Cognizant Technology Solutions Corp (CTSH) — Q2 2021 Transcript

Thank you, operator, and good afternoon, everyone. By now, you should have received a copy of the earnings release and investor supplement for the company's second quarter 2021 results. If you have not, copies are available on our website, cognizant.com. The speakers we have on today's call are Brian Humphries, Chief Executive Officer; and Jan Siegmund, Chief Financial Officer.

Thank you, Tyler. Good afternoon, everybody. Against a challenging labor market backdrop and the recent humanitarian crisis in India, we executed well in the second quarter, allowing us to deliver significant upside to our revenue guidance. Second quarter revenue of $4.6 billion represented growth of 15% year-over-year or 12% in constant currency. I'm grateful to our teams across the world for their unflagging dedication to consistently meeting our promises to clients. Thanks to the professionalism of all our associates with no major disruption to client service delivery from the second wave of the pandemic in India. We continue to execute against our previously announced Operation C3, which includes our vaccination drive across the 11 cities where Cognizant has operations in India. To date, we've administered or re-endorsed over 160,000 vaccines to associates or their families and dependents. I'm pleased with the strength of key commercial metrics. Bookings growth accelerated to 12% year-over-year in the second quarter, and our book-to-bill ratio is now 1.2 on a trailing 12-month basis. Qualified pipeline is significantly up, and our win rates are also up year-to-date, positioning us well for continued bookings momentum. Digital revenue growth accelerated to 20% year-over-year in the quarter. Moving to industry segments. We posted strong double-digit year-over-year constant currency growth in Communications, Media and Technology, Products and Resources, and Healthcare. We've achieved a double-digit CAGR over the past 4 years in Communications, Media and Technology and remain optimistic about our growth prospects. This industry is now home to some of our largest clients. Within Products and Resources, we continue to post excellent growth in manufacturing, logistics, energy, and utilities. Meanwhile, both retail and consumer goods and travel and hospitality posted their fourth successive quarter of sequential revenue increases and are now close to prepandemic revenue levels.

Thank you, Brian, and good afternoon, everyone. Our Q2 revenue was $4.6 billion, representing growth of approximately 15% or 12% in constant currency. Revenue was $125 million above the high end of our guidance range, driven by continued demand for digital, which grew 20% and represented 44% of total revenues. Year-over-year revenue growth also includes approximately of growth from our recent acquisitions and benefited from an easier compare to Q2 2020, where our revenues were impacted in the early months of the pandemic and by the ransomware attack in April 2020. Moving on to segment results, where all growth rates provided will be year-over-year in constant currency. Financial Services revenue increased approximately 5%, in line with our expectations. We continue to make progress as we reposition this business and observed a strong improvement in the pipeline. We still expect the paced recovery through the remainder of the year. Healthcare revenue increased approximately 13%. Again, driven by strong performance in both our healthcare payer and life sciences businesses. Revenue growth within our Healthcare business was primarily organic, and we continue to see strong demand for our integrated payer software solutions and improving fundamentals in our provider business. As Brian mentioned, we remain very pleased with the growth in our life sciences business. Products and Resources revenue increased approximately 18%, driven by the fifth consecutive quarter of double-digit growth in manufacturing, logistics, energy, and utilities. Segment growth included approximately 600 basis points from inorganic revenue. As Brian mentioned, we also experienced growth in retail consumer goods and travel and hospitality, driven in part by the lapping of the prepandemic conveyors. There are early signs of stabilization within these sectors most impacted by the pandemic, but we continue to monitor closely. Communications, Media, and Technology revenue grew 18%, of which approximately half of the growth was attributable to recent acquisitions. This growth was partially offset by a negative 190 basis point impact from our exit of certain portions of our content services business. Overall, we are very pleased with the growth of our core portfolio. Now moving on to margins. In Q2, our GAAP and adjusted operating margin were both 15.2%. On a year-over-year basis, adjusted operating margin improved approximately 110 basis points, primarily reflecting the savings from our cost initiatives in 2020 and the impact from the pandemic and ransomware attack in Q2 2020. This year-over-year benefit was offset in part by SG&A investments, including those intended to drive and support organic revenue growth as well as the negative impact on margin from our recently completed acquisitions and costs related to the modernization of our IT core and security infrastructure. In addition, we anticipate continued cost pressure from our elevated attrition, which includes higher recruiting costs, lateral higher wages, and subcontractor costs. Our GAAP tax rate in the quarter was 26.5%, and our adjusted tax rate was 25.4%, in line with our expectations. Diluted GAAP EPS was $0.97, and adjusted diluted EPS was $0.99. Now turning to the balance sheet. We ended the quarter with cash and short-term investments of $1.9 billion or $1.2 billion net of debt. Free cash flow in Q2 was $466 million. This included a payment from the settlement with two of the three customers that were part of the proposed customer engagement exit we announced in our fourth quarter 2020 earnings. Excluding this one-time payment, free cash flow would have been approximately 100% of net income. The payments made this quarter were in line with our prior expectations and resulted in no impact to our earnings in Q2. Overall, we were pleased with the outcome of the settlement, which includes a continued commercial relationship with both customers. Negotiations with the third client are ongoing and constructive. DSO of 71 days increased by one day sequentially and has improved from 77 days in the prior year period. During the quarter, we repurchased 4 million shares for $296 million at a weighted average price of approximately $74 per share. At the end of June, we had $2.3 billion remaining under our share repurchase authorization. We also spent cash of approximately $350 million on acquisitions and $127 million for our regular quarterly dividend. Turning to guidance. For Q3, we expect revenue in the range of $4.69 billion to $4.74 billion, representing year-over-year growth of 10.6% to 11.6% or 10% to 11% in constant currency. Our guidance assumes currency will have a favorable 60 basis points impact and inorganic contribution of approximately 320 basis points. For the full year, we now expect revenue of $18.4 billion to $18.5 billion, representing 10.2% to 11.2% growth or 9% to 10% in constant currency. This compares to our prior guidance of 7% to 9% growth as reported or 5.5% to 7.5% in constant currency. Our outlook assumes currency will have a favorable 120 basis points impact and includes approximately 320 basis points contribution from inorganic revenue. Our outlook assumes continued momentum across Healthcare, CMT, and Products and Resources, while we continue to expect a paced recovery in Financial Services over the next couple of quarters. Moving on to margins. We expect full-year adjusted operating margin to be approximately 15.4%, the midpoint of our prior guidance of 15.2% to 15.7%. As I mentioned earlier, elevated attrition is leading to increased costs in certain areas. We are also continuing to fund investments in our people, including compensation, quarterly promotions, retention, and training. We expect these costs will weigh on our results for the next several quarters as management remains keenly focused on addressing our high attrition levels through a comprehensive set of initiatives. We continue to expect SG&A growth for the remainder of the year, driven in part by the impact from our M&A activity. However, we are slowing the pace of growth in some areas not directly related to our strategic initiatives to mitigate some of this cost pressure. This leads to our full-year adjusted EPS guidance, which is $4 to $4.06 compared to $3.90 to $4.02 previously. Our full-year outlook assumes interest income of $25 million to $30 million compared to $20 million to $30 million previously. Our outlook assumes average shares outstanding of approximately 528 million compared to 530 million previously and a tax rate of 25% to 26%, which is unchanged from our prior outlook. Finally, we continue to expect free cash flow will represent approximately 100% of net income for the full year. We remain committed to our balanced capital deployment strategy and returning at least 50% of our free cash flow to shareholders through dividends and share repurchases. Before opening the call for questions, I wanted to let you know that we are planning to hold an investor briefing in the fall during which Brian and I will provide a review of our strategy and an update on our progress over the last two years. We will also provide our multiyear financial framework. Please keep an eye out and save the date in the coming weeks. With that, we will open the call for your questions.

I have a follow-up question regarding the attrition and headcount dynamics. Jan, can you explain what gives you confidence in your ability to expand margins in the second half of the year while dealing with the attrition issues? For instance, in this high demand environment, are you able to raise prices? Additionally, I'm curious about how employee satisfaction is tracking at Cognizant, as I know you monitor that closely. What is your confidence level in reducing attrition over the next few quarters?

Yes. Thank you, Lisa, and somehow I anticipated questions around our margin guidance being of interest. It's a complex situation, Lisa, in that we have actually quite a few dynamics going on that impact the margin dynamic for the second half. And so you're rightly concluded that for the second half, we are expecting really, on average, margin development around 15.6% to meet our midpoint of our guidance. And as you're also aware, we have a little bit of a quarterly dynamic towards the year-end. So margins in the third quarter, we're thinking, are going to be slightly higher than towards the fourth quarter due to typical end-of-season dynamics, including the merit increase when we administer and implement the merit thing. So that's kind of all the general margin dynamic. What we have seen, I want to point out a few other elements of the margin dynamic. We have seen, in this quarter, a fairly healthy margin dynamic on the gross margin side, and we reported a shift in our digital revenue mix, which comes actually with higher gross margin than our traditional business, which is part of the strategic rationale of why we are, of course, engaging in the transformation of the business. And that margin effect was accelerated actually; we shifted share, but we also improved that relative margin in our second quarter. So we anticipate to continue to have some benefit from that mix shift also in the second half. And then, of course, we see pressure from the compensation measures coming into our P&L. And we're offsetting that by controlling the growth of certain SG&A components that have been growing kind of likely, I would say, to and bring that more to a controlled or flattish outcome towards the end of the year. And so it's a number of factors that we have to keenly execute in order to keep, of course, the overall structure of our P&L in place, but that's the principal dynamic that we are following. And I hand over the employee engagement question to Brian.

Thanks, Jan. Hi, Lisa. Look, it's very much top of mind. As you can imagine, voluntary attrition in the quarter was 29%. But on a trailing 12-month basis, which is more how the industry tends to look at it, it was 18%. And we've seen primarily the attrition in the more junior levels of the organization or mid-levels in India, but it's also a global phenomenon. It's really one of the hottest markets we've seen or our team has seen over the last 10-plus years. So we're all dealing with it. As it happens in the last month, we had the results of our annual engagement survey. We're actually very pleased with our results. They're at or above, in many cases, industry benchmarks. I'm really pleased to see the delivery organization, engagement scores are actually above the company average, and they're very much as a total company in the same range as where we've been from 2016 and beyond. Last year, we actually had a particularly strong year, as many companies did, because of the pandemic when people were pleased when they had secure jobs or whatnot. So from one perspective, I feel very, very good about it. But in the same vein, of course, I don't feel very good about the attrition. And so that's top of mind, and it's got a lot of management focus. I'm pleased that we executed well in the quarter. We exceeded our revenue guidance despite elevated attrition, but my great hope is, over time, we can reduce attrition and yet continue to hire at the pace we have been hiring at, which is something we're very pleased with. The throughput of our recruitment team has been terrific. So what are we doing to reduce attrition and to continue to drive employee engagement is the next obvious question. Well, look, annual merit-based increases have been announced here in the last few weeks. They're effective October 1. That's on top of a whole host of ad hoc measures we played through in the course of the last year: out-of-cycle increases, promotion, retention dollars. We've announced a shift in the last few months to quarterly promotion cycles for billable resources. We've really fast-tracked job rotations and reskilling initiatives across the company, then a host of things with Cognizant Academy, which is our training capability, as well as higher education programs for select employees as well. And we've put an enormous effort behind our employee value proposition, celebrating delivery success, big wins, etc. So more work to be done, but I'm confident we're doing the right things. And as I said, while I'm pleased we executed through at this quarter, the reality is 15% revenue growth this quarter also gives the organization a little bit of energy that, look, growth is coming back and with growth comes good things in terms of career path opportunities, rotations and promotions and whatnot. So I'm sure today's top line story will help a lot of employees feel better, and we'll keep doing all the other things we're doing.

Good quarter, guys. I wanted to follow up also on attrition. Could you talk a little bit more about what you expect for Q3, Q4 attrition? And what's been the client feedback in the face of the situation?

From my point of view, it's essential to prioritize both our associates and clients since a client-centric approach relies on being associate-centric. As we consider this, it’s about how we engage with our clients and interpret the demand signals that guide us in allocating the right resources at the right time. Effective communication is crucial during this period, especially in setting realistic expectations around resource availability. It's very important for us to prioritize entities, particularly focusing on securing the right resources for our most strategic accounts, which is a key part of our daily operational discipline. Unfortunately, even with a 15% growth this quarter, we have not yet fully met our potential or market expectations. We are doing our utmost to minimize attrition while maximizing employee engagement and onboarding. This year, we plan to bring in approximately 100,000 lateral hires and train around 100,000 people, along with onboarding about 30,000 freshers and extending offers to 45,000 freshers. Irrespective of our attrition rate, we are committed to these numbers because the market demand is strong, and we are eager to seize that opportunity. We believe our portfolio is more appealing than ever, and we have made significant strides over the past year to capitalize on market opportunities. We feel optimistic about this, but it's a competitive market, and it's a challenge we all face.

I'll just ask 2 upfront here. So as it relates to bookings and the growing commercial momentum you called out, can you comment on how well distributed the bookings contribution has been across the sales force? So how much of your sales force would you say is optimized and converting versus those that are still building pipeline and will convert over the balance of this year into next? And then just to clarify on attrition, have you continued to see the trend of declining resignations month-to-month?

I will address that first. We analyze net resignations, and at the end of last quarter, we thought we had reached a peak, but they did increase slightly. We expect elevated attrition levels to persist in the upcoming quarter, and we'll evaluate the situation afterward. The market is quite competitive right now, making predictions challenging. I believe we are taking the right steps to manage this, although these attrition levels are slightly above our internal expectations. As for bookings, I feel positive about them. It's crucial to assess bookings on a trailing 12-month basis rather than just weekly or quarterly. Now that we've completed that year-long period, we have a healthy book-to-bill ratio of 1.2x over the last 12 months. We analyze this by geography, business mix, and the balance between new and expansion sales versus renewals, and everything looks solid. Our pipeline is also strong. I believe that demand isn't the issue in our industry; it's a great time for services, but we are facing supply constraints right now. Regarding our sales teams, they are ramping up, although we haven't achieved full productivity yet. We have several initiatives in place to ensure we have the right gearing ratios. However, I feel confident that our client-facing team is now positioned to effectively engage with clients, both virtually at this stage and in person when possible, and to cross-sell our full portfolio. We see a significant opportunity in our installed base; approximately 40% of our accounts currently utilize only one of our practices, while we have more than ten practices available. Therefore, cross-selling presents a substantial opportunity for us. Additionally, the acquisitions we've made in the past two years align perfectly with our digital strategy and facilitate increased cross-selling. Cross-selling is fundamental to the business case for those acquisitions. We are excited about leveraging our installed base and using our enhanced portfolio to pursue new customers, as exemplified by Qualcomm, where we are emphasizing digital offerings while also looking to cross-sell our non-digital services.

Hey, Brian, so when you consider your pipeline and your inorganic growth plan going forward, are you in a position to further substantially increase your digital mix over the next year? I'd love any color to help dimension the remaining mix shift potential over the next year or so, that would be really helpful.

Yes. Hey, Rob. So as you know very well, one of our biggest priorities when I joined the company was to accelerate our digital mix. It was 28% or less than 30%, certainly at the end of 2018 for the year. And it's been very much part and parcel of what we're setting out to achieve. It's 44% of our mix today. Candidly, a numerator denominator comes into play. We actually had very good success this quarter, driving growth as well in our non-digital business, which has declined in 2019 and 2020. So candidly, that has slowed the digital mix ramping further, the share growth of non-digital this quarter. But overall, the digital business will continue to grow. I'd like to think as we get to the latter part of this year, we'll be up closer to 50%, and it will start becoming a bigger portion of our overall business over time. That's important for us because: a, it helps us be exposed to higher growth categories; but b, it increases our intimacy with the broader C-suite in our installed base of accounts, and that enables us to sell beyond the CTO organization into the CMO into the line of service leader, etc. Of the accounts that we have added in the first half of this year versus the first half of last year, the vast majority of the bookings exactly in what we would term digital. So Rod, that mix shift to digital will continue, and I'm pretty optimistic that we'll continue to see a nice ramp there. That is not just good for revenue or client intimacy, it's actually also very good for our margin rate as a company as well. So we feel as though we're doing the right things. Our M&A strategy is 100% behind this, and it puts us in a position to actually get after our installed base to cross-sell and upsell and actually get new logos and really become a challenger in the digital arena.

Rod, if I add one comment on the dynamic of the digital organic revenue growth, we very carefully monitor the organic growth that our M&A is generating within itself, but also, of course, as a cross-sell into our client base, and we have seen a very robust organic growth from that portfolio that is kind of, in most cases, meeting our business case assumptions. So we're very pleased that actually the shift is not only about M&A; it's not only adding the incremental acquired revenues to the portfolio, but that portfolio also is accelerating and growing faster than the average in its growth trajectory.

Rod, regarding your question about the pipeline, the digital pipeline has significantly outpaced the non-digital pipeline in growth. Additionally, our win rates in the digital space exceed those in the non-digital sector. These are positive indicators for us.

Great. And Jan, you kind of read my mind. My follow-up was related to the acquisitions. And looking for an update on your progress in being able to cross-sell the newly acquired offerings into your existing accounts, that's a muscle that tends to take time to develop. So maybe just give us some thinking on where you are in that journey? Are you well into that journey? Or is there still some juice left on the cross-selling into existing accounts with these newly acquired capabilities that you have?

I would say we're still in the early and mid-parts of our journey. We made really good outcomes happen for acquisitions that have examples where we haven't even closed the acquisition. We started to think about cross-selling the product already prior to the close, so there's plenty of excitement in our sales force to bring these solutions to our clients. And as we now focus to fully integrate this acquired portfolio of digital capabilities into the fold of Cognizant, many other benefits of pipeline management will become easier, the learning for the acquired companies will grow, so I'm optimistic that we will continue to reap really good benefits out of the M&A regarding to the organic growth that they are generating, which is what I'm really keenly focused on.

This is Brad Clark on for Keith. I would like to ask if there was any way to quantify either the impact or size of the planned wage increases for employees. And then secondly, given ongoing employee and market pressure on margin throughout the remainder of the year, how do you view future M&A strategy compared to the past 12 to 18 months? Is the pace of M&A sustainable? What are your views on that going forward?

Jan?

Thank you for your question. We don't publicly disclose the specifics of our compensation changes, so I can't provide details on that. Our compensation strategy is aligned with market dynamics, and we aim to ensure Cognizant remains a competitive employer and recruiter. We're pleased with our ability to attract new associates. We've been recognized as an employer of choice, especially in the important market of India. Our compensation adjustments will be tailored to specific countries and market conditions. Regarding our M&A program, we discussed a capital allocation framework at the end of last year, dedicating 50% of our cash flow to M&A, with 25% used to counter equity compensation dilution and 25% for dividends. This framework guides our strategic execution. Moving forward, I expect to operate within this capital allocation framework to support our strategy. Our M&A efforts will remain focused on our strategic goals, particularly in the digital space. Earlier this year, some acquisitions showcased our strategy to enhance Cognizant’s global presence. For instance, we acquired Servian in Australia and ESG Mobility in Germany, a leading player in IoT, especially in the automotive sector. We recognize the need for more geographic diversification and will adjust our practices to meet strategic objectives. This is a lengthy response, but we plan to continue executing our acquisition-driven strategy.

I'll mix it up and ask about TriZetto. I think I heard that your repositioning is driving better growth, double digits. I was a little surprised by that. I'm curious, can you elaborate on that? What are you doing differently? And could this kind of change be extended or applied to other areas as well?

So our product business in Healthcare, Tien-Tsin, is something that we inherited through the TriZetto acquisition at the end of 2014. To be very honest, I think we didn't execute the integration of that optimally. And in the last few years, we've really tried to get after that opportunity because I think it's a crown jewel that I felt we could do a better job on. And so starting with that, we got off to the road map that we had, tried to understand, solicit customer feedback to make sure we had something that in the eyes of clients was in line with their needs that the user interface and the code was appropriate and fit for purpose. And in the meantime, we had some competitors that had emerged that frankly, I didn't think had the right to beat us given our heritage in this space. Fortunately, now, we've had three quarters in a row of double-digit growth in the product business. And as I said, our growth in 2020 versus 2019 doubled, and we're on track to double growth rate year-over-year again and we're getting some fantastic logos. And this is a great business in itself. It's software-centric, higher margins. But of course, the stickiness of that enables us to pull through a rich services suite thereafter. So the team has done a fantastic job. I view it as highly strategic for us, and we're 100% committed to that business, and you'll see us scale in that over time.

Okay. No, it's encouraging to hear. I'll ask quickly, if you don't mind, just on the supply side, just with more lateral hires. Can we just infer that's indicative of more digital work, so you need to go out there and grab some of the lateral hires? Or is it just purely out of necessity, given what you said about demand and the timing of university hiring or maybe more work needs to be done on the training side to meet the type of work that needs to be done? I'm just trying to understand what's structural versus cyclical there.

If you think about the lateral hires, it's really with a view to doing two things. One is addressing the attrition that we have and also getting after the market potential that we see. And so you go back to where is attrition greatest, it's at the mid-junior levels of the pyramid, particularly in India. But it's also in hot skills. And if you think about hot skills, think about hyperscalers, think about leading SaaS players, think about digital engineering, full stack engineers or across data, AI, and ML. And so you find yourself in a situation where you've got a demand-supply imbalance, and that's an area as well where we're also going after lateral skills and trying to get them in as quickly as we can, whilst also trying to train and promote our internal employees as well. So it's a race for talent in a red hot market. And I anticipate, given how bullish I am in the market, and my sense is we'll have a resilient services, the main feature for the foreseeable future, I anticipate elevated attrition across the industry.

This is Mike on for Jamie. So my first one, can you guys talk a little bit about your updated perspective on 5G? And this quarter with CMT growing so well, has 5G offered any tailwinds there?

From my perspective, 5G is still in its infancy, both in terms of device availability and the potential applications, which are likely to be more business-to-business rather than consumer-focused due to the need for security and low latency. I don't see a significant impact from the consumer market on the telecom industry, even though some may reference it to support capital expenditures. Regarding our CMT sector, it hasn't significantly contributed to our business thus far. We are very interested in autonomous driving; as Jan mentioned, we acquired ESG Mobility in Germany and are focusing heavily on the automotive sector as well as the CMT sector, but 5G hasn't played a major role up to this point. I believe IoT will benefit from 5G and various cellular technologies, but it's still too early to fully realize that potential.

Great. I wanted to ask on pricing. I mean you touched a bit on that earlier. But how has pricing trended in the quarter, particularly given some of the pure commentary around pricing stability? And I guess what we're really trying to get at is are you able to pass on some of the wage costs? And how are clients responding to that?

Yes. We have observed pricing trends by segment. And I implied in my comments that we have been expanding our gross margins on the digital business, and we have seen an ability to the tight labor market, allowing us to get good pricing for our services. We see also continued pricing pressure in the more traditional services that we have been talking about in past quarters, where clients are seeking additional cost benefit, and that pricing pressure in those more traditional type of services hasn't changed at this point in time.

And just on digital quickly. We're big believers in your acquisition strategy, and I appreciate the early color around digital battlegrounds. But are there any digital battlegrounds where you're currently under-indexed relative to the demand that you're seeing that you could take a better advantage of?

Hey, James, this is Brian, and I’ll address that. The digital landscape for us extends much further than the four key areas we initially focused on, which included cloud, digital engineering, applications, and IoT along with data and analytics. Other sectors not categorized as battlegrounds, such as digital experience, are growing rapidly for us. I’m very optimistic that this will become a fundamental aspect of our sales, particularly in enhancing the entire user experience in digital workflows. Digital engineering is a key priority for us and is expanding rapidly. It represents one of our greatest growth opportunities in the coming years, having scaled significantly over the past two years. We are now among the largest digital engineering firms globally. Our capabilities have been bolstered by our acquisitions of Softvision in 2018, and more recently, Magenic and Tin Roof. I am very confident in our potential in this field, and overall, there is substantial demand, and as we continue to grow, it will increase our average CAGR. Additionally, as Jan has indicated, it will positively impact our margin rate as well. We are moving full speed ahead to seize the digital opportunity.

All right. I think with that, we'll wrap it up. Thank you, everybody, for joining, and look forward to speaking with everyone next quarter.

Thank you.