Cognizant Technology Solutions Corporation — Q3 2012 Form 10-Q
Business context and period. The unaudited filing covers the quarter and nine months ended September 30, 2012, compared with the same 2011 periods. Cognizant provides IT consulting, technology services, outsourcing and business process services. Its reportable segments are Financial Services, Healthcare, Manufacturing/Retail/Logistics, and Other. Unless noted otherwise, dollar amounts below are in millions.
Financial performance and liquidity
- Third quarter: Revenue was $1,891.7, up 18.2%; operating income was $355.4, up 21.3%, with an 18.8% operating margin versus 18.3%; net income was $276.9, up 21.9%, with a 14.6% net margin versus 14.2%. Diluted EPS was $0.91 versus $0.73.
- Nine months: Revenue was $5,398.3, up 21.1%; operating income was $1,005.2, up 21.4%, with an 18.6% operating margin, unchanged; net income was $772.5, up 20.0%, with a 14.3% net margin versus 14.4%. Diluted EPS was $2.52 versus $2.07.
- Margins and costs: Excluding stock-based compensation, the company-reported non-GAAP operating margin was 20.0% for Q3 versus 19.8%, and 20.1% for the nine months versus 20.0%. Stock-based compensation was $22.3 in Q3 and $79.9 year to date in 2012; management notes it is recurring. Nine-month cost of revenues rose 21.8%, slightly faster than revenue.
- Cash flow: Nine-month operating cash flow was $810.7, up from $590.1. Investing activities used $429.3 and financing activities used $367.1. Capital spending on property and equipment was $208.7. Cash and cash equivalents ended the period at $1,324.7, versus $1,310.9 at year-end 2011.
- Liquidity and debt: Cash, cash equivalents and short-term investments totaled $2,631.7; working capital was $3,265.9. The company reported no third-party debt and no anticipated near-term liquidity issues. $1,633.3 of cash, cash equivalents and short-term investments was held by foreign subsidiaries; management said its intent was to permanently reinvest foreign funds outside the U.S., apart from specified pre-2002 Indian earnings.
- Balance sheet and collections: Total assets were $6,107.0 and total liabilities $1,534.7 at September 30. Trade receivables were $1,363.5 and unbilled receivables $213.7. Days sales outstanding, including unbilled receivables, increased to 77 days from 73 at December 31, 2011.
Material changes and operating drivers
- All segments grew in Q3. Manufacturing/Retail/Logistics revenue rose 27.9%, Financial Services 20.2%, Healthcare 12.4%, and Other 8.9%. For the nine months, segment revenue growth ranged from 13.6% in Other to 24.0% in Manufacturing/Retail/Logistics.
- Management attributed growth to existing-customer expansion, new customers, increased discretionary development spending, broader service offerings and demand for global delivery and outsourcing. Active clients increased to approximately 821 from 777 a year earlier.
- Q3 revenue from Europe rose 4.1%; management expected European customer revenue to grow more slowly than the rest of the company through the remainder of 2012 amid economic uncertainty. North America accounted for 79.7% of nine-month revenue.
- The Indian rupee’s depreciation benefited operating margins, while settlements of designated cash flow hedges reduced margins by about 1.62 percentage points in Q3 and 1.27 points year to date. Compensation and benefits costs increased with headcount and wage pressures; headcount was approximately 150,400, up about 20,000 year over year.
- The effective tax rate increased to 24.0% in Q3 from 21.1%, and to 24.4% year to date from 23.9%. The company cited reduced Indian tax-holiday benefits and prior-year effects from foreign-exchange contract losses.
Outlook, risks and unusual items
- The filing provides no clear quantified revenue or EPS forecast. Management said it expected to continue investing in talent, services and geographic expansion, and to reinvest amounts above its 19%–20% operating-margin target excluding stock-based compensation.
- Management expected approximately $370 million of global capital expenditures in 2012. The India development-center program planned more than $700 million of spending over 2011–2015; outstanding fixed capital commitments were approximately $253.8 million at September 30.
- Management described the global economic environment as fragile and identified customer cost containment, European uncertainty, foreign-exchange volatility, and sector-specific softness in banking and life sciences discretionary spending as factors affecting results.
- Foreign-exchange exposure is material: designated rupee cash-flow hedge contracts had $3,677.8 million notional value; management estimated a 10% currency move could change their fair value by approximately $317.4 million. The filing also reports a net unrealized hedge loss in accumulated other comprehensive income of $198.2 million after tax; its market-risk discussion gives a $236.9 million net unrealized loss, apparently on a different basis. Investors should reconcile these disclosures.
- Q3 comprehensive income was $483.6, including $206.7 of other comprehensive income, principally reflecting a favorable change in cash-flow hedge values; net income was $276.9. This non-cash OCI movement should not be confused with operating earnings.
- The company repurchased 7.7 million shares for $460.0 million, inclusive of fees and expenses, under its repurchase program during the first nine months. The program’s remaining authorization was $159.6 million at September 30 and expires December 31, 2013.
- Risks include reliance on India-based personnel and delivery centers, wage inflation, currency and hedge volatility, changes to Indian tax incentives, customer spending and concentration, receivable collection, fixed-price contract execution, competition, immigration restrictions, cybersecurity and data-protection claims, and potential liabilities under client indemnities. Management said ordinary-course legal matters were not expected to have a material adverse effect; maximum potential indemnification exposure was not determinable.
- Management concluded disclosure controls were effective as of September 30, 2012; it reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether revenue growth and segment momentum persist, particularly in Europe, banking and life sciences.
- How receivables and unbilled services develop, including whether DSO improves from 77 days.
- The effect of rupee movements and hedge settlements on operating margins, hedge fair values and future expense recognition.
- Whether planned capital spending and India expansion commitments remain consistent with cash generation and demand.
- The sustainability of reported margins alongside recurring stock-based compensation, wage inflation and rising headcount.
- Future effective tax rates and the realizability of Indian tax-holiday and minimum-alternative-tax benefits.
- Potential exposure from client claims, indemnities, data-security incidents and other contingencies; the filing does not quantify maximum indemnification exposure.