Cognizant Technology Solutions Corporation — Q3 2010 Form 10-Q
Reporting period: Three and nine months ended September 30, 2010. Financial amounts below are in millions of U.S. dollars unless otherwise stated. The interim financial statements are unaudited.
Business context and performance
Cognizant provides IT consulting, technology and outsourcing services. Growth was attributed to demand across service lines and industries, deeper work with existing customers, discretionary development and integration projects, and expansion in Europe, particularly the U.K. The company reported approximately 697 active clients, compared with 570 a year earlier.
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Revenue | $1,216.9 | $853.5 | $3,281.8 | $2,375.9 |
| Revenue growth | 42.6% | — | 38.1% | — |
| Operating income | $228.3 | $161.8 | $617.2 | $451.6 |
| Operating margin, GAAP | 18.8% | 19.0% | 18.8% | 19.0% |
| Net income | $203.7 | $136.6 | $527.4 | $391.0 |
| Diluted EPS | $0.66 | $0.45 | $1.71 | $1.30 |
| Effective tax rate | 16.3% | 16.6% | 16.3% | 16.5% |
Margins and segments: Operating margin excluding stock-based compensation and applicable Indian fringe-benefit tax was 19.9% in Q3 (20.2% prior year) and 20.1% for the nine months (20.4% prior year); this is a non-GAAP measure. Q3 revenue grew across all segments: Financial Services 42.9%, Healthcare 33.9%, Manufacturing/Retail/Logistics 57.0%, and Other 40.4%. The Manufacturing/Retail/Logistics segment had the fastest growth; its nine-month revenue rose 50.8%.
Cash flow, liquidity and balance sheet
- Nine-month operating cash flow was $372.4, versus $434.8 a year earlier. Management attributed the decline mainly to working-capital needs supporting growth, including higher receivables.
- Cash and cash equivalents were $1,317.1 and short-term investments were $611.7 at September 30, totaling $1,928.8. Working capital was $2,430.5; management said it did not anticipate near-term liquidity issues.
- Trade receivables rose to $919.6 from $626.3 at December 31, 2009; unbilled receivables increased to $145.6 from $83.0. Days sales outstanding, including unbilled receivables, rose to 81 days from 72 at year-end 2009.
- Investing activities used $292.6, including $111.0 of property and equipment purchases and $31.7 for acquisitions, net of cash acquired. Financing activities provided $134.5. Cash increased $216.1 during the nine months.
- The balance sheet reports no debt. Total liabilities were $879.1 and stockholders’ equity was $3,367.2 at September 30, 2010.
Changes, outlook and key risks
- Growth versus profitability: Revenue and net income increased substantially year over year, while GAAP operating margin declined 0.2 percentage points in both the quarter and nine-month comparison. Management cited compensation and incentive costs, rupee appreciation, and investment for growth, partly offset by efficiencies.
- Currency exposure: Management estimated rupee appreciation reduced nine-month operating margin by 158 basis points, excluding designated hedges. Salary-hedge settlements benefited nine-month margin by 83 basis points. The company had $2.085 billion notional value of designated rupee salary hedges and $384.0 million of undesignated balance-sheet hedges at quarter-end.
- Outlook: No specific revenue or EPS guidance is provided in the supplied filing text. Management expected to continue investing in the business above its targeted 19%–20% operating-margin range excluding stock-based compensation and applicable fringe-benefit tax, and expected 2010 capital expenditures of approximately $180 million.
- Tax exposure: Most Indian Software Technology Park tax holidays 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. Special Economic Zone incentives may apply to qualifying centers.
- Other risks and contingencies: The filing cites fragile global conditions, customer spending and concentration, wage inflation and talent retention, offshore-outsourcing and immigration restrictions, project execution and fixed-price contract risks, cybersecurity and client-data claims, and legal and regulatory exposure. Fixed-price contracts represented approximately 31.1% of nine-month revenue. Management said ordinary-course claims were not expected to have a material adverse effect; fixed capital commitments for Indian development-center expansion were approximately $94.3 million.
- Unusual investment item: Remaining auction-rate securities were redeemed by issuers or purchased by UBS at par during 2010, reducing the balance to zero. The company reported no material effect from adopting the accounting standards discussed in the filing.
Important facts for investors to verify
- Whether receivables and unbilled balances convert to cash, given the increase in DSO and the lower year-over-year operating cash flow.
- How Indian tax-holiday expirations affect the effective tax rate and earnings after March 2011.
- Whether wage inflation and rupee movements pressure GAAP margins, and how much protection the hedge portfolio provides.
- Whether planned hiring, facilities spending and other growth investments support revenue growth without further margin deterioration.
- Whether customer demand, fixed-price project execution and the company’s large financial-services exposure remain supportive of results.