COGNIZANT TECHNOLOGY SOLUTIONS CORP quarterly report, Q2 FY2010

Cognizant Technology Solutions Corporation — Q2 2010 Form 10-Q

Business context and period. This unaudited filing covers the quarter and six months ended June 30, 2010, compared with the same 2009 periods. Cognizant provides IT consulting, technology and outsourcing services across Financial Services, Healthcare, Manufacturing/Retail/Logistics and Other. Unless noted, financial amounts below are in USD millions.

Key financial results

Metric	Q2 2010	Q2 2009	Six months 2010	Six months 2009
Revenue	$1,105.2	$776.6	$2,064.9	$1,522.5
Operating income	$205.9	$151.7	$388.9	$289.8
GAAP operating margin	18.6%	19.5%	18.8%	19.0%
Net income	$172.2	$141.3	$323.7	$254.4
Diluted EPS	$0.56	$0.47	$1.05	$0.85
Operating cash flow	Not separately provided	Not separately provided	$137.6	$226.3

Q2 revenue rose 42.3% year over year and net income rose 21.9%; six-month revenue rose 35.6% and net income rose 27.2%. Q2 cost of revenue was 58.0% of revenue, versus 55.8% a year earlier. The company’s non-GAAP operating margin, excluding stock-based compensation and applicable Indian fringe benefit tax, was 19.9% in Q2 and 20.2% for the six-month period, versus 20.8% and 20.5%, respectively. The filing cautions that stock-based compensation is a recurring expense and non-GAAP measures are supplemental.

Balance sheet, cash flow and liquidity

• At June 30, 2010, cash and cash equivalents were $1,039.7 million and short-term investments were $612.3 million, totaling $1,652.0 million. Working capital was $2,159.3 million.
• Total assets were $3,764.2 million and total liabilities were $723.3 million. The balance sheet presents no borrowings or debt line item.
• Six-month operating cash flow fell to $137.6 million from $226.3 million. Management attributed the decline principally to working-capital needs, including higher receivables. Trade receivables rose to $814.2 million from $626.3 million at year-end 2009; unbilled receivables rose to $119.5 million from $83.0 million. Days sales outstanding, including unbilled receivables, increased to 77 from 72 at year-end.
• Six-month investing cash use was $258.0 million, including $66.2 million in property and equipment purchases, $29.0 million for acquisitions net of cash acquired, and net investment purchases. Financing activities provided $73.4 million. Cash declined by $61.2 million during the period.

Material changes and operating drivers

• All segments grew in Q2: Financial Services revenue +41.6%, Healthcare +38.1%, Manufacturing/Retail/Logistics +53.4%, and Other +39.0%. Manufacturing/Retail/Logistics was the fastest-growing segment.
• Management cited existing-client expansion, new customers, discretionary development and post-acquisition integration work, broader service offerings, and growth in Europe—particularly the UK—as drivers. Active clients increased to approximately 662 from 569 year over year.
• Q2 GAAP operating margin declined 0.9 percentage point year over year. Management cited compensation and incentive costs, Indian rupee appreciation, and investment in growth, partly offset by operating efficiencies. It estimated rupee appreciation reduced Q2 margin by about 180 basis points before designated hedge effects.
• Six-month other expense was $2.2 million, compared with $14.9 million of other income a year earlier, primarily reflecting foreign-exchange losses. Six-month net foreign-exchange losses were $15.1 million, including losses on undesignated forward contracts.
• Three business combinations were completed in the first half, with total consideration of approximately $45.4 million net of cash acquired; the filing says they were not material to operations, financial position or cash flow.

Outlook, risks and contingencies

• Management targeted a 19%–20% operating margin excluding stock-based compensation and applicable stock-based Indian fringe benefit tax, and expected to continue investing amounts above that target in the business during 2010. It expected approximately $180 million of 2010 capital expenditures and stated operating cash flow and cash were expected to cover operating requirements for the next 12 months. No specific revenue or EPS forecast is provided in the filing text.
• Management described the global economic environment as fragile. Demand, customer IT budgets, financial-services conditions and foreign-currency volatility were identified as factors affecting results. The company planned continued investment in talent, services and international growth, while maintaining cost discipline.
• Indian tax holidays for most Software Technology Parks were scheduled to expire March 31, 2011. Management warned that, absent extensions or replacement incentives, the effective tax rate could increase significantly beginning in 2011.
• Foreign-exchange exposure is significant: the company had $2.13 billion notional of designated rupee salary hedges and $409.0 million of undesignated balance-sheet hedges at June 30. Management reported that a 10% exchange-rate change could change the fair value of these hedge portfolios by approximately $205 million and $41 million, respectively, with other variables held constant.
• Commitments included $115.1 million of fixed capital commitments for India development-center expansion and a possible acquisition earn-out of up to $14.0 million in 2010. Ordinary-course legal claims were not expected by management to have a material adverse effect, but client-system failures, data breaches or contractual claims could exceed insurance or contractual liability limits.
• Other key risks include rising wages and staffing needs, customer concentration and termination rights, receivables collection, fixed-price contract estimation, competition and pricing pressure, immigration restrictions, and geopolitical, regulatory and operational risks associated with global delivery and substantial India operations.

Important facts for investors to verify

• Whether receivables growth and the increase in days sales outstanding convert into collections and improved operating cash flow.
• Whether margins remain near the stated 19%–20% non-GAAP target as wages, incentive compensation and rupee movements affect costs.
• The expected effect of the March 2011 Indian tax-holiday expiry on the effective tax rate and earnings.
• Progress and returns on the India expansion program, including the $115.1 million committed capital spending and planned 2010 capex.
• The sensitivity of reported earnings and hedge values to currency movements, and the potential effect of hedge settlements and counterparties.