高知特 (CTSH) 2005 Q3 法說會逐字稿

Good morning, my name is Cynthia, and I will be your conference facilitator. At this time I would like to welcome everyone to the Cognizant Technology Solutions third-quarter earnings conference call. [OPERATOR INSTRUCTIONS] Thank you. At this time, I would like to turn the call over to Peter Schmidt with Financial Dynamics.

Mr. Schmidt, you may begin the conference.

Thank you and good morning everyone. By now you should have received a copy of the Company's third quarter earnings release. If you have not please call our offices at 212-850-5600, and we will be sure that one is sent to you. On the call today we have Lakshmi Narayanan, President and CEO, and Gordon Coburn, CFO, 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 Lakshmi. Lakshmi, please go ahead.

Thank you, Peter, and good morning everyone. Thank you for joining us today for Cognizant's third quarter 2005 earnings call. This morning I'll provide an overview of the fiscal third quarter discussing the key drivers of Cognizant's success and overall market trends that are having a positive impact on our performance. Francisco D'Souza, our Chief Operating Officer, will join in for some part of the discussion today. I will then turn the call over to Cognizant's Chief Financial Officer, Gordon Coburn, who will take you through our numbers in greater detail.

As we said on our second quarter conference call, 2005 is shaping up to be a year of substantial growth for Cognizant. Continuing our track record of delivering strong financial and operating performance across all our key metrics. During the third quarter, we further strengthened our leadership position in the industry, by extending our investments in our people and our infrastructure, to sustain our ability to meet our customers' growing demand for large scale programs that deliver significant value to their businesses.

Three primary drivers were the catalysts behind our success in the third quarter, first we continued to generate growth from our larger and strategic clients, as a result of the cross-selling of our expanding solution set. Our strong results in the third quarter were also driven by significant growth in our vertical practice areas. We strengthened our position in verticals beyond financial services and insurance, building further on our growing market leadership in Healthcare and Life Sciences. And thirdly, we expanded an enhanced the range of services that we provide to clients. Addressing growing demand for complex large-scale outsourcing solutions.

Turning to each of these drivers in more detail, I am pleased to report that our results benefited from further ramp up of our larger client relationships. We have also noted a growing trend in the industry in that the majority of new-client wins are going to a select group of top-tier firms, among which Cognizant distinctly figures. Our unique global delivery model combining on-site industry and program management expertise with the deep technical and project management skills of our teams offshore, distinguishes Cognizant in these competitive bids, such that our growth rate continues to outpace the industry.

In addition, as we continue to build out our range of service offerings, large customers are increasingly realizing that they can turn to Cognizant for a full range of solutions. The scale of our development operations across seven cities in India, and our gradually expanding presence in China, Toronto, Phoenix, ensure that we are able to meet the needs of the largest and most sophisticated clients across the globe. As we have said before, our current and prospective clients increasingly consider outsourcing a strategic business imperative. This is further evidenced by our success in winning clients across our key industry verticals.

Our ability to provide strategic IT solutions using a fully-integrated global delivery model for our diverse range of clients is a competitive advantage, that continues to fuel Cognizant's success. As a result, not only do we continue to continue to achieve significant client wins across a broad range of industries, we also further cultivated strategic partnerships with existing top-tier clients, and expanded the depth and breadth of our service offerings to incorporate more advanced strategic solutions.

The sustained growth of our vertical BPO, ERP, CRM, testing, infrastructure management, as well as our data warehousing and business intelligence offerings, also reflect the increasing appetite of clients for greater breadth in outsourced services. We continue to build our ERP practice with particular focus on SAP applications, and an emphasis on vertical expertise in areas such as Life Sciences, Media, and Financial Services.

Additionally, during the quarter we fortified our data warehousing practice through the launch of a strategic global partnership with SAS, a leader in enterprise business intelligence and data management. I am pleased to report that these business successes have translated into our financial success, as Cognizant again delivered strong performance in our key financial and operating metrics.

We generated revenue in the third quarter of $235.5 million, a 11% sequential increase from 211.7 million in the second quarter, and a 52% increase year-over-year. Earnings per diluted share were $0.28, compared to $0.25 for the second quarter of 2005, and $0.18 in the third quarter of last year.

Operating margin for the quarter was 20%, consistent with our target margin range of 19 to 20%. We are again encouraged by the quantity, quality, and diversity of client wins during the third quarter. We added 31 new clients while significantly expanding our relationships with existing customers. We are particularly pleased that five of these new-client wins represent strategic wins for us across several key verticals, including Financial Services and Manufacturing. This brings the total number of Cognizant's current strategic clients to 63.

As previously discussed, we define a strategic client, as one offering the potential to generate between 5 and 40 million or more in annual revenues for Cognizant over the long term. And the ramp up of strategic customers continues to be a key growth driver for the business. In terms of our vertical markets, Healthcare showed the strongest momentum, growing 18% sequentially, demonstrating that industries beyond Financial Services, are regarding outsourcing as a strategic initiative.

In addition, Financial Services continued to perform extremely well in the quarter, growing 14% sequentially, demonstrating once again Cognizant's growing market leadership in this key vertical. In addition to the sustained strength in our key vertical markets, we are also seeing strong demand for our horizontal service offerings. Last quarter, we discussed the significant traction in our ERP practice area, specifically in SAP.

We are pleased to report that our strategic investments in the SAP practice, coupled with our alignment to specific verticals, such as Life Sciences and Media, demonstrated further momentum in the third quarter. The size of our ERP practice more than doubled year-over-year. Our successes in the quarter include winning several deals spanning migration, implementation, upgrades, and custom development around SAP. For example, during the quarter, we were selected to complete an end-to-end implementation of SAP's industry solution for Media, for a leading media company in the U.S.

As we continue to deepen our relationship with new and existing SAP clients, we now have several SAP clients that represent multi-million dollar relationships for Cognizant. The investments we have made to build our NetWeaver competency, also resulted in NetWeaver project wins. SAP Labs, the internal product development division at SAP, has selected Cognizant to perform testing and QA of the entire NetWeaver stack, which gives us the advantage of learning the platform, before the product is made available in the market. By leveraging our vertical knowledge and domain expertise, we are also starting to build custom solutions and industry specific frameworks using this platform, as a means of further differentiating our SAP offering from our competitors.

In addition, we saw strong demand for CRM solutions. In particular, we have seen strength in the Life Sciences vertical where we are engaged in some very large-scale deployments of CRM systems. Over the past several quarters, we have diversified our CRM practice to cover a number of leading CRM technology platforms, including Siebel, SAP/CRM, PeopleSoft CRM, and Pegasystems. By combining this diversity of our platforms with our deep industry domain expertise, we are able to effectively deploy CRM solutions that drive clients goal of using technology to improve their interface with clients.

Data Warehousing and Business Intelligence was another important factor in our success in the quarter. We are extremely gratified to have been awarded the 'Best-among-the-Best in Business Intelligence' by Computer World, for our work in building an enterprise business intelligence infrastructure. We won this award for one of our largest BI implementations for one of the world's largest biotechnology companies, against some very strong competition.

I'm also pleased to note that during the quarter we launched Cognizant's strategic global partnership with SAS, a leader in the enterprise business intelligence and data management space. Cognizant is partnering with SAS as their primary global delivery partner at the Platinum level, the highest level in the SAS Alliance program. We are one of the select 15 Platinum members, that provide products and services offering strategic advantages to SAS software and solutions.

This partnership will significantly contribute to our Data Warehousing and Business Intelligence solutions by utilizing SAS software, to meet critical business challenges, such as customer information integration, clinical data analysis, fraud detection, and churn analysis for clients in Life Sciences, Healthcare, Banking and Financial Services. Our delivery capabilities in implementing critical business solutions, combined with the strategic advantage of software by our SAS partnership, will enable us to realize new project opportunities, particularly in the Life Sciences, Healthcare, Banking, and Financial Services verticals, all of which have significant demand for SAS application development expertise. The partnership will be a strategic alliance for Cognizant, as SAS's broad range of products are addressing a variety of industry needs, can be effectively incorporated into our solutions offering.

We also experienced continued momentum in our Vertical Business Process Outsourcing, or VBPO offering. As we said last quarter, we anticipate further expansion of our BPO offering through leveraging our vertical domain knowledge, IT profit optimization expertise, and high-tech client relationships. For example, during the quarter, we re-engineered key business processes for one of the largest Healthcare payer organizations, which rationalized the workflow of the clients' core business, while transitioning part of the operations offshore. To achieve this, we created a scalable system to manage data from as many as 400 diverse data sources, which has allowed us to produce faster turnaround times with direct to business interfaces, not to mention the significant cost savings.

This example demonstrates the effectiveness of our VBPO offering, by providing BPO solutions at the intersection of business operations and technology. We are able to not really provide customers with labor arbitrage cost savings, but also savings through process improvements, using Six Sigma and other BPO techniques. Once we have identified these process improvement opportunities, we are able to implement these by building new systems, or modifying existing systems, to support the new streamlined business processes. Cognizant has a unique ability to combine industry BPR and technology expertise, to provide VBPO services across the range of industries that we serve.

Let me now request Francisco to talk about telecom practice, and also the continuing progress that we are making in developing our team and our infrastructure.

Frank.

Good morning, everyone. Following our acquisition of Fathom Solutions in April 2005, we've made good progress in our telecom industry vertical, by creating a strong service delivery model, to provide end-to-end business aligned IT solutions to telecom customers. The combined Fathom Cognizant value proposition has already earned us new projects from a Top-5 telecommunication provider in the U.S.

The Telecommunications industry is seeing many changes driven by M&A, investments in next-generation services, and the evolution of business models as a result of convergence. Cognizant has created an impressive set of proven services of service offerings, to deal with these changes. Some examples include customer data integration, order and billing consolidation, and end-to-end service delivery for IP services.

In order to keep up with the strong momentum across our business, we continue to invest in our people and our infrastructure. We accelerated our previous rates of hiring, growing our staff by 16% sequentially, and reflecting Cognizant's status as a preferred employer around the world. We hired more than 3100 staff last quarter, bringing our headcount to just over 22,400 at the end of the third quarter. We now expect to exceed 23,500 employees worldwide by the end of this year. We opened our expanded facility for Cognizant Academy in Chennai over the summer. Our modern training centers ensure that every new recruit, gains access to the technical expertise, and the business skills required to maintain the level of quality and professionalism, that is the hallmark of Cognizant's success.

In addition, we continued to add to our leadership team during the quarter. We announced that during the quarter Malcolm Frank joined Cognizant as Senior Vice President of Marketing and Strategy. Malcolm brings a wealth of expertise and experience in our field to this role.

Prior to joining us, Malcolm was co-Founder, President and CEO of CXO Systems. He was the Founder, President, and CEO and Chairman of NerveWire Incorporated, a leading management, consulting and systems integration firm, which he grew from concept to recognized industry leadership. Prior to founding NerveWire, Malcolm was a co-Founder, Executive Officer, and Senior Vice President at Cambridge Technology Partners, where he ran Worldwide Marketing, Business Development, and five P&Ls.

Let me now have Lakshmi talk about a couple of recognitions that Cognizant has achieved of which we are especially proud. Lakshmi.

Thanks, Frank. I am excited to report that Cognizant was recently named one of the Best Small Companies in America by Forbes Magazine for the fourth consecutive year. This is the fifth time that Cognizant has been named to the list, and our annual high-ranking, continues to demonstrate our dedication to managing the Company in a method that ensures we are identifying future opportunities, and for growth while leveraging our current services and solutions, to deliver consistent business benefits to our customers. A strategy that has consistently delivered strong financial performance across the metrics analyzed by Forbes.

Furthermore, our exceptional track record and strong potential for sustained growth, was honored by the Economic Times of India, who named Cognizant's management team as their selection for the 'Entrepreneur of the Year' award. The independent jury of leading industrialists recognized Cognizant for being a straightforward result-oriented, fast-growing company, which not only achieved world-class brand equity, profitability, and governance, but has also made a significant impact in its industry. Francisco D'Souza and myself are honored to have been jointly recognized as the 'Entrepreneur of the Year.'

With that, let me turn the call over to Gordon for a closer look at our financials. Gordon.

Thank you, Lakshmi, and good morning to everyone. I would like to provide some additional information on the third quarter, and then discuss our financial expectations for the remainder of the year. Revenue for the third quarter exceeded our prior guidance, due to continued application management ramp up of clients won over the past few years, and continued greater than anticipated strength in discretionary development spending, a trend that started for us in the second quarter of 2003.

Revenue grew 11% sequentially, and 52% year-over-year. Our core businesses remain vibrant and our pipeline is robust. For the quarter, application management represented 52% of revenue, and application development and integration the remaining 48%. Both services grew significantly in Q3. On a year-over-year basis, application management grew 48%, and application development and re-engineering grew 55% during the quarter.

The largest growth driver in the third quarter, both in terms of gross dollars and percentage was Financial Services, which includes our practices in Insurance, Banking, and Transaction Processing. It grew approximately $42 million, or 55% year-over-year, and represented 50% of revenue for the quarter. Retail manufacturing logistics grew by approximately $11 million, or 41% year-over-year, representing 16% of revenues during the third quarter. Healthcare grew $15 million, or 50%, and represented 20% of revenues. The remaining 14% of revenues came primarily from other service-oriented industries, as well as our alliances.

During the quarter, 88% of revenue came from clients in North America, and Europe was 11% of total revenue. The remaining 1% of revenue came from the Asian market. We added 31 customers during the third quarter, our active customer base is now 247. During the quarter, we added five accounts which we consider to be strategic, and have the potential to become significant revenue sources for us in the future. We ended work at 30 clients during the quarter, almost all of which were very small clients.

Turning to costs. Costs of revenues increased 52% for the quarter, as compared to the third quarter of 2004. The increase is due to additional technical staff, both on-site and offshore, required to support our revenue growth. We increased our technical staff by approximately 3,000 during the quarter, and ended the quarter with approximately 20,900 technical staff. This is a net increase of over 7,900 staff from September of last year.

Our gross margin was 45.6% for the quarter, an increase of 120 basis points sequentially, and unchanged compared to the third quarter of last year. Gross margin in Q3 was positively impacted by a slight increase in offshore delivery ratios, a small increase in average on-site rates, and a flattening of the pyramid as we increased the percentage of trainees this time of year. These benefits were partially offset by a decrease in utilization including trainees, excluding trainees utilization actually increased during the quarter. In addition, we accrued bonuses at a level well above 100%, we were pleased to continue to have the opportunity to share a portion of our success with our employees.

SG&A expenses, including depreciation, were $60.3 million. Up from $40 million in the third quarter of last year. As a percentage of revenue SG&A was 25.6% in the quarter, down 10 basis points from the third quarter of 2004, and up 125 basis points sequentially from the second quarter of 2005. During the quarter, we continued to strengthen our vertical expertise, and we aggressively hired client partners to manage and grow our customer base, and we further enhanced our training and leadership programs, while benefiting from scale economies associated with rapid growth.

Operating income for the quarter increased 52% to $47 million, from 30.9 million in the third quarter of last year. And our operating margin was 20%, up 10 basis points compared to the third quarter of last year, and essentially flat with the second quarter of this year. Interest income for the third quarter increased to $2.2 million, compared to 1.3 million in the third quarter of last year.

Interest income increased due to higher global cash balance, as well as an increase in U.S. short-term rates. We had $130,000 foreign exchange gain during the quarter. Our tax rate for the third quarter was 17.8%, in-line with prior guidance and flat with Q2 of this year. For the full year, we currently expect the tax rate to remain at 17.8%, excluding any potential beneficial impact from year-end repatriation, which I will discuss shortly.

Turning to the balance sheet. Our balance sheet remained very healthy. We finished the third quarter with over $368 million of cash and short-term investments. Up over $41 million from June of this year.

During the third quarter, operating activities generated approximately $63 million of cash, financing activities primarily exercise of stock options, generated an additional $11 million of cash, these amounts were partially offset by approximately $27 million of capital expenditures, including expenditures on our India construction program, as well as $4.5 million towards the previously announced purchase of Fathom Technologies. In addition we used $1 million of cash due to currency translation adjustments.

We are in the process of evaluating the opportunity to leverage the recently enacted Jobs Creation Act. This act would allow us to repatriate foreign profits through the end of this year at a U.S. tax rate of 5.25%, compared to the normal rate of 35%. However, due to the existence of a dividend tax in India, our total cost of repatriation would be approximately 18%. We are still in the process of evaluating our overseas cash requirements for capital purchases, and therefore no decision has yet been made, whether to repatriate any portion of our profits from our overseas operations.

In the event that we eventually decide to repatriate a portion of our profits, such repatriation would likely result in a one-time tax benefit in our Q4 results. The size of such a benefit would depend on the amount of cash repatriated. Hence the likelihood and size of such repatriation and associated benefits are still undetermined, our guidance assumes no repatriation during the fourth quarter. In the event we do repatriate, we will update investors that we have taken such action, and the expected benefit to Q4 results.

Our collection of trade receivables during the quarter improved from June 30 levels. Based on our $171 million plus balance on September 30th, we finished the quarter with a DSO including unbilled receivables of 67 days, compared to 71 days at the end of June. Excluding unbilled receivables our DSO was 57 days. The quality of our receivables portfolio remains exceptionally strong.

Our unbilled receivables balance was 24.7 million at the end of the third quarter, up 2.1 million from June of this year. The increase in unbilled receivables resulted primarily from volume associated with our continued revenue growth. We expect approximately 60% of the September 30th, unbilled balance to bill this month.

During the third quarter, overall 24.2% of our revenues came from fixed-price contracts, down slightly from 25.4% in the second quarter of 2005, and up from 22.9% in the third quarter of last year. When we look at the mix by solution type during the quarter, 28% of our development revenue, and 20% of our maintenance revenue, came from fixed-price contracts.

Turning to headcount. At the end of the third quarter, our worldwide headcount including both technical professionals and support staff totaled just over 22,400. This represents a net increase of over 3100 people for the quarter, and over 8400 people compared to September of last year. Approximately 70% of our Q3 hires were recent college graduates, who will enter our training program, and the remainder were lateral hires of experienced IT professionals.

Based on our 2005 revenue expectations and ongoing success in recruiting, we now expect to exceed 23,500 people globally by the end of 2005. And we are moving well along towards this goal having seated 23,000 global employees just a few days ago. Turnover, including both voluntary and involuntary, was 16% annualized during the third quarter. Historically second and third quarters are the peak quarters for attrition, due to the timing of bonus payouts and reticulation into graduate steady programs. Attrition in the third quarter of last year was between 15 and 16%.

The attrition rate declined each month during Q3 of this year, and that trend has continued in October. The vast majority of Cognizant turnover occurs in India, resulting in on-site annualized attrition rates well below the global rate. In addition, attrition is heavily weighted towards the most junior members of our staff.

On-site utilization once again was around 86% for the quarter. Offshore utilization excluding recent college graduates who were in our training program during the quarter increased to approximately 68%, including trainees, offshore utilization was approximately 53% for the quarter. We had over 3,000 unbilled people in our trainee program at the end of the quarter, as we hired a large number of trainees during the past several months.

I would now like to comment on our growth expectations for the remainder of 2005, and comment on initial feedback from our clients and account teams about 2006 growth plans. We are projecting revenue for the fourth quarter of at least $252 million, we continue to have significant revenue visibility, due to our high level of recurring revenue, and long-term nature of our customer relationships. In fact, today we have customer commitments for well over 90% of our fourth-quarter revenue guidance. I would also remind you that the fourth quarter of this year has 3% fewer billing days, as compared to the third quarter of this year.

For full-year 2005 based on the strong demand environment for offshore services and our favorable experience on ramp up rates, we now expect revenue to be at least $881 million, this is a $5 million increase from our prior guidance, and represents growth in excess of 50%. As has been typical in prior quarters, we expect the majority of our growth for the remainder of 2005, will come from ramp up of clients won over the past few years. During the remainder of 2005, we intend to continue to closely monitor our spending, and expect our operating margin to remain in the range of 19% to 20%, in-line with our historic margin level and prior guidance.

With this expected level of revenue growth and our expected operating margins, we are currently comfortable with our ability to deliver EPS of $0.29 for Q4. This guidance includes the anticipation of Q4 share count of approximately 148.4 million shares, a tax rate of 17.8%, operating margins in the upper half of our guidance range, and the absence of further non-operating foreign exchange gains or losses. Based on current business trends, we currently expect EPS for the full year of $1.03, a $0.02 increase from our prior guidance.

This guidance includes the anticipation of a full-year share count of approximately 147.5 million shares, in addition this guidance assumes a tax rate of 17.8%, operating margin at the upper end of our guidance range, and the absence of further non-operating foreign exchange gains and losses. We expect the vast majority of our Q4 growth to come from existing clients, particularly the numerous strategic deals we've won in the last few years. As we look ahead to 2006, we are in the process of completing the 2006 planning process with our clients and account teams. Based on initial feedback about the market's intentions to leverage the offshore advantage, combined with the strongest sales pipeline in our history, we are highly encouraged about our prospects for continued industry-leading growth in 2006.

We would now like to open the call for questions. Operator.

Thank you. [OPERATOR INSTRUCTIONS] Your first question comes from Edward Caso with Wachovia Securities.

Congratulations on another great quarter. Can you update us on your alliance with EDS, are you seeing any business from that?

Yeah, hi, Ed. This is Frank. We are very excited about our alliance with EDS. We view the opportunity with EDS as an incremental market opportunity to participate in large-scale bundled deals, where we've historically not had a presence. We are also looking at EDS like any strategic client. We have to, now that we've done the alliance, how far and how fast the alliance progresses, still remains to be seen.

It's still early days with the alliance. The EDS management team is very progressive in how we're working together with them, but at this stage it's a little early to comment on the results of the alliance, and as we have further updates we'll keep you updated over the course of 2006. But I think at this juncture, it's fair to say that we're feeling very good about the alliance.

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

Hi. Could we just get some metrics on the staffing side, onshore versus off-site as a percentage of total?

Sure thing, Cynthia. Hold on one second. We had a slight shift offshore during the quarter. We're running about 26% -- sorry, about 74% of our staff offshore, 26% of the staff on-site. That's about a 1 percentage point movement from last quarter.

And then just an update on J.P. Morgan as a percentage of revenue?

During the quarter we had two clients who represented 10% of revenue, as we disclosed previously, J.P. Morgan is one of those clients.

Okay. And then just the Top 5 and Top 10?

The trend continues exactly what we're expecting. The Top 5 with 34% of revenue, Top 10 was 45%, after you account for rounding, the percentage from Top 5 and Top 10 both declined slightly, which is exactly what we expect, as we continue to have more and more customers, and by definition more customers outside the Top 5 and Top 10. But we continue to have actually very healthy growth in the Top 5 and Top 10 this quarter, so a slight movement, but not a significant movement.

Right. And then maybe just as a final question would just be on -- if we look at kind of what sequential growth assumptions would be for the December quarter, and I guess historically, in some respects December tends to be seasonally a fairly strong quarter in terms of customer projects, the guidance, can you give me a little bit more comment on the pretty significant sequential decline, and what would potentially be causing that, or kind of what you see relative to the Q4 outlook in terms of existing customer projects?

Sure thing, Cynthia. First of all, Q2 and Q3 tend to be the strongest quarter historically, both because the number of billing days, and just where people are in their budget cycles, so that's why you always see Q2 and Q3 quite strong. Q4 tends to be not as strong as the first two quarters, if you look back historically. And part of the reason for that is fewer billing days.

As I mentioned we have 3% fewer billing days in Q4 than we do in Q3. The big question is, do we see some last-minute surge in discretionary spending as as we did last year, as people fleshed out their budget a little bit, and that's something as we get our October results in we'll have a better sense of, and that's why we used the words 'at least' when we gave our guidance.

Great. Thank you.

Your next question comes from the line of Rod Bourgeois with Sanford Bernstein.

Hey, guys. You posted accelerated staff growth, you mentioned 16% sequential staff growth. I'm wondering if we can infer that this would have implications for a sort of minimum level of growth that we can expect in '06? And then if you can also comment on just at least a ballpark on an '06, how much business you might be able to do in your joint relationship with EDS?

Sure. Let's start with the staff question, Rod.

Yes.

As we've discussed on prior calls, we're attempting to move the model more towards a college recruiting model. Due to the nature of the people that we recruit, the time we can put into it, therefore put into training and we're trying to get ahead of the curve a little bit. As I mentioned, we are getting very strong feedback from our clients about what they want to do with us in 2006, and second I have Lakshmi my comments on some very recent feedback, we had at our customer event last week.

Now when we hired these trainees, 70% of the people we hired were trainees, it's a longer lead cycle, because now I have to have them in training for six months first, so the people I'm hiring now are clearly people who will help me drive 2006 growth.

I'll come back to your EDS question in a second, but let me just have Lakshmi comment on what he heard last week from our client community.

Thanks.

I think I there are two datapoints that I'd like to share with you. First and foremost are our current teams have started participating in some of the budget discussions with our customers. As they make plans for the next year. So we are getting a good sense of what they spend for next year is likely to be as we go forward. And the clear thing there is almost all our customers have expressed interest to do a lot more work offshore.

And the second datapoint is, last week we had Cognizant community, where we had all our existing customers and prospects come in. We had the largest community ever, more than 250 client representatives and prospects, participated in the three-day conference that we had at Scottsdale last week. Again, the team there has been more work offshore, increased sense of using many of the new solutions and services that we have launched.

And more importantly, this is the community where we had the largest number of prospects participate. So based on these two datapoints, the Cognizant community, as well as our discussions and the budget cycles of our customers, we feel very strongly about the future prospects. And that's one of the themes that is driving our college recruitment program.

Rod, just to come back to your question -- I think you asked about revenue from EDS. As Francisco mentioned, we're feeling very good about the relationship. We were just down there this week, Francisco, Lakshmi, and I, meeting with their entire executive team to review how things are going.

But remember, what we want is a hunting license so we're in the process just like any other new strategic account, going through the portfolio analysis stage now, identifying opportunities, so we're very, certainly optimistic about the contributions about next year, but still too early to know how far, and how fast things will ramp up.

Just to complete that question on the work with EDS. You mentioned that you're ramping up your capability to win larger deals. Is that capability exactly equal to your partnership with EDS, or are you chasing larger outsourcing deals, sort of on your own accord without EDS?

We are chasing larger outsourcing deals on our own. In fact, one of the things that you would notice, something that we have noticed is a large number of, greater interest in unbundled, deals where the customers want to partner with multiple service providers. And that's a great opportunity for us to play in, and those type of opportunities, we are continuing to pursue on our own.

Rod, really think about it as two separate markets. Our market bundled deals are getting larger, and we are clearly going after that on our own. There still is a market for bundled IT deals, and that's where we're working with EDS, because obviously that's a market where otherwise we just would not participate since the vast majority of those deals, have nothing to do with the business that we're in.

Great. That's very clear. Thanks, guys.

Your next question comes from the line of Andrew Steinerman with Bear, Stearns. Hi there. Could you just give a comment on the pricing environment, what did we net out offshore on-site in the third quarter versus the second, and what's your feeling overall on the direction for pricing for the services you're providing?

Andrew, this is Gordon. Pricing's acting exactly the way that we were expecting, the way that we've been articulated throughout the year. Our on-site rate was up slightly during the third quarter, up to about $71 an hour, offshore rate -- this is sequentially.

Right.

Offshore rate was flat at about $24.50 an hour. So by demand is not moving prices dramatically, but we are getting a little bit here and there.

Okay. And when you think about the higher end, say the newer services that you're providing, is that helping bill rate environment? Is that new to the bill rate environment? How about a quick question on, did you comments include BPO, is BPO not moving the needle enough yet to even think about it?

BPO is not moving the needle enough to think about it, because that's 100% offshore work, so you'll see that in the headcount well before the revenue.

On the new services, you have counteracting forces, clearly as we are now really gaining traction in ERP, that clearly has higher rates. As does the complex development work. But other sorts of activities such as testing, would not necessarily have rates higher than the company average.

So when you net it all out, the new horizontal services is probably helping a little bit on the average price.

Okay. Sounds good. Thanks so much.

Thanks.

Your next question comes from the line of Adam Frisch with UBS.

Great. Good morning, guys. Of the 63 strategic clients that you have, how many do you consider to be mature with limited growth potential, and how would you describe the rest of them in terms of growth potential, and also maybe offer if you could, an idea for the ramp up schedules, a matter of months or quarters or years, for your current stable of these kinds of clients?

Adam, you hit the key issue here. No more strategic clients have matured in a long time. And the reason for that is as clients are looking to do a broader range of services offshore, the penetration bar has been reset, because we can now go after a larger slice of the budget. So we still only have 5 of those 63 accounts that are mature.

And even some of our large accounts, and you saw that by the fact that the Top 5 and Top 10 numbers, essentially grew in-line with the overall company. We're getting renewed growth there because clients want to do a broader range of service, so we have clients both in, who we just won or who are past the inflection point into the hyper-growth phase, and ones that are large and clearly growing at a slower growth rate, but still growing as we offer more services.

So I think the biggest part of the story here is that the market, the size of the market opportunity that we can go after has expanded dramatically in the last 18 to 24 months, as clients look to do more, a wider range of work offshore and that has reset the penetration rates.

So even strategic accounts that you signed in 2002, are still in the process of ramping up?

That is correct.

Okay. And is that why you feel comfortable having a stronger bench with whatever utilization rates because you see these clients ramping in '06, potentially?

Absolutely. We got caught short of resources back in 2003. We want to make sure that mistake doesn't happen again.

Okay. And then also if you can switching gears here, on infrastructure investment with respect to two different factors. One, how does it keep you from Gordon, to use words that you've used in the past, how does it keep you from 'keeping the wheels from falling off?' So if you could address things like training and client satisfaction, et cetera? And also how did your infrastructure investment help you grow, and how will prior investments allow you to keep growing topline faster than the rest of the industry is?

Adam let's break this into two pieces physical infrastructure, and then the training and career development type things. Physical infrastructure we're in very good shape. As you know, we launched last year a program to build close to a million square feet of owned facilities, that program's going along very well in addition we continue to rent more facilities. We're having success in winning some additional tax incentives through special enterprise zones.

So from a physical infrastructure standpoint, we're in very good shape. Let me have Francisco comment a little bit on what we're doing on training both technical training and leadership development training, which are key things as we grow the business.

Sure. I think as I mentioned, in the comments earlier, over the summer we opened our expanded facility for Cognizant Academy in Chennai, for all of our entry-level trainees, we have now the ability to scale that the ability to scale that, the ability to bring in the entry level trainees, put them through our training program, and get them onto the projects in a very efficient manner.

In addition to the entry-level training, we are also focused very, very much on middle level and senior level training, and perhaps most importantly, on a very significantly enhanced leadership development and training program. This past year we launched our internal leadership development training programs, where we are identifying the hundred key leaders across the organization, and focusing on developing them into the leaders of tomorrow, so that they can scale to take on greater responsibility across the organization.

We also will impart sever million hours of training across the organization through the year on technical training, to make sure that the team is up to speed and up-to-date with the latest technologies, so that we can continue to push the envelope on services we provide to clients.

Okay then. In terms of -- that was great on the -- on the keeping the wheels on so to speak, but in terms of growth, what kind of things are you investing in to make sure you can still grow at the levels that we've been spoiled at, at seeing in the past couple years?

One of the things that's worked in our favor, Adam, is as clients are looking to do a broader range of work offshore with us, we need a broader range of employee population. So we're recruiting a lot more schools for a broader range of people, so the pool of candidates that we can go after has expanded fairly significantly, and now the key is to make sure we have consistent training, as we bring them into the organization.

The challenge obviously, is as you go into this space, how do you maintain the culture of the company. And the way we've done that is by giving, pushing down decision making, P&L responsibility to our industries, and then to sub-industries within that. So people feel that they have something that they own and they run, and therefore they just have a lot more gusto in what they do, and that process has worked really well over the past year, and we think that's the key as we go forward.

Okay. Final question. Any future M&A plans that we should be targeting here?

We'll tell you when we announce it. We continue to look at three things. Obviously we're growing organically at a very healthy pace. So our strategy is to look at small acquisitions that do one of two things, either add technical expertise, add geographic presence, or add vertical expertise. And we'll continue to look at those. We're fairly choosy about acquisitions that we do, but if we can find good ones, we will certainly look at small ones.

Thanks guys and good job.

Thanks, Adam.

Your next question comes from the line of Sandra Notardonato with Robert W. Baird.

Thank you. Did you give the number on what Fathom contributed this quarter, and whether their contribution for the year is different from the 20 million you mentioned on the June call?

Yes. At this point we don't break it out anymore, Sandy, because they're so integrated into our telco business, and they've taken over part of our core telco business, so as new clients are added, you know, what's Fathom and what's core you can no longer tell, so I think the numbers that we gave last quarter are still a very good indication.

Okay. And then you mentioned the strength in your doing more complex, more strategic work. Can you tell us what percentage of your custom application development work, you would characterize as more complex, more strategic and how many people you have, that you can put up projects like that?

Obviously it becomes a judgment call on what's complex and strategic versus what's business as usual.

Sure.

But if you look at the half of our revenue that comes from development, roughly probably half of that, so 25% total revenue is 'business as usual' development where the CIO says give me 50 people, and I'll just have you work through a stack of projects and when you finish those projects, come back and I'll give you more projects. So they almost view us not as body shopping, but as an extension of their announced development shop, where they hand over projects to us to do, and the other quarter is the more discrete complex development. Complex development is both, requires both knowledge on technology as well as very deep domain knowledge.

Okay. And so the percentage of the people of your workforce that you would consider more high level, more complex or more strategic, could you give that number Gord? I know it's probably a feel, but just to get a sense of it would be great?

I'm not even sure how to answer that, because even when you look at maintenance you have to have domain experts and your high-tech knowledge work, let me think about it I'll get back to you on that offline.

And then the last question I have is that, if I look at the upside that you guys reported in '04 compared to the guidance that you had coming into '04 versus your outlook for '05, and what you were thinking you would do coming into '05, obviously the pace of outperformance has slowed. We have Fathom included in this year. But you still have a lot of new client adds, as you mentioned before, you have further penetration of your strategic accounts, what do you attribute this, let's just say slower upside, or less upside? Is that better forecasting, is it due to slower ramp of new projects? And is this what we should be thinking about your guidance, and how to compare you know maybe upside, as we look out to '06?

Sure, Sandy. I think there's several things going on. First of all, in '04 this whole development spending, discretionary development spending was still fairly new thing to us, so we just didn't know how many legs it had, so we were more conservative on our expectations. And so we started '04 with a lower growth rate than we started '05.

By the time we got to '05 we understood, had a better understanding of how to forecast the development spending, and better comfort that it had legs to it. So part of it is we started with a higher base, and so we -- so I guess I would tie that into -- I don't know if I'd want to call it better forecasting, but we're more comfortable with our forecasts.

So we should take that into consideration as you provide your guidance for 2006, because the environment is more like we've seen this year, as opposed to 2004, we're it still kind of wasn't clear.

You know, I think obviously we haven't given any numbers for 2006, we'll do on our Q4 earnings call. We did make some preliminary comments just because we were hearing such good things from our customers we wanted to share that with investors. Obviously we'll look at in February when we give the guidance how we feel about the visibility on development spending.

And -- but we will always be conservative on our guidance with development spending because it is discretionary, so the economy -- if there's a change in the economy that can impact things quickly, and we want to have that some room in there if a slowdown were to occur if it were to occur, but as Lakshmi said, we're hearing really good things from our clients, and we saw most of them last week at our customer event.

Good. Great. Great quarter.

Thank you.

Your next question comes from the line of Bill Zinsmeister with Piper Jaffray.

Thanks. Two questions. One is, Gordon, you had mentioned on the call I believe that 60% of the outstanding unbilled receivable balance was to be billed this month, does that mean October or November?

Oh, no, that's October.

Okay. Then the second question is the last two quarters, you seemed to be very bullish, particularly on your retail vertical, and I didn't hear much commentary on retail. Could you clarify where your retail practice stands in the outlook there?

Yes. Retail practice is still very healthy. We're seeing a good pipeline. It slipped a little bit as a percentage of overall revenue during Q3. I'm not sure that's a trend that has caused me a whole lot of concern, when I look at budget for Retail and Manufacturing for next year. I'm feeling pretty good about the growth rates and what's in the pipeline, so I think that was just a little bit of an anomaly in Q3.

Okay. Thank you.

Operator, we have time for one more question.

Thank you. Your final question comes from the line of Julio Quinteros with Goldman Sachs.

I just want to make sure I understand the headcount trajectory for the fourth quarter, Gordon, can you walk us through what your expectations are right now given the current ramp that you had in the third quarter here?

Sure. Q2 and Q3 are stronger hiring quarters than Q4, particularly as you get late into Q4 in December, you do very little hiring, we finished Q3 at 22,400, we expect to finish Q4 in excess of 23,500. So obviously that hiring slows a little bit in Q4. That was planned throughout, that was a planned activity. We are already over 23,000 as of a few days ago. But what you'll see is October, November, October's a strong month, November's a little bit weaker, and then very little activity happens in December.

Got it. And I think you also commented that 70% of the hires came from campus recruiters, is that correct.

During the quarter, that is correct. Because Q3 is the big quarter for campus, because of the timing of graduation.

Right. And so as you look at the model going into 2006, I think you also commented this is going to mean sort of a pyramid, that moves a little bit more towards the campus fresher level. Maybe -- can you just walk us through that the impact this could have on margins, as we begin to look out over the next 12 months, and then related to that just the other levers that have helped, or have been negative to margins in the current year?

Sure. You know this year compared to '04, we moved a little bit more towards campus hiring, we tried to do that even a little bit more in '06. And it's not just, it's far less a cost issue than our track record with college recruits on retention, on the ability to have a much longer training cycle, makes them very good long-term employees.

Obviously there's also some financial benefit to flattening the pyramid, but at the same time we're flattening the pyramid with the junior recruits in India. We are doing some senior level, technical hiring here in the U.S. for some of the horizontals. So you net those two out, it probably helps margin a little bit, not a lot.

Okay. And then what about other margins headed into 2006? Sorry.

Are the levers, I apologize. There are a whole bunch of levers. Rupee is a great example. The rupee has actually appreciated 3% as of today, compared to the average in Q3. Every 1% depreciation of the rupee is worth 20 basis points to me, so I'm up 60 basis points if the rupee stays right where it is, compared to where it was in Q3.

So the rupee is one, utilization is another, bonus accrual is big one, up, and we're recruiting well above 100% this year. Due to the strength we're seeing in the business. On-site offshore mix , I think would be the final one. Okay. And then -- So -- I'm sorry, just to finish. So we have quite a few levers. Then in addition to that, there's natural leverage that occurs down in SG&A, as we add scale.

Okay. One last question on the headcount adds. What percentage of the hires were specifically for BPO. Because I think you said 100% of those would be in BPO. I'm sorry, the offshore work is 100% of the BPO.

The numbers are immaterial.

Okay. Okay. And just a final point of clarification. Did you say that the client concentration at the top account is now, I think two accounts now make up more than 10% of revenue?

We had two 10% customers, yes.

Two 10% customers. Oh, okay. Good. And then that compares last quarter where you only had one.

That is correct.

Okay. Great.

Thank you everyone. Just to add to that point. To add to what Gordon said. The campus hiring contributes significantly to maintaining our culture in the organization, the culture of customer focus, and culture is very, very excellent, so that's something that we are really geared towards.

And thank you for joining us for this call. Just to recap, we are pleased with our performance in the third quarter. We continue to broaden our penetration of vertical markets, and we expanded the range of services that we offer. We are confident that we have built the right platform, that we will continue to deliver strong value to our customers. And consistent financial performance for Cognizant shareholders. Thank you all once again for joining today's call.

Ladies and gentlemen, this does conclude today's conference call. You may now disconnect