高知特 (CTSH) 2003 Q1 法說會逐字稿

Good afternoon. My name is Kim and I will be your conference facilitator. At this time, I would like to welcome everyone to the Cognizant technology solutions first quarter 2003 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number 1, on your telephone keypad. If you would like to withdraw your question, press star, then the number 2, on your telephone keypad. Thank you. Ms. Stephanie Prince of FD Morgan Walk, you may begin your conference.

Thank you, operator and good afternoon, everyone. By now, you should have received a copy of the company's first quarter earnings release. If you haven't (inaudible). On the call today, we have Kumar Mahadeva, Chairman and CEO, and Gordon Coburn, Chief Financial Officer of Cognizant Technology Solutions.

Before we begin, I'd like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward looking statements. These statements are subject to the risks and uncertainties as described in the company's earnings release and other filings with the SEC.

I'd now like to turn the call over to Kumar. Please go ahead.

Thank you, Stephanie, and good afternoon, everyone. Thank you for joining us. The first quarter was another solid quarter for Cognizant, marked again by strong revenue growth, which reflects our consistent track record on strategy and execution.

We finished the quarter with sales of $74.5 million, compared with $46 million a year ago, and Wall Street consensus of $71 million.

Revenue growth was 60% year over year, and 11% sequentially. Pro forma earnings per diluted share, which excludes a $2 million transaction cost related to the recently completed IMS health exchange offer was 18 cents.

This compares with 12 cents in the year ago quarter and Wall Street consensus of 17 cents.

This is our fourth quarter of double digit sequential growth. A considerable accomplishment in the current IT environment. Cognizant is growing faster than it peers because of its superior business model and strong execution. Our fourth generation offshore business model is focused on partnering with customers who achieve substantial reductions in their cost structure while rationalizing and stream lining the applications portfolios to better align with business needs.

A process we call transforming while performing.

Cognizant's best of breed on site offshore project delivery capability works hand in glove with in depth local consulting presence, vertical expertise, and local executive management to partner closely with our clients.

As a result, we continue to win key strategic clients, having added three strategic clients for a total of 10 added this quarter, and we are able to ramp up business with new strategic clients and move work offshore at a faster rate than our competitors.

As we define them, strategic clients have the potential to generate 5 million to $30 million per year or more in revenues. Offshore outsourcing is usually driven down by the CIO or the C level executives with offshore cost savings baked into line operating budgets. Cognizant is now firmly established as one of only 4 or 5 top players who have what it takes to compete for these strategic engagements, and within this narrow field, we are further differentiated by our fourth generation model.

We believe that our early investment in consulting capability, domain expertise, vertical depth and client partnership separate us from the pack and will remain key as the industry continues to evolve. We also believe we have demonstrated the strongest execution in the industry.

For example, we have a sophisticated understanding of what drives direct and indirect costs or different types of assignments, and as a result, we are able to price accurately to be highly competitive while maintaining strong operating margins.

We can also forecast our profitability at project level and company level with a great deal of accuracy.

Building on the CMM Level 5 process maturity we built for project delivery, we have six sigma process improvement for other key processes, such as resource management and profit management, which is further improving our cost structure and business performance.

Application management continues to outpace development work due to new deals quickly ramping up as companies continue to look to do more with less of their IT budgets. For the first quarter, application management services represented 62% of revenue and grew 80% year over year. Application development, integration, and re-engineering grew 36% year over year in dollar terms, and accounted for 38% of revenue in the first quarter. We continue to actively cross sell development integration services to our application management clients with considerable success. As development and integration spending recovers, we expect to see growth in this side of the business, catching up with applications management.

Continuing our record of robust repeat business, during the quarter approximately 80% of our revenue came from clients who have been working with Cognizant for at least a year. While rapidly ramping up new strategic clients, we have continued to grow relationships with our legacy clients. Because of our continuing relationships, Cognizant has a strong recurring revenue base which substantially reduces risk.

We recently announced the successful completion of the exchange offer to distribute IM is.' majority interest in Cognizant. The exchange offer closed on February 6th, 2003. We believe that dramatically increased liquidity (inaudible) benefit of all of our shareholders.

In addition, the company announced this quarter that its board of directors declared a 3 for 1 stock split on its capital stock in the form of a stock dividend. The stock split will -- is expected to result in a trading volume and trading range for our stock likely to appear to a broader spectrum of investors. On the 1st of April, Cognizant closed on the acquisition of Asyst, a company specializing in CRM solutions with a strong record of serving which you blood pressure clients in (inaudible) and telecommunications verticals. We have seen strong (inaudible) expect that this acquisition will substantially strength our ability to win this business. In conclusion, Cognizant ended the first quarter with remarkable momentum. Based on the ramp up of new, large, strategic clients, the continued revenue growth from our established customer base and the potential customers in our robust new deal pipeline, we are pleased to once again raise guidance.

For the second quarter, we expect to record revenues of at least $82 million and EPS of at least 17 cents. We are also pleased to raise guidance for the full year to at least $330 million in revenue that is 330 up from $305 million, and at least 74 cents in EPS, up from 71 cents.

In his comments, Gordon will provide the details behind these numbers and with that, let me turn you over to Gordon.

Thank you, Kumar, and good afternoon. I would like to provide some additional information on the quarter, and then discuss our financial expectations for the remainder of the year.

Revenue for the quarter exceeded our prior guidance due to faster than anticipated ramp up of clients won over the past year or two. Our core businesses remain solid and performed well. Our pipeline is robust. And we are confident in our ability to continue to deliver healthy sequential revenue growth for the remainder of this year.

Application management now represents 62% of revenue, and development integration the remaining 38%. Both services grew sequentially in Q1. During the quarter, application management grew 17% sequentially, application development and re-engineering grew 3% sequentially.

All of our key industry sectors grew on a sequential basis. As anticipated, we experienced continued strong growth in our financial services sector. Financial services, which includes our practices in insurance, banking and transaction processing, grew to 47% of revenue in the quarter.

Many of the strategic clients won during 2002 were in the financial services sector. The growth of this sector is a result of these accounts ramping up. Healthcare was 22% of revenue for the quarter. Retail and manufacturing was 15%. And information services was 10%. The remainder of our revenues came primarily from other service oriented industries, as well as our alliances.

During the quarter, approximately 89% of revenue came from clients in North America. This percentage is up slightly from Q4 of 2002, and reflects the ramp up of strategic accounts we have won over the past year. The vast majority of these new strategic accounts were in North America.

We are now starting to see an increasing interest level in northern Europe for offshore services. As a result, we would expect this trend to slowly reverse in the future.

As Kumar mentioned, we added 10 new customers during the first quarter. Our active customer base increased to 107. Three of the clients won during the quarter have the potential to become significant revenue sources for us in the future. Due to the completion of the IMS split off exchange offering in February, revenue from providing services to IMS is split between related party revenue and non related party revenue on the income statement.

Turning to costs, cost of revenues increased 55% for the quarter as compared to the first quarter of 2002. The increase is almost entirely due to additional technical staff, both on site and offshore, required to support our revenue growth. We increased our technical staff by almost 2500 people, compared to the first quarter of 2002, and ended the quarter with close to 5900 technical staff. This is a net increase of nearly 300 staff from December 31st, 2002.

Gross margin was 45% for the quarter. A decrease of 300 basis points compared with our gross margin in the first quarter of 2002, and a 100 basis point decrease compared to fourth quarter of last year. The decline in Q1 gross margin resulted, in part, from volume incentives associated with the rapid ramp up of several strategic accounts, addition of key high end on site personnel and the appreciation of the Indian rupee. SG&A expenses, including depreciation, were $19 million, up $13.1 million in the first quarter -- from the first quarter of 2002. As a percentage of revenue, SG&A was 25.5% for the first quarter, a decline of 280 basis points from the first quarter of 2002, resulting from our ability to leverage last year's sales and marketing investment as well as continued cost control actions.

Pro forma operating income for the quarter increased 59% to $14.5 million from $9.1 million in the first quarter of 2002. Our operating margin was 19.5%, down approximately 20 basis points from the first quarter of 2002.

We were able to maintain our operating margin in the first quarter, despite the lower gross margin, due to the SG&A leverage we can achieve on larger deals, and our ability to leverage prior sales and marketing investment.

Interest income for the first quarter was $421,000, compared to $429,000 in the first quarter of last year. Interest income increased only slightly, despite higher cash balances, due to the significant drop in short term interest rates.

We had a $197,000 foreign exchange loss during the quarter.

During the first quarter, we incurred approximately $2 million of expenses associated with the recently completed split off exchange offering. As previously announced, we incurred $1.7 million in the fourth quarter of last year, bringing the total nonrecurring expenses for the split off to $3.7 million. We do not expect any further costs related to the split off.

Our GAAP tax rate was 20.1% for the quarter. On a pro forma basis, which excludes the split off related expenses, our rate was 17.4%. This is about 500 basis points lower than we originally anticipated. The decline in the rate for the quarter was due to several factors, including an increase in the Indian tax exemption from 90 to 100 percent starting in the second quarter of this year. On a full year basis, the tax rate may still be as high as 22.5 percent, as originally anticipated. Under the proposed Indian government budget, the costs for re (inaudible) our profits from years prior to 2002 would increase modestly. Since this budget has not yet been approved, GAAP does not allow us to accrue these expenses in Q1. Assuming that the Indian budget passes as currently proposed, our pro forma tax rate, both for the first half of 2003 and the full year of 2003, would return to around the originally planned 22.5 percent. This would result in a higher than normal rate in the second quarter to allow for to allow for a year to date catch up.

Turning to the balance sheet, we finished the first quarter with over $126 million of cash, an increase of approximately $400,000 for the quarter.

During the first quarter, operating activities generated $3.7 million. The Q1 operating cash flow includes pay out of a portion of the 2002 employee bonuses. Financing activities, primarily the exercise of stock options, generated an additional $2.8 million of cash. These amounts were largely offset by $6.1 million of capital expenditures, including expenditures on our Indian construction program.

As Kumar mentioned earlier, we completed the acquisitions of Asyst International on April 1st. The $4 million plus purchase price plus normal transaction costs will be reflected in our second quarter cash flow. Our collection of trade receivables during the quarter was very strong, once again. Based on our $46.8 million balance on March 31st, we finished the quarter with a DSO, including unbilled receivables, of 57 days, well below our targeted DSO of 70 days. Excluding unbilled receivables, our DSO was 49 days. Overall, our billed and unbilled AR balance grew by $5.8 million during the quarter as a result of the strong sequential revenue growth experienced. The quality of our receivables portfolio remains exceptionally strong. Of our total A/R balance, less than 2% is over 90 days old.

Our un billed receivables balance was $6.2 million at the end of the first quarter, up $1.9 million from December.

Turning to the first quarter, 23% of revenue came from fixed price contracts. Substantial revenue from fixed priced increases slightly increased from 21% in the fourth quarter of last year. Approximately 60% of the March unbilled balance will be billed during the month of April.

Turning to headcount; at the end of the first quarter, our worldwide headcount, including both technical professionals and support staff totaled close to 6500. This represents a net increase of about 300 people for the quarter. The majority of these additions were lateral hires of experienced IT professionals. Annualized turnover was 9% during the first quarter, including both voluntary and involuntary. Voluntary turnover was approximately 7% annualized, half of which was people joining other companies and the balance were people leaving the workforce for personal reasons. Involuntary turnover was 2% on an annualized basis.

Utilization was essentially flat, compared to the fourth quarter of last year. On site utilization was slightly below 90% during the first quarter. Offshore utilization was in the high '60s. Excluding recent college graduates who are in our training program.

Including trainees, offshore utilization was approximately 56% for the quarter. We had 350 people in our training program at the end of the quarter, though the average during the quarter was substantially higher.

Now I'd like to comment on our growth expectations for the second quarter, and beyond.

We are comfortable with our ability to deliver revenue in the second quarter of at least $82 million. This includes at least $80 million from our core business, and an estimated $2 million from our recent acquisition of Asyst. We continue to have significant revenue visibility due to the fact -- due to the high level of recurring level and the long term nature of our customer contracts. In fact, today we have customer commitments for well over 90% of our second quarter revenue guidance.

For the full year, based on strong demand environment for offshore services and our favorable experience on ramp up rates, we now expect revenue to be at least $330 million. This includes at least $323 million from our core business and an estimated $7 million from Asyst.

During the second quarter, we intend to closely monitor our spending and expect our operating margin to remain in the 19 to 20% range, in line with our historic margin levels and prior guidance. This excludes the impact of the Asyst acquisition which we expect to negatively impact operating margin by approximately 50 basis points in the second quarter as we quickly integrate the acquisition and leverage its capabilities into our core business.

We expect operating margins for full year 2003 to be in the 19 to 20% range, including Asyst.

With this expected level of revenue growth and our expected operating margins, we are currently comfortable with our ability to deliver EPS of at least 17 cents in Q2.

This guidance includes the anticipation of a higher than normal tax rate in the second quarter as previously discussed. In order to bring the first half tax rate to 22.5 percent, the rate in the second quarter would need to be approximately 27%. In addition, Q2 guidance includes about one half of one cent of dilution from Asyst. We expect the Asyst acquisition will be neutral to slightly accretive for the full year. Based on current trends, we expect EPS for the full year to be at least 74 cents, up from the 71 cent guidance we provided on our last earnings call.

Full year guidance excludes the impact of the nonrecurring expenses we incurred in the first quarter related to the split off exchange offering, and it assumes a full year pro forma tax rate of 22 and a half percent.

We expect the vast majority of our 2003 growth to come from our existing client base, particularly the numerous strategic deals we won in 2002 and the first quarter of this year. Based on the feedback we have been receiving from these clients, and their attention to leverage the advantages of offshore, we are quite optimistic about the outlook for the remainder of this year. Kumar and I would now like to open the call for questions. Operator?

At this time, I would like to remind everyone in order to ask a question, please press star, then the number 1, on your telephone keypad. We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Ed Castle of Wachovia Securities.

Hi, Ed, how are you?

Good, good. Can you give us a little bit more color on what you're seeing in Europe and are there any particular verticals that you're targeting?

Yeah. The European market, we see some signs of life. We're seeing the beginnings, I would say, of some of the large strategic deals that we've seen we've seen in the U.S. over the last year and a half now. You know, I think many of these deals will still take several months to close and then some further time to wrap up. So I don't think you'll see a major contribution from those deals for at least through early next year, I would say. But the encouraging signs are that certainly the large companies in Europe are following the example set by companies in the U.S. and so we should expect to see the market pick up not too long in the future.

In terms of verticals, clearly the strongest, I think in terms of market demand and for us, has been financial services. And as Gordon mentioned, we've seen faster growth in that vertical than all of the others.

Can you give us a sense for the delay in new business generation? And answer these separately. One from the war in Iraq and one from the SARS virus, if any.

We have not at this point seen anything, Ed. We haven't had any trips cancelled on account of this. We've had 1 or 2 for other reasons. But, you know, I think particularly on the SARS issue, it's a little early to tell so far, as you probably know. There has been minimal impact in India. I think there was one case, but I think it's really too early to tell if that will have any sort of a significant impact.

Last question. You gave volume discounts for some of the was it volume discounts for the large clients or volume discounts because they ramped quicker, and then will that continue on in the future?

Sure. The volume discounts are related to the clients ramping actually ramping up quickly. Assuming, you know, they'll continue to have healthy ramp ups, some of those volume discounts and incentives would certainly continue.

And, but Ed, one thing to point out there is that they're sort of carefully calculated so that our margins actually increase. Because as these accounts get larger, our costs to support them go down.

So, in fact, even though some volume incentives do kick in, the margins remain the same or even increase slightly, and we're talking about operating margin now, not necessarily gross margin.

Thank you.

Your next question comes from Andrew Steineman of Bear Stearns.

Hi there.

Hi, Andrew.

Could you just gave the on site and offshore bill rates and, you know, kind of given the evolution of your client base, where do you think that's going to trend through the year?

Sure. Bill rates on site offshore were almost flat. They were down less than a half of a percent, primarily just related to some of these volume incentives kicking in.

When we're looking at the price at which new deals are going off, you know, we think they're going to stay somewhere in this range. You know, they're always going to bounce around a little bit, depending upon which clients ramp up, but we don't see we certainly don't see rates falling off a cliff.

Right. And so you think by the the end of the year, you think your average offshore bill rate would still be around $24 an hour?

You know, once again, if we shift more towards these bigger new accounts with some volume incentives, it might drop slightly, but, you know, I think that would be a very slight drop.

Okay. Have you detected any wage rate inflation? You know, obviously we hear a lot about you know, all sorts of companies moving into India. Not particularly your competitors but more like software firms and what are you seeing out there on the wave side?

You know, actually, Andrew, what we've seen is something of a deceleration in wage inflation because I think primarily because the big players like (inaudible) and (inaudible) seem to have delayed awarding wage increases. So even though we were planning on wage increases, we've now and we will have some, we've delayed them by a little bit to see what the others do. So I think if anything, the rate of wage increase seems to have gone down some this year.

Right. But Kumar, just to get it straight, like when we hear like Oracle and Microsoft pushing more in India, are they chasing after the same skill base as you, or is that not applicable?

I think they are chasing after a slightly different skill base, and the numbers they're talking about are at least at the moment pretty small.

Okay. I appreciate the comments. Thank you.

Okay.

Congratulations.

Thanks, Andrew.

Your next question comes from Julio Quinteras (ph.) of Goldman Sachs.

Hey, guys, how are you?

Hi, Julio.

Real quickly, maybe we can touch on something else. HBV 1 visas and L1 visas come due in October 2003 and related to that, can you touch a little bit on the hiring trends that you guys have sort of forecasted for the rest of '03?

Sure. Let me start with the second part of the question. Hiring, as you know, there's a lot of seasonality in that. We hired a tremendous number of people in the back half of last year. Those are the college graduates coming in. You'll certainly see the same store seasonality characteristics this year, as was seen in Q1 because we did not have a lot of college kids coming in.

So Q2, you should anticipate that we'll certainly add people, but not at the rate that we saw in the back half of last year. And then Q3 would certainly be a fairly significant hiring quarter for us.

On the on the visa front, the -- it's more an issue related to the H 1 visas, where the cap -- the annual cap declines starting for the next government fiscal year in October. Because of the way Cognizant is structured and the nature of our work, we use multiple visa types, including both H visas and for certain specialized staff L visas, so we're certainly keeping an eye on it. Based on what we're seeing at this point, we don't see it being a significant concern.

I mean how the materiality of the change, I mean we're going from a hundred thousand plus HB 1 V Visas to 61,000. Are those the right types of numbers and then I guess in terms of your models, specifically, does that put a crimp on your potential hiring plans?

You know, I think the best thing to look at is several years ago when the visa cap was going to hit mid year, we were able to manage the business around that because of the multiple visa structures that we have, the number of people that we already have over here, the number of people who have valid visas in India already, so, you know, certainly we have to plan well, but for a company such as Cognizant where we've been in place for a while and where our people tend to stay long term once they come over, at this point we don't see it as a significant issue.

And we've also geared up our U.S. based recruiting quite substantially, so and at this point, to recruit locally for on site positions is really not a problem, so that's the other avenue we could use.

Okay. Great. One final question. Maybe if we can go back to the components that drove some of the pressure in the gross margin this last quarter, you highlighted three of them, Gordon. Can you just go through those and maybe just kind of weight them in terms of, you know, what the sort of, what the basis point impact was, if you don't want to give that much clarity, at least just kind of give a weighting on where the pressure was on the gross margin side?

I think at a macro level, they're all probably contributed somewhat equally.

Okay.

Yeah. The rupee appreciation, hiring some senior on site delivery people, and the small decline that I mentioned in rates because of the volume incentives.

Okay. And you guys aren't seeing any pressure from subcontractors -- subcontractor costs.

We're a very small user of subcontractors. We use a few in very specialized areas but it's a very, very small percentage of our workforce.

Yeah. And I think one of the factors that I don't know if Gordon mentioned that also impacted us was just the rate of ramp up. We've had to recruit a lot of people and then sort of a training and induction period, which is why, I think, the utilization numbers we talked about were a little lower than usual.

Definitely. I mean that's a big part of the way that the model flows so not a great supplies.

Right.

Great quarter, guys.

Thank you.

Your next question comes from Joseph (inaudible) of Jeffries & Company.

Hi, guys, and solid results again.

Thanks, Joe.

Can we talk a little bit more about some of the lateral hires that you picked up? I assume when you say "lateral hire," those are mostly people that you picked up in India, first of all and then secondly, I would imagine that some of the kind of more seasoned executives might be or project managers in India might be the ones that might be coming a little bit more valuable these days. Can you talk a little bit about the recruiting environment for some of the more experienced project managers versus the kind of on site or the on campus recruiting efforts?

Sure. The, you know, the percentage we sort of like to run is 60 to 70 percent campus and about 30 percent lateral. Now, that has reversed quite a bit recently. I think in the first quarter we didn't add a lot of people, but about 70% were lateral, I believe.

Right. Because some of that is seasonality of the college hiring.

And the college hiring fell off in the first quarter. And, you know, it is a lot easier to recruit laterally in India now than it was. They're a lot more people available, good people, because many of the sort of second tier players and some of the leading players are not growing as fast, so it's become easy to attract fairly good quality people. And what was the second part of your question, Joe? Sorry.

Just generally, if oat the if you would see potentially if these people might be causing a little bit more wage inflation than maybe the campus kids might potentially be doing?

I think that is possible, although we haven't seen it yet. I think what we are seeing is that salaries at the lower levels is certainly not going up, but it's possible that the more senior people, and, you know, there's a plentiful supply of, you know, the average Java programmer or it's not really an issue. As you get to the more senior people, the supply is clearly tighter, although Cognizant, you know, has grown a lot of its own. One of the advantages we have from having been around and recruited people, the best people off campus and developed them, is that we have a huge supply of people just growing within the company. Which eases our problem. But it's possible I mean obviously we have to hold onto those people, and so we will be, in fact, to the extent we do raise it this year, we will be concentrating that on the more senior people and the top performers.

Okay. And then drilling into your acquisition, this is kind of the first kind of real acquisition the company's done. I mean the other two kind of business combinations were pieces of business from other organizations. Is this is this a U.S. based firm? Is this an Indian based firm that you're picking up?

This is primarily a U.S. based firm though they do have a small offshore operation and they have you know, they have the experience of working with the offshore model.

So that means that you were already using some of the cash for this acquisition that was that was fully taxed, is that correct?

No. This is this acquisition occurred in the U.S., so these are --

It's a U.S. company, it's a U.S. headquartered company so --

Okay. So this is using the cash that the company had already accrued taxes on?

Exactly.

Okay. Very good. Thanks a lot, guys.

Okay.

Thanks, Joe.

Your next question comes from Adam (inaudible) of UBS Warburg.

Hey, guys, good afternoon.

Hey, Adam.

On Gordon, on the SG&A line, how much of the if I'm doing it correctly here, how much of the $18.9 million or so in SG&A was organic and how much was due to the acquisition?

The acquisition actually closed April 1st, so there was no impact from the Asyst acquisition in the Q1 numbers.

Okay. So if I'm looking at your margins a little bit, obviously there's been a lot of concern in the industry about the margins. If I'm doing my math correctly, your growth in SG&A year over year was roughly 68 and a half percent?

No. SG&A, including depreciation and amortization, grew 25% year over year. I'm sorry, I'm sorry. I take that back. Grew 45% year over year.

Okay. And that's if I'm looking at the second and third and fourth quarters, that matches the high of those other three quarters, so I guess my point is: You didn't have to take a lot out of SG&A or stifle spending or anything to get to your gross your operating margin line of 19 and a half percent. Is that the right way to look at it?

I think you raise a very important point. Because we're growing so quickly, and because we have the privilege to be able to reinvest significant amounts in the business, in order to achieve our operating margins we did not have to reduce SG&A spend. It's just we had to control the growth of SG&A spend. And obviously that's a much easier thing to do, especially when we have things benefiting us such as moving from leased facilities to owned facilities, things such as starting to get the leverage on the client partners that we've been investing in, and getting the leverage on the industry partners. But I think you hit an important point and that is, we continue to invest in SG&A and we will continue to invest, but we have leverage there that we can take advantage of.

(inaudible) that on some of the large relationships, you know, increasing part of our revenues coming from relationships which are not of $10 million. The SG&A on those accounts is a lot lower than our traditional accounts.

Okay.

So inherently, that SG&A line is going down, just as we get more of these large accounts.

Okay. I just wanted to clear that up because I think it's important if your gross margin line was not as strong as we thought, obviously the natural conclusion is maybe the other factors that have hurt the other vendors, like (inaudible) or whatever, are taking place of your shop also. Can you just give a sense of it doesn't seem like that's the case, though, because SG&A grew 45% year over year.

Yeah, I think there are a couple of factors working here. First of all, we are very comfortable that this year we can maintain the 19, 20% operating margins. As Gordon mentioned, we are not really seeing a significant deadline in average price. I think the big difference between us and a (inaudible) or (inaudible) is that they have legacy clients from a few years back that are billing at, you know, in the mid 30s offshore and coming down. They're renegotiating those rates. We have not had any clients renegotiating rates with us, and that's because our legacy clients are pretty much at the same rates that we have currently.

So average pricing is remaining pretty constant, and right now, you're seeing the ramp up of clients whose contracts were negotiated six to nine months ago when, you know, the price competition was at its most intense.

In fact, I'd say if anything, the prices have stabilized a little bit and maybe even turned up a little bit, so you will start to see some of that kicking in later as well.

So I think I'd like you know, for the moment, sort of confirm what Gordon said, which is that we expect no real problem with maintaining operating margins.

The wildcards, I think, are exchange rate. There is a possible impact from repeat rupee appreciation, but again, about only 25% of our cost structure is in rupees, and we have see a little bit of rupee appreciation in the last couple of months, so I think that's the main risk factor looking forward. And a lot of the gross margin contraction you've seen is also related a lot to the rapid ramp up and on site presence.

Okay. If I could just ask a final question here.

Yeah.

Do you are you guys still looking at the next three years or so operating margin still in the 19 to 20% range, and then Gordon, if you could comment on the second half of the year. Is it illogical to think about operating margins approaching the same levels as they as they did maybe in '02 we higher end of that 19 to 20% range?

Let me take the second part of the question first. Whether at the low end or the high end of the range, I think that's just going to depend on what happens with ramp up and utilization, so I'm not sure I want to commit one way or the other on that you know, our objective that we're very comfortable with is staying within the range and, you know, it does bounce around a little bit and it depends on, you know, how good ramp up is.

When we look out several years, you know, I think it's going to depend on what happens in the pricing environment in future years. As Kumar mentioned, we're actually feeling pretty good about what we're seeing in the pricing environment today for deals that are being signed, and I think that will, you know, if that continues, I think that will position us pretty well for the coming years, but, you know, we'll have to continue to watch that.

You know, I think going forward, it really will depend on supply and demand. I think what is clear is that the field of competition has narrowed, increasingly. It's, you know, Cognizant, Emphasis, [Whip Row], and I think it really depends on what these three companies do with pricing and I think if the demand is strong, the pricing will be stable, and if demand is weak, then who can tell?

Okay. Thanks, guys, for your answers. I appreciate it.

Thanks, Adam.

Your next question comes from Moshe Katri SG Cowen Securities Corporation.

Thanks, thanks. A couple of questions, guys. Can you I'm not sure if you provided us the number for the headcount mix onshore versus offshore.

Sure. That’s quite consistent with last quarter. Right around 70/30. It was down our on site percentage was down very slightly, but for all purposes, assume it was roughly flat.

Okay. And then let's talk briefly about win rates, if possible. Have there been any change in the trends for within rates in the past few quarters, specifically looking at Q1 of this year and then compared to Q4 of last year and in the same context, are there any notable competitors from the U.S. that are showing up more on the radar screen?

I don't think we've seen a big shift in win rate. I don't have the numbers done for the first quarter yet, but I think we are continuing to win good accounts and certainly plenty of accounts to drive very strong growth into the next year or so.

And the set of competitors really remains the same. The toughest competitors are Emphasis and [Whip Row] to some extent, Tau Tau, although they're considered, you know, slightly more of a commodity player, and I haven't really seen much presence from any of the U.S. players yet.

Okay. And then last question. I hate to talk about the same subject again and again.

Yes. Moshe Katri: I just wanted to focus a little bit more on gross margins. In terms of a trend going forward, there's been an impact on a relative basis that hasn't been as significant compared to some of your peers. Where do you think that the -- what sort of a trend are we going to see down the road for gross margins? And assuming pricing remains here where it is today, it doesn't change much, should we should be should we look for a certain range, should we look for a certain trend?

I'm a little hesitant to give we've always tried to stay away from giving specific guidance on gross margin, and the reason why is each and every deal that we price, we price for customer profitability, which is somewhat equivalent to operating margin. And I'm just as happy having a deal with a gross margin at 43% as I am at 48%, if it delivers the same customer profitability.

So in part, it's going to depend on what sorts of deals do we win. Are they the mega deals, are they the mid size deals, do we see a rebound in development or does it say more application/maintenance. You know, it's sort of if you step back, the gross margin moved by a total of 100 basis points during the quarter, which in the realm of things is, you know, given a portion of that was simply rupee devaluation was really quite modest, and our strategy is, you know, we are going to price deals to maintain our operating margin.

Okay. And then finally, I'm looking at your bid and proposal pipeline. Are you noticing a significant increase in average engagement sizes, looking at your new strategic clients that you're winning? Is there is there a noticeable increase in those in those deal sizes?

A noticeable increase from what it was a couple of years ago. It's probably the same as we won last year.

And (inaudible) obviously the average size of our client relationships continues to grow each quarter as the strategic deals become a bigger part of our portfolio. It's exactly what we were expecting and hoping for.

Okay. Thank you.

Your next question comes from Cynthia Houlton of RBC Capital Markets.

Hi. Just a couple of questions. First, on you mentioned that related party revenue post the split off, that that became in total revenue. Could you just give us that number? Was it fairly flat quarter over quarter with total revenue from IMS?

It was up slightly. It was just over $5 million total for Q1.

Okay. And then on looking at utilization and, you know, off balancing what you can potentially do on any, you know, modest increases in wage pressures going up, could you kind of walk us through, you know, what we could anticipate on how to look at the impact in terms of, you know, utilization going up X percent versus wages going up a certain percent, how that could off balance on the operating margin line?

Sure. At a macro line, utilization, particularly offshore, is running relatively low right now and that's intentional because of the strength we're seeing in the demand environment. We want to make absolutely sure we have enough well qualified people to meet customer demand for rapid ramp up. You know, certainly one of the tools in our bag is to take utilization up a little bit to offset any wage pressure. Then in addition to that, remember there are lots of other things down in SG&A including, you know, the revenues growing so quickly, simply growing SG&A spend slower than revenue as we get leverage in our client partners, as we get leverage in our account managers, as we move to our own facilities. So we have a wide range of tools to be able to absorb what we expect to be quite modest wage inflation.

Can we think about, still in that 1 to 3% increase, or do you have any sense of what you are modeling in for wage increases kind of across the board or do you look at it on segmented of your headcount base?

Yeah. We're still watching what the competition is doing a little bit, but as Kumar said, we think the impact to the business will be quite modest.

Okay. And then just a final question on verticals. I know financial services continues to be strong but maybe a little bit of color on what you're seeing in healthcare and manufacturing and retail, and what are kind of indications that you'd like to see for those industries to perhaps, you know, move faster or be more like financial services. Just a little bit more color on that would be great.

Yeah. We've seen a fair amount of action recently in the retail segment. Several of the strategic wins in the last couple of quarters have been in retail, so we're seeing some pickup there. Healthcare, you know, is I think a very large long term opportunity. It tends to be low moving industry, as you all know, and so the decision cycles are longer and they have not been as aggressive as financial services in moving to very large deals.

But I think that is coming. I think there are lots of clients who are talking about it. It may take just a little longer until they make the commitment to move.

Thank you.

Thanks, Cynthia.

Your next question comes from Pat Burton of Smith Barney.

Hi, and congratulations on the quarter. I guess I'll ask about your BPO strategy and activities. Could you provide us with an update in that area? Thanks.

Okay. Pat, we have some pilots going with clients. We are looking at a number of investments in the BPO area. We are looking at a strategy of making minority investments rather than outright acquisitions because particularly in the call center area, we are we are still not convinced that this is going to be a long term profitable business.

However, we want to be in the game. Many of our clients are interested in it. So we are looking at the option of taking making a minority investment in a company that will allow us to play in that game, and steer it or change it to a higher value added BPO activities that can generate higher margins before acquiring it outright. So you'll probably see sort of a two step process in that area from us.

Okay. But you're still intent on avoiding call center, correct?

We are still intent on avoiding an outright acquisition in call center. We may make a minority investment since many of our clients seem to want some capability in that space as well.

Thank you.

Okay.

Your next question comes from Julie (inaudible) from Morgan Stanley.

Thanks. Good afternoon.

Hi, Julie.

I wanted to ask you about your a little bit more on the SG&A spending strategy. I understand you get you get good leverage from client partners and as you add these large strategic clients. What I want to understand is more going forward, relating to adding new clients. Some of your major competitors are talking about stepping up SG&A spending. They're adding 20 or so clients per quarter, and seem to be more going after a new client strategy whereas Cognizant's seems to be a strategy more to capture additional business from existing client. Can you help me understand this strategy a little more correctly?

I don't think that's correct, Julie. If you look at our revenue in terms of revenue coming out of clients it's about 20%. I think that's probably about the highest in the industry so we are, in fact, adding more new clients than most of our competitors. So I'm not exactly sure what the thrust of your question is. Is it are you asking whether we have enough salespeople or what is the question?

Yeah. Is just how focused for 2003 are you on adding new clients, and will that mean, what kind of -- what will that mean in terms of additional SG&A spending?

Julie, I think the best evidence of that is that we significantly increased our sales force in Q1. We increased the number of client partners to manage new customers that we won. You know, one of the things you have to remember is we've been making a lot of those investments in the infrastructure to win new clients that our competition is now just making and that's one reason why our margins was at 19 to 20% when our competition was at 30% plus. So I think already in our SG&A expense base is the infrastructure necessary to win at least our fair share, if not a disproportionate share, of the deals we compete in for new clients. I think and that's one reason why, I think, you know, the revenue guidance we were able to give or increase on this call was due to the fact that of the number of client wins that we had, both in Q1, as well as last year.

And but the of (inaudible) the thrust of your question is actually correct in that we have a lot more successful in ramping up the clients we have won, and that's because of the model we have, because of the change management capabilities. So if you look at the ramp up of our clients, it is tends to be a lot faster than many of our peers, and that is the sort of consulting capability we are able to put in front of the clients and the processes that we're able to use to ramp up clients very quickly, which I think a lot of the companies are having difficulty with.

Okay. If I could just ask you have one more on the pricing. As the pricing differential now begins to narrow a bit, between Cognizant and some of the other top tier India firms, are you concerned at all about increased competition?

The price differential has been almost nonexistent for well over a year. What you're seeing now is a result of deals that were priced six to nine months ago, and going back then, the difference between Cognizant and the others has been zero. If anything, Cognizant is at a little bit of a premium. So the situation that existed 3 or 4 years ago when Cognizant was a lot less known and we had to price at a discount over Emphasis are long gone, so today there really essentially hasn't been any difference in prices for well over a year, I'd say.

Okay. Thank you.

Thanks, Julie.

Your next question comes from (inaudible) of Janney Montgomery Scott.

Thank you. Good evening.

Hi.

Just wanted to ask you a question on the tax rate again. I'm not sure I'm clear on what the tax rate should be in the second quarter. If you could clarify that and what is your expectation for the whole year?

Certainly. We assuming the India budget passes as currently proposed, we would expect the tax rate to be around 27% in Q2. That would bring the year to date tax rate for the first half of the year to 22 and a half percent. And we would expect that 22 and a half percent to continue for the remainder of the year. That's all excluding the split off stuff on all on a pro forma basis.

Okay. And then the 17% this quarter pro forma was the result of a catch up? Or --

Not quite a catch up. Basically it's because of the way the India budget is happening. We were required to book the there's good things and bad things happening in the budget for us. GAAP requires that we book the good things in Q1 but we not book the bad things until Q2, when the budget's passed, so, you know, it's just a timing thing. And that's why on a full year basis, we still expect to be at the rate that we planned. And for the first half of the year, on a year to date basis, we'll be at the rate that we planned.

Okay. And the 17 cent guidance for the second quarter includes the higher tax rate and the 50 basis point increase in the SG&A from the acquisition cost, is that correct?

Absolutely. It includes the higher tax rate of 27%, and includes a 50 basis point hit to operating margins from the acquisition.

Got it. Okay. And just on organic growth, well, I guess revenue growth, how much was the impact from the American Express contract completed last year, when you break down your revenue?

It gets -- it's not really possible to break that down anymore because, remember, you know, that was a client we had already selected us, so what's from the acquisition and what's organic becomes very --

The run rate of the acquisition was about $15 million when we acquired it, but obviously we've cross sold a lot of business to American Express since, so it's hard to separate what was from the acquisition and what's new.

Okay. And then going back to pricing just for a quick second here, when do the volume discounts kick in? At what size does the contract have to get to before you see that, in your business?

Once again, you know, I don't want to get into specifics for competitive reasons, but, you know, what we do is we price deals, including whatever if we were to use volume incentives, to achieve targeted customer profitability, so where they're going to kick in is will depend on the pricing on the deal, on what we think we're going to have to do with the client relationship, what we think the overhead costs on the deal will be. So I don't think there's one simple answer. But bottom line, you know, deals certainly have to be quite large in order to take advantage of the volume incentives.

I guess on the newer contracts, what are the deal sizes these days? . Is that 5 to 30 million sort of a good reflection of what you're saying today?

Yeah, that's what we're shooting for and I think a lot of them get into the middle of that range. 3 or 4 of them are at the top end of the range.

Okay. And I guess the last question is: When you talk about pricing, are there any verticals or services that you are not exposed to which are seeing most of the pricing pressure that your clients or sorry, your vendors, other vendors in the space are seeing? For example, product engineering, product testing, things like that, which you don't do?

You know, I'm not sure that the price pressure issue is really related to vertical. I think it's more a question of the fact that starting about a year ago, the prices were a lot lower than some of the legacy prices that particularly emphasis and [inaudible] were getting 5 or 6 years ago. But since that line, prices have stabilized and if anything, gone up.

Now, Cognizant has always priced at those lower levels, even going back 5 or 6 years, so for us, actually prices have been remarkably stable throughout our history.

Makes sense. Hang you, Kumar. Thank you, Gordon.

Thanks. Operator, I think we have time for one more call.

Your next question comes from Ashland (inaudible) of CitiGroup.

Hi. Thanks for taking the question. Just a broad perspective question. As you look at sort of the next generation of India based services and, you know, looking at the continuum of what you can offer, (inaudible) higher value services or you can go to BPO or you can do you know, go to lower cost countries like China.

Could you just very briefly address those three? How would you rate yourself, for example, on the higher value stuff against both traditional U.S. Acenture type companies as well as emphasis [whip pro] and BPO also you provided China. If you could provide some kind of an update.

Sure. I'm not sure what is high value and what is low value anymore, but let me tell you how we think about the market and how we think clients think about the market. I think clients, if you talk to our clients, they think about the market in, I'd say, three or maybe four segments, and the segments are infrastructure and that's the segment in which, you know, EDS and CSC and IBM are strong. Then there's the business as usual application management, application development. That's the stuff that traditionally has been done in house. And that's where the Indian companies are fitted in, and that's where Cognizant really has its trend. And I think Cognizant, emphasis, [whip pro], really dominate that space today. And then there is sort of the consulting or innovation segment of, you know, business transformation, re-engineering, et cetera, which has been traditionally the turf of the Acentures and the big five, the consulting companies.

Now, I'm not sure, which is higher value, whether the consulting piece is higher value added or the stuff we do is higher add value added. I think certainly the stuff we do is more critical because it's the stuff that keeps the business going. And the margins are higher. So, again, you can argue about which is higher value added. The reality is that the Acentures are trying to move into our space, and we are certainly encroaching into the space occupied by the Acentures, because by virtue of being in the business as usual segment, we get given a large number of development integration projects, particularly the sort of $1 million to $3 million range of projects.

Now, the fourth piece of the market is BPO, and as I mentioned earlier, we're sort of approaching that cautiously because again, we're not convinced, unlike many of the other Indian companies, that the call center business, for example, is a good long term profitable business, so we are trying to focus on the higher value added, more administrative segments of the market where the business processes are integral to the client's operation, just like our application management business is.

And in those segments and we may use a call center investment as an entry strategy to get into that segment, but that's how we're looking at that.

In terms of China, et cetera, we think China is a longer term play for development. We don't think that the country is ready yet to ramp up on a large scale, so we're not looking at China near term but we are certainly looking at it as a longer term possibility. We're looking at several other countries as well as possible development centers.

Okay. And a quick follow up on I may have missed this data. Did you disclose terms for the acquisition?

We said the purchase price was $4 million plus. In addition, there's normal acquisition transaction costs.

Okay. And is there any earn out or anything like that or

I don't want to get into it those sorts of details.

Okay. Thank you.

We'd like to thank everyone for joining us this evening. We look forward to speaking to everyone again on our second quarter earnings call in July. Thank you very much.

Thank you for participating in today's conference. You may now disconnect.