The Hindu Business Line : 'When you win customers, you are winning a long-term relationship'

Since this whole trend towards offshore is in an early growth phase, there is the opportunity to win many customers and grow them as quickly as you can. — Mr Gordon Coburn, Chief Financial Officer, Cognizant Technology Solutions

The recent global market meltdown that started with the US Federal Reserve rate hike in May set every one thinking if the discretionary IT spending in the US would begin to taper off. Since these spends have fuelled the sharp rise in software development revenues for frontline IT companies, Business Line sought an industry perspective from Mr Gordon Coburn, Chief Financial Officer, Cognizant Technology Solutions, on this and related issues in a free-wheeling conference call from the US.

Excerpts from the interview:

Comments from top vendors indicate that discretionary spending is exceptionally strong now and will be so for a few quarters to come. We see it from your latest results, too. Which areas do you see are unusually different from the past — verticals, technologies, remote infrastructure management... ?

Several things are happening at once. First, clients' overall budgets for discretionary spending are increasing. Second, now that our clients have become more comfortable with the offshore model, a very large percentage of discretionary spending is going offshore. Plus, a healthy portion of the existing development spend too is. Hence, the growth in offshore development work, which is really the discretionary spending, is growing at a faster pace than the industry.

A few things have fuelled that: First, more industries are embracing offshore which is an important growth driver. For example, our healthcare practice grew 77 per cent year over year, driven primarily by pharmaceutical companies, which two years ago which had very little interest in offshore. They are virtually all embracing offshore. We do work with seven of the top 10 such in the world.

Second, as clients become comfortable with offshore, they seek to do a broader range of services. That's increasing the share of the client wallet or of their IT budget that we are eligible to serve. For example, our ERP and CRM business grew over a hundred per cent last quarter. Testing business grew over 140 per cent. Our data warehousing (DWH) business grew approximately 100 per cent.

So, we see strong growth in the newer service offerings. That has the benefit of driving growth and of allowing us to further expand client relationships. So, we have not seen additional clients mature because we are able to sell them more and more services. The March quarter experience shows healthy growth in Europe. Europe tends to start with development, which is discretionary work rather than maintenance work due to cultural and labour issues.

Is this year going to be significant for you in Europe? In the last 7-8 quarters, we noticed that it contributed to only 9-11 per cent of revenue. This quarter, you have seen 22 per cent growth as well as a 12 per cent revenue contribution. Anything happening there?

I don't think it is going to be a watershed event. I think it is going to be an evolution. Two things are happening: Market is beginning to get comfortable with offshore, but that's going to be a process and will not happen overnight. Two, we are now investing heavily in Continental Europe as demand starts to materialise. Do I expect European revenues to change materially as a percentage of overall revenue? Probably not. As we are winning clients in Continental Europe and in the UK, we are starting to see the ramp up in those clients. The question is how far and fast they ramp up through labour and cultural issues. Are we in much better shape in Europe now than a year ago? The answer to that is an absolute yes.

A recent IDC report indicates that companies of European origin are looking at near- and off-shoring possibilities. Is that a cause of concern — a challenge?

Not a cause of concern. It's part of market reality. Traditional onshore European players have to start to build off- or near-shore facilities. That's the way the market is headed. And it's not an easy thing to do, however. A lot of MNCs have been trying to build offshore capability and many have struggled. The question would be: Can they build quality delivery and how long that would take.

On wage inflation, we notice that the top five software services firms seem to be better placed than the others. In turn, this would help them increase market share and enhance their command over college freshers. Even among laterals, the onshore and offshore rates seem better for the top few. Is this trend sustainable? How do you manage that?

It is a very important trend that is happening in the software industry. It is broader than just the wages. In terms of growth rates, winning new clients, quality of clients... you see tremendous separation between Tier 1 and 2 companies. A vast majority of strategic deals awarded are going to Tier 1 firms. Because clients want to scale, they want the breadth of services and deep industry expertise. Very few Tier 2 companies can offer those.

In the market, we see orders being awarded to Tier 1 firms. We have finally started to see that in the December and March quarters when Tier 1 firms overall grew a lot faster than Tier 2 firms. Now, that's starting to have an impact on the work force in several ways.

First, Tier 1 firms do a lot of hiring and one of the places they go to hire are the Tier 2 firms. If you are working for a Tier 2 firm and have the opportunity to upgrade to a Tier 1 firm, you are probably going to do it.

Second, because of the growth and type of work that Tier 1 firms do — development projects and, generally, more interesting work — staff prefers to work with them, from a prestige standpoint, career point of view as well as the kind of work that they do. Because the Tier 1 firms are growing faster, there is a chance for promotion and responsibility.

Therefore, what happened on the wage front is that Tier 2 firms are having to increase wages substantially because they are not able to offer many of the benefits as Tier 1 firms do.

Interestingly, they have lower rates, and they might have to end up paying higher salaries.

This trend would continue and emphasise the separation between these two tiers in terms of growth rates, billing rates and pressure on wage inflation.

Where did this thinking — of reinvesting additional money from operating margins — start from? Did you see any other industry successfully pursue this?

I don't think it came from other industries. It was an assessment of the market, where we saw a couple of things: First, when you win customers in our space, you don't go in and win one project and then go away, but you are winning a long-term relationship. Since this whole trend towards offshore is in an early growth phase, there is this opportunity to win as many customers and grow them as quickly as you can. By keeping margins a little bit lower, reinvest in the business that would result in long-term revenue growth. The key here is because it is a recurrent revenue model, you want that long-term view. It's a philosophy — do you want long-term revenue growth or short-term margins? It's the former.

From a CFO point of view, do large deals make sense to you at all? For, in such deals, margins are typically hit by one or two percentage points. Your COO, Francisco D' Souza, had felt that as such they don't fit the bill. Considering that you have 70-odd clients of which five are mature, does it now make sense to you?

It's interesting. What is a large deal? The only difference between the large deals announced recently and a couple of strategic clients won is an upfront commitment in the former. It's a press release upfront. I can assure you that those upfront commitments have lots and lots of `out' clauses. If a client decides he does not want it, he can get out of it. Our view is, when you get a strategic client, you win a client and a hunting licence. You don't have an upfront commitment but are a preferred offshore vendor. We then have to prove ourselves all the time. The relationship grows only when we provide high quality work delivering value added services. In the end, those relationships can end up being equal size compared to these large deals. I agree with you that a vendor has to give concessions. Whether it's worth that for an upfront commitment, is the question.

Your utilisation rate has remained static — not changed from the 50-odd per cent levels. Are you comfortable with that going forward?

In calendar 2004 and 2005, our headcount grew faster than revenue. We consciously wanted to bring down utilisation rates. Why did we do that? Because we saw that clients will want a broader range of services and we expected to continue to grow our business at a healthy rate. So, we needed to have a broad bench. We didn't know if the next order that came through the door would need 200 testers or 200 Java programmers. We hence needed a broad range of skills. Today, we are done with bringing utilisation rates down. It's interesting that some competitors are now talking about lower utilisation rates. They need to do the same thing that we have already done for two years. We were a bit ahead of the curve and happy where we are now.

On the manpower front, we see that big companies in the industry are talking about a 50 per cent addition this fiscal. The rest, we assume, would have similar ambitions. Do we have the middle management expertise to handle this kind of growth?

You are hitting the key risk factor for the industry. To offer a broad range of services, you need a broader profile of people. It's not the ability to recruit. Training is not an issue. Integration of new people on to project teams is the key. For that, you need enough experienced people, enough managers... I think the model works with the kind of growth rates we have had thus far. It could get tricky if you try to add more than 60 per cent to your population in a year. You then stand to lose the historical knowledge that goes out with people.

For Tier 1 firms, training programmes are intense and process driven. And, because we have all been around long enough, we have been able to grow that middle management strength internally. Is it an operational challenge? The answer is absolutely yes. Is it a challenge that Tier 1 companies are ready to successfully manage? I think the answer to that is `yes' as well.

Nasscom recently touched upon the other industries — be it retail or automotives — wanting more quality graduates. The H1B ceiling too has increased. All this means that that much less quality manpower is available for India-based software companies. What does that mean to you in the long term... the next 5-8 years? Is China an alternative resource, so that you can fully derisk one geography?

Two things here: One issue is, do you need to expand because you are going to run out of people or would you expand just for risk diversification? Obviously India has an extraordinarily large population, probably one of the best education systems in the world and has more and more technically oriented professionals graduating every year. Interestingly, you see little or no wage inflation at the college/fresher level.

That is a testimony to the fact that the supply of college graduates is keeping up with demand. That said, clearly, over time, it is prudent to diversify development locations. Not just because of labour but also due to geopolitical risks, to natural disaster risk, etc. would we look around? Clearly, we think India is a tremendous place to do business in.

We are expanding in cities we are in and expanding to others as well — Mumbai and Coimbatore being our newer locations. We have also opened up a small operation in Shanghai because we think that after India, China is the most attractive location for large-scale activities, because it obviously has a large population and a strong education system. China will take time to come up — there are challenges of clients becoming comfy with IP, with language and accent... with the expectation that China would be less expensive than India, which it is not, but similar to India. But over time, will China be an additional location for developmental activities? Yes. It won't be able to replace, but will supplement India.

A recent IDC report indicates that companies of European origin are looking at near- and off-shoring possibilities. Is that a cause of concern — a challenge? For, given the cultural nature of Continental Europe, what if companies there decide to offshore with companies from the Continent?

Across parameters you seem to have done well. Your full-year guidance has also gone up. What is it that you have done right the last quarter?

It's difficult to say exactly what is going right. But (broadly) the three growth drivers that I talked about help — though, that is not unique to Cognizant. Part of the reason why, we think, we have done well is because of our conscious decision to keep our operating margins lower than Tier 1 competitors. We prefer to take that money, reinvest it back into value adding activities, customer relationships, business analytical capabilities, industry and domain expertise, and the like. As a result, what we experience is once we win accounts, we are ramping up and growing those relationships faster than any others in the industry. That investment we made is reaping dividends.

(With inputs from Krishnan Thiagarajan)

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