The Hindu Business Line : `Long-term sustained revenue growth is the name of the game' — Mr Gordon Coburn, CFO, Cognizant Technology Solutions

Investment World - Interview
Info-Tech - Software

`Long-term sustained revenue growth is the name of the game' — Mr Gordon Coburn, CFO, Cognizant Technology Solutions

Krishnan Thiagarajan
Bharat Kumar

The big difference between us and our key competitors is in the SG&A line. We spend a lot more SG&A dollars as a percentage of revenues. Therefore, we are able to offer high domain, high analytic capabilities at offshore prices.

NASDAQ-listed Cognizant Technology Solutions has always taken great pride in its well-oiled sales engine, which has proved to be a key differentiator in the competitive IT services marketplace. The company's philosophy has been to take "every available dollar that we have above 20 per cent operating margins and use that to win and grow as many customers."

In line with this, it has consistently spent 22-23 per cent of its revenues on selling, general and administrative expense for the past several years. In a conference call from the US, Mr Gordon Coburn, Chief Financial Officer of Cognizant, reinforced these views while speaking to Business Line.

Excerpts from the interview:

Cognizant is one of the few companies that provide full-year revenue guidance. What are the variables that go into this exercise? How do you think the picture will emerge for 2006?

It is unusual for us to make any comments about 2006 at this time of the year. Normally, we go through the full planning cycle with our clients, as they do their own budgets, to understand what they budget specifically for us, what they budget for offshore, and what they budget for outsourcing but are undecided on whether it will go onsite or offshore. That process is not yet over and customers are still planning on what they want to outsource and to what extent. Last week, we had our annual customer conference, Cognizant Community, where we got some very positive feedback on high-level trends.

But why we are feeling good about what clients are saying for next year is that customers want to do a broader range of services with us. They want to take advantage of our testing, infrastructure management, complex application development, ERP, and vertical BPO services.

It is not just about application development and maintenance services, which was the case two years ago. What that translates into is that we are clearly now eligible for a larger slice of the client's IT budget, which is a powerful trend. Another big trend is that companies beyond financial services such as healthcare, manufacturing, retail and logistics are adopting offshore in a strategic way.

Your target-operating margin is in the 19 to 20 per cent range, lower than your competitors'. Do you have something similar for return on capital? What will help you substantially re-invest in business and what are the real drivers for return on capital going forward?

Obviously, growth rates have a lot to do with it. We are growing a lot faster than our key competitors, which means that we have to invest our dollars in growth and differentiation, and in training facilities and so forth.

Yes, we run at a lower margin than our competitors, which is tied to return on capital. We invest that money in domain expertise and onsite relationship management, which we believe allow us to differentiate ourselves and we also believe is one of the reasons why we are the fastest growing player in the market today.

Since Cognizant has been maintaining the SG&A (Selling, General and Administrative) spend in the 23-25 per cent range, what are the newer things that you are deploying to retain the differentiation in your services portfolio?

The big difference between us and our key competitors is in the SG&A line. We spend a lot more SG&A dollars as a percentage of revenues. We invest in onsite relationship managers, domain experts, and analytic capabilities — things that help us to take the best of what the traditional domestic (read, the US) players have and combine it with the best of what the offshore players have. Therefore, we are able to offer high domain, high analytic capabilities at offshore prices. Customers love that, and that's why we are winning a disproportionate share of deals in the market, and our faster growth rate is directly due to our investments in SG&A. A lot of people say, `why use up those investment dollars, instead take your margins up'. We believe that this is a once in a life-time opportunity now to win new clients.

This is not one-time revenue but long-term relationships that we are winning. We should take every available dollar that we have above 20 per cent operating margins and use that to win and grow as many customers that we can. What we are interested in is long-term, sustained revenue growth. I think that's the name of the game. We are investing our capital dollars and SG&A dollars to achieve that.

Do you anticipate any pressure on the operating margin because of competition?

In the near to medium term, we are comfortable with the 19-20 per cent operating margins. At 19-20 per cent, we have a lot of incremental dollars to invest.

You now have 63 strategic clients and only five of them are mature. And that seems to have remained at that level for about a year and a half...

If you had asked me this question a couple of years ago, I would have said we would have expected more number of mature clients. But, today, what's happening is that clients are looking to do a broader range of services offshore, because of which the penetration bar has been reset. Clients that might have been getting closer to being mature, are now not so as we have a whole bunch of additional areas where we sell services like testing, infrastructure management, ERP and vertical BPO. As such, we have not seen more customers mature, as we are now eligible for a bigger slice of their IT budget.

This is the most important part of our story today— that customers want to do a broader range of stuff with us, which helps us grow relationships larger than they would have otherwise, and do not reach maturity earlier.

For the record, our definition of a strategic client is one with the potential to grow to annualised revenues of $5 million to over $40 million. During Q3, we had two clients with over 10 per cent of our overall revenues.

We see a churn in your client portfolio. As CFO, does it concern you that you spend time, money and efforts to acquire a client and then you find that they are not good enough?

I normally encourage people to look at both new client wins and the number of strategic client wins. In any quarter, we take on some work with small clients, either the client came over the fence or through some acquisition which also had some staff augmentation component that did not fit into our business strategically.

The dollar revenues from those customers are tiny and are not the clients that our sales force goes after, spending time and effort. So, although the total number of clients added is important, I would not focus only on that number of 31 in Q3. I would encourage you to focus more on the five5 strategic clients we won during the quarter, taking the number to 15 so far this year, compared to 12 in all of last year. It is those strategic customer acquisitions on which we spend a lot of money through our sales force.

In terms of composition of services, how much do new offerings such as like testing, data warehousing and infrastructure management services and related applications now contribute to your revenue?

Our data warehousing practice is perhaps the best in the industry. We started Testing with 200 last year and we see that going past 2000 this year. Infrastructure management, which was a brand new business 18 months ago, now has almost 25 clients and employing a large number of people. We are seeing a good growth across all these services.

Coming back to utilisation level, you have intentionally kept it low. What will you be comfortable with and what is the timeline that you will achieve it?

Onsite utilisation has been consistent in the high 80s. Where you see some fluctuations in utilisation is at offshore, specifically when we include trainees. In fact, in Q3, our offshore utilisation excluding trainees went up from about 65 per cent to 68 per cent. We are comfortable with the high 60s excluding trainees. The fortunate thing is that we can afford this cost structure offshore, as it does not cost us too much.

You have a growth of 50 per cent while the industry's growth has averaged been 30-35 per cent. With your revenue base growing do you think you will come in line with the growth of the industry?

It is too early to know that. The key thing I look at it is how different are we. We invest a lot more on SG&A, which we believe will continue to differentiate us in domain expertise, analytic capabilities and relationship management. Our belief is that it should reflect in our growth rates.

Finally, what are the variables that play as far as valuations go? Does the greater weightage lie in industry growth rate, consistency of performance?

It is probably more a question for the buy side analysts and for investors. I think it is broadly the strategic decision we made to reinvest anything above 20 percent operating margin back into our business for growth and differentiation. That positions us better for long-term, sustained revenue growth. I think we get a lot of credit and goodwill with investors for that.

We have a very good track record of delivering on our promises. Investors are comfortable that we have a good handle on our business, understand the drivers of our growth, and where the investment dollars are going, and consequently, are comfortable that when we say things we understand the underlying drivers and deliver on our promises.

Are the US investors demanding less than investors in India?

I do not think so, as the reality is that many of the investors are the same investors. I think it is not a difference in the investor base, it is the fact that people believe in the fact that our re-investment for growth and differentiation makes sense.

How does your financial guidance tie in with your investments in physical infrastructure and planning for manpower, and, in turn, how does that reflect on your return on net worth. Unlike other industries, IT services has typically had a consistent return on net worth over a long period of time?

Let’s take up headcount first. Our headcount in Q3 of 2005 grew faster than revenues and utilisation came down. Why did we do that? It’s partly the seasonality as college graduates come in during this quarter. The point is that we want to be ready for the opportunities in 2006.

About 60-70 per cent of our hires are freshers out of college, and hiring freshers from college has a lead cycle of at least six months to recruit and another six months for training before they can be deployed on projects. The remaining 30 to 40 percent of our recruitment is lateral hires, which can be turned on and off, depending on business demand.

We control our utilisation at a level, and speed up or slow down our lateral hires depending on business needs. We have taken a conscious decision of having our utilisation lower this year because we are seeing a healthy demand and we want to make sure that we have the people available to ramp up quickly.

And more importantly, as clients are looking to do a broader range of services, coupled with our hyper growth, we do not know what the next client coming in would need — testing, infrastructure management or complex development. As such, we need a wider range of skilled people. Fortunately, we can afford that within our cost structure. We are very pleased with our capability to have people with deep capabilities ready to service our clients better.

Turning to infrastructure, we have a combination of both owned and leased facilities across locations. We built our 600,000 sq ft of fully-owned facilities a couple of years back, and we are currently constructing an additional 900,000 sq. ft. of space.

If there’s a spurt in business, just like the lateral hiring, our leasing of infrastructure facilities will be higher to meet the immediate demand (and it usually takes about ten weeks to lease a facility and commence operations). If it turns out that we have more capacity than we need, we stop leasing for a while. We clearly do not see infrastructure to be a gating or constraining factor to our growth.

With respect to return on capital, obviously every time we decide on lease versus build, we look at what’s the cost of lease and that of build, and take a financial position. The reality is that it’s a combination and we believe it will be a combination going forward. We always optimise the economics of our investment decisions, and manage business demand.

Like some others in the sector, do you have a benchmark for Return on Capital Employed (ROCE), cash in hand, and Return on Net Worth (RONW)?

We don’t have a specific benchmark. The reality is that the profits or return on capital is very healthy in this industry. We generate a significant amount of cash flow. What’s important is “what’s the best use of cash that’s generated — what interest return do we get on it versus pulling it into construction, and therefore, not having to pay leased cost. We look at it from the perspective of return on investment on leased versus buy, and interest accrual on cash.

We are wondering How does the strategic alliance with EDS fits into this whole equation, when you already have 63 strategic clients. Is it a de-risking move? or what is it about?

We asked ourselves the same question when we were looking at the relationship. We sat down with their EDS executive management and they took a very progressive view to partnering.

All we are going to focus on is “bundled” IT deals that includes data centres, network, infrastructure management as well as the application layer. Bundled IT deals are not the ones we can compete in all by ourselves as we just do not have that capability.

This is an entirely incremental market opportunity without any channel conflicts. This is non-exclusive. If customers want to do an offshore specific outsourcing, we will go direct on that. In other words in unbundled deals, we will go directly. From our perspective, it gives us an opportunity to play in the applications layer of the bundled deals which otherwise we would not get.

But wouldn’t the bundled deals get unbundled over time, especially the ones that have a large applications layer? An example is ABN AMRO type of a deal.

Clearly bundled deals is a much slower growth in a very mature market. But it’s a very large market.

For example, one of our existing clients came to us and said they are putting out a bundled deal RFP and wanted us to participate. We were doing some development and maintenance work for that client. But we told the client that we couldn’t as we did not have the capability. After we got into this alliance, we went up to them and said we can now do it. It’s clearly a slower growth market, but a large market which we would not have been able to tap earlier.

But wouldn’t it be judicious to take it on a case-by-case basis as companies have done historically? Why tie up with somebody for some time to come?

This is non-exclusive, either way. EDS can work with others; we can work with others. From our perspective, this is like winning an additional strategic client.

Will this not affect your winning unbundled deals as the market may not understand your relationship with EDS? Will it reflect positively on your SG&A?

I do not think there is any confusion. We definitely see this as an incremental opportunity and it will not affect our existing business. Our market for unbundled deals are getting larger, and we are clearly going after that on our own.

On the SG&A part, we believe that the deals from this relationship will have a higher offshore ratio than the rest of the company. Obviously, there will be less sales effort, but clearly we will have our relationship management team on that account like any other strategic account. We do not expect it to have any negative impact on our margins.

There has been some talk of value-based pricing in the industry as against efforts-based pricing? Is it best for the vendors or the clients?

Roughly 75 per cent of our revenue is Time and Materials and the remaining 25 percent is fixed price. In our infrastructure management practice, some part of the business is charged on the basis of per-service work.

The only thing that beats me is that the percentage of revenue from fixed bid is not going up, which I thought would go up as we are doing more development work. What appears to be happening is that clients want to get going quickly. They don’t want to spend much time deciding the parameters that are needed to do fixed price work. They see the blended offshore rates are good, our track record of delivering is good and therefore are happy to go with us. They have so much to be done quickly and hence they are taking on this route.

Over time, I would expect fixed pricing or value-based pricing to go up. Where we will see more of it is in BPO, which will be more per transaction or per unit of service delivered.

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