-8 quarters. The application development work we undertake largely comes from clients' discretionary spend. As such, we have relatively less visibility on the application development work we do.

Typically, when we provide guidance, we have a good sense of where the application maintenance business is growing. We try to be rather conservative on the application development side simply because we do not have much visibility. So our guidance for 2005 includes business growth roughly at the same pace. If there are to be upsides, the majority of the upside will come from application development.

Does this growth plan tie-in with your plans for the approximately one million sq. ft, of space and headcount additions for the year? In your industry, would you not want to have capacity rather than a low bench, as you cannot execute projects for want of capacity? So how does it tie in with infrastructure and head count?

I completely agree with you. Our business model is exactly the same as you described. We try to keep a large bench so that if there is a higher demand we have the capacity to meet it. You saw that in our Q4, 2004 numbers, where our offshore utilisation was a little lower than 60 per cent. That's exactly what we want — the ability to quickly ramp up on client demands.

On the physical infrastructure side, as mentioned, we are adding one million sq. ft. at an investment of $76 million in India, and we continue to take additional leased facility depending on where the demand is and where the headcount ends up. We do not see physical infrastructure as a constraint to growth, at least in the short-to-medium term. The key aspect is: "Is there more demand?" and "Are clients ramping up?" The other aspect is "Are we comfortable with how strong the demand is?" and we believe that the outlook for 2005 is very healthy from a demand standpoint. We expect to top $845 million in revenue.

We see the employee growth rate matching company growth rate. Two years hence, are we looking at the top-tier companies reaching 45,000 to 75,000 headcount. When will employee productivity come in large measure?

I would expect employee growth and revenue growth to be somewhat equal. There will be some small difference here and there. Obviously, as you go higher up the value chain and start charging higher rates, revenues would grow faster.

Application development starting to recover in last several quarters, with no consensus on US economy, and the indicator that economy turning around... Will these put pressure on onsite billing rates?

Yes, we have seen the pick-up in application development from Q2, 2003. Since then, it has been growing in excess of 70 per cent year-over-year in these quarters.

First, US customers do have some growth in their IT budgets; although not huge, they have some. More importantly, offshore companies such as Cognizant are getting a "disproportionate share" of that growth. Which is why we see a very healthy demand and the customers resolve to have picked up to send more and more work offshore and get more value for the dollar.

Your strategic customers seem to be the foundation of your growth. How many of these are mature and how many are in the ramp-up stage?

Our definition of strategic customers includes those that have the potential to generate revenues of $5 million to $40 million and more. Of the 48 customers whom we define as strategic, five are mature and 43 are still in the growth and ramp-up phase. Having won so many strategic customers in the last 24 months, coming into 2005, we have more strategic customers in the ramp-up phase than we had in previous years.

There have been some acquisitions or mergers in your Top 3 clients. Will those clients grow at the same pace and will vendor consolidation generate more opportunity?

In our entire customer base, we have had mergers, acquisitions and consolidations going on all the time. Not just with our large customers, but also across our customer base. Generally, we find that acquisitions and consolidations create new opportunities for us.

With over $300 million in cash, are you strongly pursuing inorganic growth options?

We are very selective in our acquisitions and focus on three things. One, acquisitions for geographic expansion like the Infopulse acquisition we did in The Netherlands. Two, acquisitions for technology capability like the ACES and Ygyan acquisitions that helped us strengthen our CRM and SAP capabilities. Three, acquisitions for strengthening the verticals we specialise in. A good example is again Infopulse that specialised entirely in financial services.

Our strategy is to do small, tuck-under acquisitions due to the challenge of integration and we are certainly in a position to focus on small acquisitions that fit any of these criteria.

What do you see as major challenges for 2005?

I think the biggest challenge is "managing growth". While adding the numbers of people that we're adding, the biggest challenge is maintaining the culture of the company, maintaining the same level of intimacy with our customers, which is a big differentiator for us, and maintaining high quality in all that we do.

Apart from managing growth, would you be concerned about wage inflation and attrition?

Surely. In the near to the medium term, those issues are manageable. In my opinion, they have become a part of managing our day-to-day business.

We expect wage inflation offshore to be on the lines of last year, at low double digits. Onsite wage inflation would be modest; our expectation is that it will be mostly negligible. We see that model going quite well as we go into 2005, and obviously we have to keep an eye on rupee appreciation, but it has moved both ways— appreciated and depreciated in the past year.

If something disruptive were to happen for this industry, say a top-tier company acquiring a mid-tier company, what would be your reaction to this development?

By the end of this year, we expect to be 22,500-plus and that's a significant scale to be a highly credible player in the global industry.

Consolidation in the Tier 1 or Tier 2 space will leave those companies with significant integration challenges. If such a thing were to happen, it will create more opportunities for us, as their entire focus will be on integration, while we could continue to focus on our customers and provide greater value.

With mid-tier companies in India gaining niche focus and building differentiation, would they be attractive targets for scaling up the business?

In the last few years, there has been a significant separation between Tier 1 and Tier 2 players and the large, strategic deals have invariably gone to Tier 1 players. Cognizant is today so large that we've been able to build our own portfolio and span of expertise.

So I am not sure if there is any significant benefit in acquiring a Tier 2 or Tier 3 player, with the exception of those that have specific technology capabilities. Having achieved critical mass, we would much rather focus on further strengthening things that we do well and continue to provide exceptional customer value.

Is this a sustainable trend? Most of the companies are looking at freshers to ramp up the numbers and then move up to higher services. Is this happening at a pace companies want it happening?

Yes, we are very pleased that our clients are looking at us to provide higher-end services and we're seeing that on our number charts. The application development work that tends to be the higher-end work, for several quarters in a row, grew in excess of our application maintenance business. So clients are indeed looking to us for higher-end and high-velocity application development work.

Between 2000 and now, esoteric theories have come about with respect to signing up for business benefits rather than mere SLAs on productivity and budget. How much more is the customer demanding? Is revenue determined by the success of successful business implementation?

The key thing clients look for and demand is that the offshore partner not only understands technology, but also the business issues that the clients are facing. That's the reason we are making so much investment in the MBAs who bring in the much-needed industry knowledge and business analytics capability.

This is an investment that we have made ahead of the curve. One sure thing is that customers do not expect a partner to be just an order taker, but help develop the solution by understanding the business pressure points and challenges that they face. It's a good change in the marketplace, and the expectation of the customer is that Cognizant and other offshore vendors have that capability.

Cognizant has stated that it today enjoys a ratio of 1 MBA or Business Analyst for every 30-35 professionals in the company. How do you leverage on this capability? What differentiator do you hope to build using this?

It is very significant. The fact that business analysts are working with industry experts allows us to differentiate ourselves by proactively providing business-process frameworks and solutions for clients' business issues, regulatory issues and the like, and apply technology to solve those issues. It has allowed us to differentiate ourselves in the market and build a number of services for which the clients have traditionally looked at the global MNC system integrators. It has allowed us to close the gap with those players in terms of business knowledge and providing solutions to business problems. It's clearly an area of investment for us going forward.

With Infosys and Satyam doing rounds of sponsored ADS offers, will the increase in their float impact the valuation of Cognizant and the industry?

It would be difficult for me to predict on Cognizant's valuations; it's for the stock traders to figure out. But we clearly see this trend as further enhancing the awareness among shareholders and customers on using offshore, both of which would be good for all of us.

maverick@thehindu.co.in

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