The Hindu Business Line : Clients will need to keep spending…

It isn’t easy to stump Francisco D’Souza, President and CEO, Cognizant. At age 39, and as CEO of a $3-billion corporation, he has obviously seen a bit and has a hold on most things. This once, though, he needed time to think over his response to our query: If you had a chance to relive the last 12 or 18 months again, given the global turmoil in the period, what would you do different? He says, “It’s been such a whirl for a while that I haven’t really thought about this.” He has promised to revert shortly with his response. Till then, here’s what he had to say to K Bharat Kumar about his company’s recent results and the impact of the slowdown...

You have said that the economy would continue to be weak the rest of the year, without too much scope for a rebound. What do you make of companies offshoring or wanting to offshore for the first time?

There are many factors at play here. First, in general, year over year, IT and operations budgets of clients overall are flat to down.

In some cases, budgets may be flat to up but that could be a minority and are firm-specific. Shrinking budgets result in clients pulling back on a set of planned initiatives and, in some cases (pulling back on) things that are already in progress. (Discretionary spending particularly was hit.) This resulted in our Q1 sequential revenue declining. Coupled with this, budgets this year took longer than prior years to finalise.

Now that budgets have been reset to a new level, though a lower, new-level, that is not to say that spending is going to disappear completely.

Clients are still spending; there are still things that clients need to get done. I have seen different sets of estimates in terms of the magnitude of how much budgets have come down from different analyst groups. The reality is, all of the numbers that I have seen have been in the low single-digit percentages.

That still means they have approximately 90 per cent budgets that are being spent and that creates opportunities for firms like us to capture that, even though we are operating from a lower base compared to 2009. There are still opportunities and clients have to continue to spend on different things, although a bit more carefully.

As we look out for the rest of 2009, we don’t think it’s prudent right now to assume any sort of economic recovery throughout 2009 in our planning, in our guidance, etc. We are assuming that the economy will continue to be roughly where it is today and that we don’t see a back half recovery.

If that assumption changes, then, of course, and if we do see a back half recovery then it would have implications on our business, but right now we don’t think it’s prudent to forecast that.

Any positives you see in the environment? Intel recently said that the hardware market had bottomed out; which would have an impact later on the software industry. Wells Fargo reported a profit, Citi made a less than expected loss…

With our clients what we can tell you is that, we certainly have seen early signs of stability in financial services (FS). This industry went through a bit of turmoil, when I look back over Q3-Q4 of last year and even to some extent Q2 of last year. The pace of change in that industry was unprecedented, the M&As, the bankruptcies, among other things.

That was really unprecedented and in Q1, we certainly saw significant amount of stability return to that industry, in terms of decision-making, budget processes and so on.

As we go through the rest of the year, even in FS, (and FS continues along the Q1 pace so to speak) we are not expecting any growth in FS for the rest of the year from a revenue standpoint for Cognizant.

That would be the primary trend that I would point to in terms of our client base. The rest of the sectors would continue to get impacted by the economy, more pronounced in some places than in others. The technology group within Cognizant continues to feel the impact of the slowdown. Sectors such as Healthcare (HC) and Life Sciences (LS) and Retail have been less impacted by the cyclical trends. Those continue to show signs of growth in 2009.

In general, revenue from clients offshoring for the first time seems to be rising for your industry. Any trends you see?

There are two sides to that trend. There’s no doubt that the pace of ramp-up for offshoring today is faster than it was three or five years ago because offshore has gone mainstream. Today offshore is not considered to be a ‘risky’ proposition, so to speak. Clients are much more willing to put their foot on the accelerator more aggressively. Let’s say, 10 years ago offshoring was considered by early adopters.

Most early adopters took a very cautious approach. The projects were undertaken in a relatively low risk part of the business; ramp-up in those situations was slow and steady as they gained confidence. That mindset has changed now.

But offsetting that, we will also have to understand that in the North American market, there are few first time outsourcers (left).

If we look at the industries Cognizant serves today, be it financial services, healthcare, Telecom, Technology, there are comparatively fewer companies that have not offshored. There are relatively fewer first-time offshorers. Take Life Sciences, for example, today Cognizant serves 27 out of the top 30 LS companies in the world. I don’t think the remaining three have not offshored.

You have seen quick growth in Europe, with revenue contribution going up from the 9-10 per cent range earlier to about 18 per cent now. What is the kind of action you see in Continental Europe relative to the UK?

Continental Europe (CE), particularly, is different from the US. There are still many first time offshorers in CE and the market is different, because in Europe you have to be able to go beyond relationship management.

At the project level, you have to engage with the project management of client users. Often it’s done in the local language. Even though many multinational clients in Europe are adopting English as the global language, even so it’s necessary to understand the local language in those countries.

Protectionism is a hot issue now. If President Obama should put his words into action, we understand that the likes of Cognizant, IBM and Accenture would be impacted more than the likes of Infosys, TCS and Wipro…

We are still looking at the proposals. We only have the broad-level summaries that were released. The actual language used is not available to us yet.

Clearly, we support any tax legislation that’s going to eliminate offshore tax havens that the administration is going after.

But in terms of the other issues until we have seen the language I won’t be able to have a very definitive view on the impact to Cognizant or to anybody else for that matter.

We would have to keep in mind that any impact of this potential change will be significant not just on Cognizant as a US offshorer but any US multinational with global operations.

In fact, with the extreme interpretation, what it could possibly do is make the US multinationals in general far less competitive than their global counterparts. In the US, with tax legislation, the US companies would be less competitive in the world market. We need to look at the details of the proposed tax code.

But, I don’t think it would be in anyone’s interest for the US companies to be globally less competitive.

In the earnings call, you had said that offshoring momentum need not necessarily go up in your Q3 vs Q2. Could we tie that in to your point about first time offshorers declining in number?

I see no specific catalyst in Q3 that’s going to create a meaningful movement in the trend and I mean that our assumption right now is that the economy continues to be sort of pumping along at the current level throughout the rest of the year. I was asked what will happen in Q3 and whether there will be accelerated momentum and I don’t see any catalyst for that, specifically in Q3.

I can’t think of anything that’s going to make Q3 a specifically stronger quarter than Q2 and I am talking about the calendar quarter.

Back in 2000-2001, the then slowdown helped offshoring momentum pick up about a year-and-a-half or two later. Do you see a similar kind of off-shoring momentum this time around and if yes, when?

I won’t put a timeline on it because I don’t have a crystal ball on what happens in the economy, for, that would drive the pick-up. We are not assuming a rebound in 2009. I don’t know if that will come in 2010 or not. All I can say is that for us to see a return to significant momentum in the offshoring space, the industry growth rates returning to 20-30 per cent-plus that they were prior to the recession, the economy will have to turn around.

Research reports tell us that companies that invest in sales and marketing during a recession typically ride the wave when the turnaround happens. Do you have a target for the kind of additional investments in S&M over the succeeding quarters?

We look at the target a little differently. We said we would deliver operating margin in a certain range to our investors and talked about the 19 to 20 per cent range even in the past. Anything over and above that, we would be reinvesting back in the business. You will continue to see us doing that. Whether you characterise the investments we make into S&M or SG&A, we certainly know that it’s the area where we have invested significant amounts. The investments also go to new service offerings, new geographies and so on. We talked on the earnings call about new geographies where we are under-represented, such as West Asia and Latin America.

Most of your competitors have talked about pricing being hit essentially because of the competition. Is the current pricing environment dragging deals now?

I would not characterise it as that extreme. Pricing was certainly down sequentially in our first quarter and we expect it to be down for the full year in the low single digits. Some of the price decline was purely due to European currency movement. So, that’s had an impact on price because there are some cases where we bill in local European currencies and we report our results in dollars — so that looks like a price decline. The other factor that contributed to the price decline was shift in the mix of work. Application maintenance is relatively lower priced than development and systems integration work. So the mix shifted towards application maintenance work and that’s not a price decline, we are not cutting price to the client. We are just moving towards lower priced services.

The larger players in the market have understood that cutting price benefits nobody because, in the end what would happen is everyone would respond and it becomes a zero sum game. I don’t see at this point amongst the tier ones what I consider to be irrational pricing. It’s a competitive market, it always has been, but it’s not one that I would characterise as being irrational. It’s a separate story with the tier-two players. They may be subject to different types of pressures and may be less rational in their pricing. But, tier-two players are not big enough to pull the market overall on pricing. So, they don’t have an overall impact on the market.

The DSO or collections by your competitors in India are far better than it used to be. In some cases, the improvement has been as much as 10 days or more annually. Utilisation has also has been in the 75 per cent range for most of these players. Yours is 68 per cent including trainees. Your view on these metrics?

We watch DSO carefully, but equally and perhaps more importantly, quality of the receivables … portfolio is a more important measure for us. The quality of our portfolio remains very high. That’s an item we keep a close eye on. Given what’s happening in the economy all around the world, client bankruptcy risk has gone up a little so, that part of the portfolio needs to be watched very carefully and we are managing that piece very tightly. I am not sure if it’s prudent beyond a certain point to manage DSOs too aggressively because in the end it becomes a client management issue as well. DSO is not one that I am extraordinarily concerned about at this moment. It does bounce around, depending on what happens quarter to quarter, but I am keeping a very close eye on the quality of receivables.

On utilisation, we spoke about taking it up and that’s a trend you have seen over a few quarters at Cognizant. In 2008 we did take the utilisation up. This March 2009 quarter it came down a little bit. At Cognizant you would see the trend go upwards as we run the business more tightly and as we take advantage of economies of scale. But, I would also say that utilisation will be lumpy, it would not be as straight going forward because we have to bring in entry level trainees (ELTs). It always brings utilisation down while those people are in training. I personally am not looking at utilisation and tracking it quarter by quarter. Even if I am tracking it, I am not expecting the trend to go up quarter over quarter.

bharatk@thehindu.co.in

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