Cognizant Technology Solutions Corporation (NASDAQ:CTSH) Q3 2023 Earnings Call Transcript

Cognizant Technology Solutions Corporation (NASDAQ:CTSH) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Ladies and gentlemen, welcome to the Cognizant Technology Solutions Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn the conference over to Mr. Tyler Scott, Vice President, Investor Relations. Please go ahead, sir.

Tyler Scott: 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 third quarter 2023 results. If you have not, copies are available on our website, cognizant.com. The speakers we have on today's call are Ravi Kumar, Chief Executive Officer; and Jan Siegmund, Chief Financial Officer. Before we begin, I would 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. Additionally, during our call today, we will reference certain non-GAAP financial measures that we believe provide useful information for our investors.

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Reconciliations of non-GAAP financial measures where appropriate to the corresponding GAAP measures can be found in the company's earnings release and other filings with the SEC. With that, I'd like to now turn the call over to Ravi. Please go ahead.

Ravi Kumar: Thank you, Tyler. Good afternoon, everyone. Today, I would like to cover 3 topics: our third quarter results, the demand environment and a brief update on our strategic priorities. We are pleased with the company's continued progress in the third quarter, during which clients remained cautious amid economic uncertainty and discretionary spend was under pressure. Q3 revenue came in at $4.9 billion, within our guidance range. We saw sequential revenue growth of 20 basis points year-over-year. Revenue grew 0.8% as reported or a modest decline of 20 basis points in constant currency. Our adjusted operating margin of 15.5% exceeded our expectations, mostly reflecting savings from our next generation program which remains on track as well as from our operational discipline and the timing of spend on investment opportunities.

We recorded another quarter of bookings growth, up approximately 9% year-over-year. We ended Q3 with a record trailing 12-month bookings growth of $26.9 billion, up 16% year-over-year and a strong book-to-bill of 1.4x. We have sustained our large deal momentum through Q3. Approximately 30% of our in-quarter Q3 bookings were large deals and 3 of these deals exceeded $100 million each. I believe we are getting progressively better at building a creative deal generation engine and solutioning large deals. I am especially encouraged to see our continued decline in attrition. Trailing 12-month voluntary attrition for our tech services business declined to 16.2%, down about 4 percentage points sequentially and down 13 points year-over-year. This decline in attrition was a positive factor in our just completed annual client Net Promoter Score survey which showed significant improvement year-over-year and hit a historic high for Cognizant.

Clients let us know that leadership, account management and delivery are especially important to them. And the survey results show that in these areas, we're doing a great job. This assessment of how clients perceive Cognizant underscores the interdependence of the employee and client experience that gives us confidence that the changes we are making will help strengthen the portfolio over the long run. While Jan will cover our performance at a business segment level, I want to offer a quick word about financial services. We continue to reposition our Financial Services segment, while responding to an increasingly challenged demand environment. One of the ways we are striving to reinvigorate growth is through a sharply focused subindustry go-to-market approach in the Americas directly by highly experienced leaders.

We believe this change will increase our agility and deepen our domain expertise. Let's turn to the demand environment and what I'm hearing from clients. Clients remain focused on efficiency initiatives to reduce costs and consolidate providers as they increase their productivity and resilience and we are helping them do so. This should, in turn, enable them to underwrite their continuing investment in digital transformation. For example, during the quarter, we expanded our relationship with Lineage, a global leader in temperature-controlled logistics to help build an industry-leading operating platform and establish a plan to support their operations through automation and infrastructure management. We also established a new multiyear relationship with Swedish firm, Intrum.

We expect to provide end-to-end digital integration and core modernization services for their credit management technology platform. To dive deeper into clients' long-term objectives and discover new ways to strengthen our partnership with them, Cognizant held a 2-day Discovery Summit last month for about 130 of our North America clients, our first large-scale client gathering in more than 4 years. We discussed the transformative power of generative AI and how we believe it can reshape every industry. We showed clients how to apply generative AI to create more connected, collaborative and responsive relationships with their customers. We also ran live use cases at Cognizant's new AI platform, showing generative AI working alongside legacy data and machine learning models to rapidly create end-to-end AI use cases to tackle client KPIs. As mentioned last quarter, we expect to invest approximately $1 billion in our generative AI capabilities over the next 3 years, focusing on areas such as platform modernization infrastructure, recruiting and upskilling.

To that end, we opened a dedicated AI innovation studio in London. And later this year, we expect to OpenAI studios in New York, Dallas and Bangalore. We have trained about 55,000 of our employees in generative AI this year and have an additional 40,000 employees from all levels of our company registered in pursuing training on Gen AI. We have also invested in AI partnerships and experimental infrastructure to support early client engagements. We believe clients will depend on partners like Cognizant to generate significant productivity gains through automated AI-powered platforms for design, engineering and operations. This shift in client behavior further validates a recently refined strategy which is aimed at strengthening Cognizant's differentiation to help drive growth.

Our strategy is focused on 3 imperatives. First, we are resolved to be an industry-led, creating value for clients by integrating technology with industry use cases to drive business outcomes. We are embedding industry expertise across our value chain and select industries. We are developing more enterprise scale platforms designed for industry and operational use cases. Partnerships have a major role to play here. We are focused on expanding our partner ecosystem across a range of technology providers. Among them, hyperscalers, cloud providers, enterprise software companies, digital software enterprises and emerging start-ups. We believe this partner ecosystem will enable us to enhance our integrated offering by combining third-party products with our service solutions, helping to deliver enterprise-wide digital transformation.

We believe this strategy as a full stack provider opens new and significant managed services opportunities. Second, given today's more heterogeneous technology landscape and the desire of many clients to build their own technology muscle, we focus on operating a highly flexible business model to meet clients where they are in their digital transformation journeys. We can support them across a range of project types, whether that's structured deals, traditional managed services, build-operate-transfer, co-innovation, partner solutions or large technology transformations. And to help clients strengthen their technology expertise, we can either lend our human capital along with our human capital value chain which includes learning, development, automation and AI infrastructure and more.

Our business model flexibility is well suited to the changing nature of large deals where we see increasing demand for bundling services, often a combination of software people takeover infrastructure and services. These deals have a potential to bring Cognizant into the heart of clients' business landscape, putting us in a strong position to capture future services opportunities. Our third imperative is to enable more intimate levels of client collaboration and co-innovation. This effort grows out of our heritage of client centricity and grassroots innovation. Given the scale and diversity of our global teams, we believe we have a potential to harvest an abundance of ideas, big and small, that can contribute to our clients' focus. Inspired by our BlueBolt's grassroots innovation movement launched in quarter 2, more than 35,000 of our employees have generated 75,000 ideas.

We have already implemented about 14,000 of these ideas, nearly 6,000 of which are client-facing. A strengthened ability to co-innovate with clients is especially valuable as they grapple with understanding and applying generative AI. During the quarter, we launched Telco Assurance 360; a cloud-based AI-powered solution built on ServiceNow and designed to provide telcos with real-time visibility into network issues and fast proactive resolution through AI-powered analytics. We also signed a multiyear agreement with a leading provider of digital and cloud-enabled solutions that are vital to the administration of health and human services programs across the U.S. Cognizant will serve as the client's sole global IT services and operations partner to help drive transformation at scale.

We also provide the client with access to our AI, machine learning and generated AI tools, along with our TriZetto platform to advance revenue growth, increase administrative efficiency and improve the member experience. What's more, we are expanding our strategic collaboration with Qualcomm Technologies to jointly implement the AI-based solutions at the edge as a part of our Car-to-Cloud initiative. We encourage our clients who want to transform their businesses by being AI first to begin the journey by modernizing the data architecture, cloud infrastructure and core business applications. Today, we are running more than 150-plus early client engagements that incorporate the use of generative AI. Some of the examples of this work include general productivity use cases related to writing code, code analysis and troubleshooting, knowledge management and translating product specs into natural chat or speech, business specific use cases for call center automation product prototyping, audience prediction, claims management, medical scribing and research and development; and domain specific use cases like onboarding new employees, validating deep documents and financial statement planning analytics.

We have 300-plus additional opportunities in our pipeline that we are planning to scale. Let's turn to a quick update on our 3 long-term strategic objectives, starting with becoming an employer of choice in our industry. I see Cognizant as a human capital company, first; and a technology company, second. Everything we do hinges on the quality, dedication and scale of our talent base. That's why it is so consequential that our voluntary attrition continues to fall, putting us on par with the industry average. We expect further improvement in our attrition in quarter 4. It's also worth noting that in quarter 3, we had a net sequential head count increase for the first time in several quarters. As a human capital company, we are determined to help improve the lives of workers around the world.

With that in mind, we announced a ground-breaking training initiative yesterday called Cognizant Synapse Initiative, a job training endeavor, is aimed at empowering more than 1 million individuals with the advanced technology skills, including generative AI and that, they will need to thrive in the digital economy. We intend to build a consortium of partners for training and jobs which will then employ individuals who have upskilled through our Synapse Initiative. Our next performance objective is to accelerate revenue growth. When I joined Cognizant in January, I said large deals are one of my top priorities. As I mentioned earlier, we are pleased to see our continuing large deals momentum which is underpinned by the work we are doing to improve the capabilities required to seed, shape and sell large deals and our ongoing investment in the client-facing roles needed for driving growth.

These efforts have helped to partially offset what remains a softer discretionary spending environment and provides new growth opportunities following last year's muted bookings growth. Our third performance objective is to ensure operational excellence across the company. We remain focused on simplifying our operations, including a sales and delivery structure so we can continue to become more agile and get closer to clients and their unique business challenges. In general, we are operating with fewer layers, optimizing our day-to-day operations with enhanced systems and tools and working to streamline our processes and automate information flows using AI. Differentiation in the tech services industry happens at the clients' side and the project level, making relationships and strong execution key.

That's why I've invested so much time in meeting with over 270 clients so far this year, building trust and learning all I can about Cognizant can deliver more value to them. Over the past 3 quarters, I believe Cognizant has made meaningful progress on our long-term priorities. While we have a lot of work ahead, we also have much to be proud of. This includes continuing large deals momentum, improved employee and client satisfaction scores, declining attrition, the scaling of our industry leadership with a platform-centered approach, heightened operational discipline and the launch of a grassroots innovation movement. Looking ahead, we believe the soft demand environment is unlikely to see a rapid rebound. Therefore, we expect clients to continue tempering the discretionary spending as we begin the new year.

Given that market reality, we remain focused on winning efficiency-led large deals aimed at cost takeout and vendor consolidation which can offset current pressure on discretionary spending. Our focus on operating discipline and our year-to-date progress on the NextGen program gives us confidence that we can meet our expectation to deliver our 20 to 40 basis points of margin expansion next year. Jan will share more detail on NextGen in a moment. Taking a longer view with my read of business history, periods of great uncertainty and periods of change rarely coincide. Today, I believe we are in just such a period of simultaneous great uncertainty and deep-seated change. The uncertainty is being compounded by a number of intertwined domestic and international risks.

What can become a transformative change is being driven primarily by new general-purpose technologies with immense power such as generative AI which I believe could become as ubiquitous and consequential for business as society as the Internet did 3 decades ago. I expect this reality will leave most clients. However, focused they are on navigating uncertainty with no choice but to make some big bets if they are not to be left behind by the peers. I believe Cognizant is in a position -- in a great position to prepare them for this future, whether by helping them achieve significant savings to underwrite investments in transformation or by helping them build their own technology muscle which can include becoming fully AI-ready. In closing, you are all aware that we recently appointed Jatin Dalal to be Cognizant's next Chief Financial Officer and we're excited that he will be joining us in December.

Since this is Jan's last earnings call with Cognizant, I want you all to know that what a powerful partner he's been to me across so many dimensions: strategic, financial, operational and cultural. He left a positive and indelible mark on our global organization and I'm especially grateful that he agreed to stay with us until early next year to ensure smooth transition to Jatin. With that, I'll turn the call over to Jan to provide additional details on this quarter.

Jan Siegmund: Thank you, Ravi, for the kind words. I want to thank all of our associates around the world for welcoming me into the Cognizant family 3 years ago and for making my time here such a memorable experience. It has been a pleasure working with so many great people at Cognizant and all of you on this call. I'm confident that I'm leaving the company in great hands with Jatin, who many of you know, is an accomplished CFO and an experienced IT services executive. Over the next several months, I look forward to working with Ravi the Jatin and the rest of the leadership team to ensure a smooth transition. With that, let's turn to our third quarter results. We delivered revenue within our guidance range despite a soft discretionary spending environment and ongoing economic uncertainty.

Adjusted operating margin exceeded our expectations, reflecting savings from our NextGen program and the timing of investments which is driving some modest upside in our guidance range that I will touch on later. We were also pleased to deliver another quarter of solid bookings growth which continue to be driven by larger longer-duration engagements. Moving on to the details of the quarter; third quarter revenue was $4.9 billion, an increase of 0.2% sequentially. Year-over-year, revenue grew 0.8% but declined 0.2% in constant currency. Year-over-year growth includes approximately 110 basis points of contributions from our acquisitions. Similar to last quarter, our 9% quarterly bookings growth was driven primarily by larger and longer-duration deals.

On a trailing 12-month basis, duration is up over 50% from the prior year period. At the same time, we are continuing to experience softness in the smaller short-duration contracts, driven by weak discretionary spending. This dynamic has negatively impacted our near-term revenue but we believe will put us in a better position to accelerate revenue growth in the future when discretionary spending improves. Moving on to segment results for the third quarter where all growth rates discussed will be in year-over-year in constant currency. Within Financial Services, revenue declined 4%, reflecting the softer demand environment across regions and subindustries. This decline was partially offset by the benefit from the resale of third-party products in connection with our integrated offering strategy that Ravi mentioned earlier in his prepared remarks.

Looking ahead, we believe the market remains challenging and we expect the macroeconomic uncertainty will again have a meaningful impact for this segment in the fourth quarter. That said, we are working hard to correct what is in our control and I believe we can make meaningful progress under the new subindustry go-to-market approach and leadership. Health Sciences revenue declined 1%. Growth was negatively impacted by a large renewal that we signed earlier this year with a payer customer which resulted in a lower revenue run rate but meaningfully improved profitability. In addition, several of our larger customers have been impacted by their own company-specific and end market challenges which has in turn led to softer discretionary spending.

Products and Resources revenue grew less than 1%, reflecting the benefit from recently completed acquisitions, strong performance from utility clients driven by their grid modernization investments and growth among automotive clients in Europe. Growth in these areas was partially offset by pressure in manufacturing. Communications, Media and Technology revenue increased 7%, reflecting the benefit from recently completed acquisitions and the ramp of new contract awards. This includes the expansion of current engagement with our largest customers in this portfolio, who are launching innovative vertical solutions and leveraging our expertise in these areas to rapidly scale globally. Continuing with year-over-year revenue growth in constant currency from a geographic perspective in Q3, North America revenue was down less than 1%, driven by declines within our Financial Services and Health Sciences portfolios.

This was partially offset by growth in CMT and Products and Resources. Our global growth markets or GGM which include all revenue outside of North America grew approximately 1%. Growth was led by Europe which grew 3% and included strong growth within CMT, Life Sciences customers within our Health Sciences segment and Products and Resources. Finally, the resale of third-party products contributed 120 basis points to our overall revenue growth in Q3, the majority of which was in the Financial Services segment. Now, moving on to margins. During the quarter, we incurred approximately $72 million of costs related to our NextGen program. This negatively impacted our GAAP operating margin by approximately 150 basis points. Excluding this impact, adjusted operating margin was 15.5%.

Similar to last quarter, our adjusted operating margin included the negative impact from increased compensation costs attributable to our 2 merit cycles over the last 12 months. This was partially offset by savings from our NextGen program and tailwinds from the depreciation of the Indian rupee. Our GAAP tax rate in the quarter was 26.8%. Adjusted tax rate in the quarter was 25.7%. Q3 diluted GAAP EPS was $1.04 and Q3 adjusted EPS was $1.16. Now turning to the balance sheet. We ended the quarter with cash and short-term investments of $2.4 billion, or net cash of $1.7 billion. DSO of 77 days increased 2 days sequentially and 3 days year-over-year. Free cash flow in Q3 was $755 million which brings year-to-date free cash flow to approximately $1.4 billion.

For the full year, we continue to expect free cash flow to represent approximately 90% of net income. During the quarter, we repurchased 4 million shares for $300 million under our share repurchase program and returned $147 million to shareholders through our regular dividend. Year-to-date, we have repurchased approximately 11 million shares for about $700 million. At quarter end, we had $2.1 billion remaining under our share repurchase authorization. Turning to our forward outlook. For the fourth quarter, we expect revenue in the range of $4.69 billion to $4.82 billion, representing a year-over-year decline of 3.1% to 0.3% or a decline of 4% to 1.2% in constant currency. Our guidance assumes currency will have a benefit of approximately 90 basis points as well as an inorganic contribution of approximately 100 basis points.

Our Q4 revenue guidance range is wider than our historical practice, reflecting a heightened level of uncertainty regarding client discretionary spending and recent pace of decision-making heading into the end of the year. For the full year, we expect revenue will be in the range of $19.3 billion to $19.4 billion which is down approximately 0.7% to flat, both as reported and in constant currency, as we do not expect a material impact from foreign exchange rates. This compares to our prior guidance range of $19.2 billion to $19.6 billion or negative 1% to plus 1% growth in constant currency. We still expect inorganic contribution to be approximately 100 basis points. Our NextGen program remains on track and our assumptions for cost savings are unchanged from last quarter.

I'm also pleased to share that we are further reducing our expectations for NextGen costs. We now expect to incur $300 million in total charges versus $350 million previously, with $200 million this year versus $250 million previously. The reduction is a result of lower real estate cost as we are now -- as we now expect to incur about $100 million related to the net consolidation of office space in 2023 versus $150 million previously. This reflects lower expected third-party costs associated with the real estate exits. As we have spoken about previously, we still intend to reinvest the majority of the NextGen savings and growth opportunities in 2024 and beyond. Moving on to adjusted operating margin; we are modestly increasing our guidance to 14.7% which is the high end of our prior range.

As a reminder, our Q4 operating margin is typically seasonally lower than Q3 levels. We still anticipate 2023 interest income of approximately $115 million and an adjusted tax rate of approximately 24% and versus the range of 23% to 24% previously provided. In addition, we now expect to deploy approximately $1 billion on share repurchases in 2023 versus our prior expectations of approximately $800 million which assumes an additional $300 million of share repurchases in the fourth quarter. In total, we expect to return approximately $1.6 billion to shareholders through share repurchases and dividends in 2023. Our guidance for shares outstanding is unchanged at approximately 506 million. This leads to our full year adjusted earnings per share guidance of $4.39 in to $4.42 versus $4.25 and $4.48 previously, reflecting our updated expectations for revenue and adjusted operating margin.

With that, we will open the call for your questions.

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