UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2005
For the transition period from to
Commission File Number 0-24429
COGNIZANT TECHNOLOGY SOLUTIONS CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
Registrant’s telephone number, including area code (201) 801-0233
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No: ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes x No: ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes ¨ No: x
Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of November 1, 2005:
Class
Number of Shares
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
AND COMPREHENSIVE INCOME
(in thousands, except per share data)
Revenues
Cost of revenues
Gross profit
Selling, general and administrative expenses
Depreciation and amortization expense
Income from operations
Other income (expense):
Interest income
Other income (expense) - net
Total other income (expense)
Income before provision for income taxes
Provision for income taxes
Net income
Basic earnings per share
Diluted earnings per share
Weighted average number of common shares outstanding – Basic
Dilutive effect of shares issuable as of period-end under stock option plans
Weighted average number of common shares outstanding – Diluted
Comprehensive income:
Foreign currency translation adjustments
Comprehensive income
The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
(in thousands, except par values)
September 30,
2005
December 31,
2004
Current assets:
Cash and cash equivalents (See Note 2)
Short-term investments (See Note 2)
Trade accounts receivable, net of allowance of $1,924 and $1,560, respectively
Unbilled accounts receivable
Deferred income tax assets
Other current assets
Total current assets
Property and equipment, net of accumulated depreciation of $61,473 and $47,436, respectively
Goodwill
Other intangible assets, net
Other assets
Total assets
Current liabilities:
Accounts payable
Accrued and other current liabilities
Total current liabilities
Deferred income tax liabilities
Total liabilities
Commitments and Contingencies (See Note 6)
Stockholders’ equity:
Preferred stock, $.10 par value, 15,000 shares authorized, none issued
Class A common stock, $.01 par value, 325,000 shares authorized, 138,190 and 134,177 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively
Additional paid-in-capital
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
For the Nine Months Ended
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Provision for doubtful accounts
Deferred income taxes
Tax benefit related to stock option exercises
Changes in assets and liabilities:
Trade accounts receivable
Net cash provided by operating activities
Cash flows from investing activities:
Purchases of property and equipment
Purchases of short-term investments
Proceeds from maturity or sale of short-term investments
Acquisition, net of cash acquired
Net cash used in investing activities
Cash flows from financing activities – proceeds from issued shares
Effect of currency translation on cash and cash equivalents
Increase in cash and cash equivalents
Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of period
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollar amounts in thousands)
Note 1 — Interim Condensed Consolidated Financial Statements
The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Cognizant Technology Solutions Corporation (“Cognizant” or the “Company”) in accordance with generally accepted accounting principles in the United States of America and Article 10 of Regulation S-X under the Securities and Exchange Act of 1934, as amended, and should be read in conjunction with the Company’s consolidated financial statements (and notes thereto) included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. In the opinion of the Company’s management, all adjustments considered necessary for a fair presentation of the accompanying unaudited condensed consolidated financial statements have been included, and all adjustments are of a normal and recurring nature. Operating results for the interim periods are not necessarily indicative of results that may be expected to occur for the entire year. Certain prior period amounts have been restated to conform to the presentation of the Company’s financial statements for fiscal year 2005. See Note 2.
Note 2 — Cash and Cash Equivalents and Short-Term Investments
In the first quarter of 2005, the Company began to classify its investment in auction-rate securities as short-term investments. In previously issued financial statements such investments were included in cash and cash equivalents ($94,150, $49,850, $57,100 and $34,550 at December 31, 2004, 2003, 2002 and 2001, respectively). The change in presentation of auction-rate securities had no effect on the amounts of total current assets, total assets, net income or cash flow from operations of the Company for previously reported periods. In the accompanying interim financial statements, prior period balances of auction-rate securities have been reclassified to short-term investments to conform to the current period presentation.
Cash and cash equivalents and short-term investments as of December 31, 2004 and 2003, and the captions: investment in short-term investments, proceeds from maturity or sale of short-term investments, net cash used in investing activities and net increase in cash and cash equivalents presented in the Company’s statements of cash flows for the three years ended December 31, 2004, after reclassification, and as previously reported, are as follows:
Cash and cash equivalents
Short-term investments
Investment in short-term investments
Net increase in cash and cash equivalents
The Company’s short-term investments consists of: (a) bank deposits which mature in less than one year, valued at cost, which approximates fair value and (b) auction-rate securities with auction rate reset periods of less than three months and other marketable debt securities, classified as available-for-sale securities. The Company’s investment in auction-rate securities consist of investment-grade municipal and corporate debt securities and are reported at fair market value. The Company has not recorded any unrealized gains or losses as of September 30, 2005 and December 31, 2004, principally because the Company’s investment in auction-rate securities trade at par value.
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Cash and cash equivalents consists of cash deposits, including money market funds, and highly liquid instruments with a maturity of three months or less at the time of purchase.
Note 3 — Acquisition
In April 2005, the Company acquired substantially all the assets of Fathom Solutions, LLC (“Fathom”), a U.S. based company specializing in IT consulting in the telecommunications and financial services industries, for initial consideration of approximately $23,300 (including deal fees and consideration for delivery by sellers of net assets above the contractual target) in cash and stock. During the quarter ended June 30, 2005, the Company made cash payments of approximately $14,100 and issued 113,225 shares of Class A common stock valued at approximately $4,700 related to the acquisition. The remaining portion of the initial consideration of approximately $4,500 was paid in cash during the quarter ended September 30, 2005. Additional purchase price, not to exceed $16,000, payable in 2007, is contingent on Fathom achieving certain financial and operating targets over the two years ended April 30, 2007 and will be recorded when the contingency is resolved. The Company completed this acquisition primarily to strengthen its service capabilities in the telecommunications industry.
The Company has accounted for the acquisition of Fathom as business combination under the provisions of SFAS No. 141, “Business Combinations.” In accordance with the provisions of SFAS No. 142, the Company has made a preliminary allocation of the purchase price to the tangible and intangible assets and liabilities acquired. Accordingly, the allocations are subject to revision when the Company receives final information concerning asset and liability valuations. As part of the preliminary allocation of purchase price, the Company recorded approximately $9,100 of goodwill and $6,750 of intangible assets, principally customer relationships. For the three and nine months ended September 30, 2005, amortization of $200 and $376, respectively, related to the acquisition of amortizable intangible assets of Fathom has been included in the accompanying condensed consolidated statements of income and comprehensive income. The operating results of Fathom have been included in the consolidated financial statements of the Company effective April 16, 2005. The acquisition of Fathom was not material to the Company’s consolidated results of operations, cash flows or financial condition.
During the first quarter of 2005, the Company made an additional purchase price payment of $1,183 relating to the acquisition of Infopulse, which was acquired in November 2003. Additional purchase price, not to exceed 3.5 million Euros (approximately $4,200), payable in 2006 is contingent on Infopulse achieving certain revenue and operating income targets for the 24-month period ending December 31, 2005.
Note 4 — Income Taxes
Cognizant’s Indian subsidiary, Cognizant India, is an export-oriented company, which, under the Indian Income Tax Act of 1961 is entitled to claim tax holidays for a period of ten consecutive years for each Software Technology Park (“STP”) with respect to export profits for each STP. Substantially all of the earnings of Cognizant India are attributable to export profits. In 2004, the ten-year tax holiday period expired for one STP and, accordingly, the export profits for that STP are subject to income tax. Export profits from the remaining STPs in India are currently entitled to a 100% exemption from Indian income tax. Under current law, these tax holidays will be completely phased out by March of 2009. The incremental Indian taxes related to the STP for which the Indian tax holiday expired in 2004 have been incorporated into the Company’s effective income tax rates for 2005 and 2004. The principal difference between the effective rates during the 2005 and 2004 periods and the Company’s United States Federal statutory rate is the effect of the tax holiday in India.
On October 22, 2004, the American Jobs Creation Act of 2004 (the “Act”) was enacted into law. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. The Company is currently reviewing whether, and to what extent, it might repatriate foreign earnings that have not yet been remitted to the U.S. Under the provisions of the Act and subject to the operating results of its controlled foreign corporations during 2005, the Company will be eligible to repatriate an amount between $0 and $500 million. The Company has estimated the blended income tax rate, including domestic and foreign taxes, to be in the range of 17% to 19% of the amount repatriated. The Company will finalize its assessment by the end of 2005 and, if it elects to repatriate any accumulated foreign earnings, the funds will be repatriated by December 31, 2005.
Note 5 — Employee Stock-Based Compensation Plans
At September 30, 2005, the Company had four stock-based employee compensation plans. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board Opinion (“APB”) No. 25,
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“Accounting for Stock Issued to Employees and Related Interpretations” (“APB No. 25”). There is no stock-based employee compensation cost reflected in net income as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share for the three and nine months ended September 30, 2005 and 2004, if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), to stock-based employee compensation.
Three Months Ended
Nine Months Ended
Net income as reported
Deduct: Total stock-based compensation expense determined under the fair value method for all awards, net of tax related benefits
Pro forma net income
Earnings per share:
As reported — basic
Pro forma — basic
As reported — diluted.
Pro forma — diluted
On June 14, 2005, the stockholders of the Company approved an amendment to the 1999 Incentive Compensation Plan (the “Incentive Plan”), to (i) increase the maximum number of shares of Class A Common Stock reserved for issuance from 36,000,000 to 37,500,000 shares and to reserve an additional 1,500,000 shares of Class A Common Stock for issuance upon the exercise of stock options or stock appreciation rights or for the issuance of other awards granted under the Incentive Plan, (ii) provide that repricing of stock options may not occur without stockholder approval, (iii) provide for minimum vesting periods for stock based awards, other than stock options or stock appreciation rights, (iv) provide that stock options may not be granted below fair market value, and (v) provide that all material amendments to the Incentive Plan shall be subject to stockholder approval.
Note 6 — Commitments and Contingencies
The Company has plans to construct additional fully-owned development and training centers located in Chennai, Pune, Calcutta and Bangalore, India. The total construction expenditure related to this program is estimated to be approximately $76,000. As of September 30, 2005, the Company has entered into fixed capital commitments of approximately $66,200 related to this India development center expansion program, of which approximately $37,100 has been spent to date.
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the outcome of such claims and legal actions, if decided adversely, is not expected to have a material adverse effect on the Company’s quarterly or annual operating results, cash flows, or consolidated financial position. Additionally, many of the Company’s engagements involve projects that are critical to the operations of its customers’ businesses and provide benefits that are difficult to quantify. Any failure in a customer’s computer system could result in a claim for substantial damages against the Company, regardless of the Company’s responsibility for such failure. Although the Company attempts to contractually limit its liability for damages arising from negligent acts, errors, mistakes, or omissions in rendering its software development and maintenance services, there can be no assurance that the limitations of liability set forth in its contracts will be enforceable in all instances or will otherwise protect the Company from liability for damages. Although the Company has general liability insurance coverage, including coverage for errors or omissions, there can be no assurance that such coverage will continue to be available on reasonable terms or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims against the Company that exceed available insurance coverage or changes in the Company’s insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on the Company’s business, results of operations, cash flows and financial condition.
In connection with the split-off of the Company from IMS Health Incorporated (“IMS Health”) on February 13, 2003, the Company entered into a Distribution Agreement, dated January 7, 2003, with IMS Health (the “Distribution Agreement”), that provides, among other things, that IMS Health and the Company will comply with, and not take any action during the
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relevant time period that is inconsistent with, the representations made to and relied upon by McDermott, Will & Emery in connection with rendering its opinion regarding the U.S. Federal income tax consequences of the exchange offer. In addition, pursuant to the Distribution Agreement, the Company indemnified IMS Health for any tax liability to which they may be subject as a result of the exchange offer but only to the extent that such tax liability resulted solely from a breach in the representations the Company made to and were relied upon by McDermott, Will & Emery in connection with rendering its opinion regarding the U.S. Federal income tax consequences of the exchange offer. If the Company breaches any of its representations in connection with the Distribution Agreement, the related indemnification liability could be material to the Company’s results of operations, financial position and cash flows.
Note 7 — Segment Information
The Company’s reportable segments are: Financial Services, which includes customers providing banking / transaction processing, capital markets and insurance services; Healthcare, which includes healthcare providers and payers as well as life sciences customers; Manufacturing / Retail / Logistics, which includes manufacturers, retailers, travel and other hospitality customers, as well as customers providing logistics services; and Other, which is an aggregation of industry segments which, individually, are less than 10% of consolidated revenues and segment operating profit. The Other reportable segment includes media, information services, telecommunications and high technology operating segments. The Company’s sales managers, account executives, account managers and project teams are aligned in accordance with the specific industries they serve.
The Company’s chief operating decision maker evaluates the Company’s performance and allocates resources based on segment revenues and operating profit. Segment operating profit is defined as income from operations before unallocated costs. Expenses included in segment operating profit consist principally of direct selling and delivery costs as well as a per seat charge for use of the Company’s development centers. Certain expenses, such as general and administrative, and a portion of depreciation and amortization, are not specifically allocated to specific segments as management does not believe it is practical to allocate such costs to individual segments because they are not directly attributable to any specific segment. Accordingly, these expenses are separately disclosed as “unallocated” and adjusted only against the total income from operations of the Company. Additionally, management has determined that it is not practical to allocate identifiable assets, by segment, since such assets are used interchangeably among the segments.
Revenues from external customers and segment operating profit, before unallocated expenses, for the Financial Services, Healthcare, Manufacturing / Retail / Logistics, and Other reportable segments for the three and nine months ended September 30, 2005 and 2004 are as follows:
Revenues:
Financial services
Healthcare
Manufacturing / retail / logistics
Other
Total revenue
Segment Operating Profit:
Total segment operating profit
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Unallocated costs
Other costs( 1)
Geographic Area Information
Revenue and long-lived assets, by geographic area, are as follows:
Revenues(1)
North America(2)
Europe(3)
Asia
Total
As of
Long-lived Assets(4)
North America
Europe
Asia(5)
During the three months ended September 30, 2005 and 2004, JPMorgan Chase and another customer, each individually accounted for more than 10.0% of revenues and during the nine months ended September 30, 2005 and 2004, JPMorgan Chase was the only customer to account for more than 10.0% of revenues.
Note 8 – Recent Accounting Standards
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 replaces Accounting Principles Board Opinion No.
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20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and changes the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when specific transition provisions are not provided. SFAS No. 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless it is impracticable to determine the period specific or cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB No. 25 and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options and issuances under employee stock purchase plans, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative under the new standard.
In accordance with the Securities and Exchange Commission’s amendment in April 2005 of the compliance dates of SFAS No. 123(R), Cognizant must adopt SFAS No. 123(R) on January 1, 2006. Early adoption is permitted in periods in which financial statements have not yet been issued. Cognizant expects to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) allows for two transition methods. The basic difference between the two methods is that the modified-prospective transition method does not require restatement of prior periods, whereas the modified-retrospective transition method will require restatement.
As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options or stock issuances under the employee stock purchase plan. Although the full impact of Cognizant’s adoption of SFAS No. 123(R)’s fair value method has not yet been determined, the Company expects that it will have a significant impact on its results of operations. The disclosure in Note 5 of pro forma net income and earnings per share as if the Company had recognized compensation cost for share-based payments under SFAS No. 123 for the three months and nine months ended September 30, 2005 and 2004 is not necessarily indicative of the potential impact of recognizing compensation cost for share based payments under SFAS No. 123(R) in future periods. The potential impact of adopting SFAS No. 123(R) is dependent on levels of share-based payments granted, the specific option pricing model utilized to determine fair value and the transition methodology selected.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
We are a leading provider of custom IT services related to IT design, development, integration and maintenance services primarily for Fortune 1000 companies located in North America and Europe. Our core competencies include web-centric applications, data warehousing, component-based development and legacy and client-server systems. We provide IT services using an integrated on-site/offshore business model. This seamless on-site/offshore business model combines technical and account management teams located on-site at the customer location and offshore at dedicated development centers located primarily in India.
During the three and nine months ended September 30, 2005, our revenue increased to $235.5 million and $628.9 million, respectively, compared to $155.4 million and $413.9 million during the three and nine months ended September 30, 2004. Net income increased to $40.6 million and $108.6 million, respectively, or $0.28 and $0.74 per diluted share during the three and nine months ended September 30, 2005 compared to $26.1 million and $69.6 million or $0.18 and $0.49 per diluted share during the three and nine months ended September 30, 2004. We had 247 active clients at September 30, 2005 compared to 219 at September 30, 2004. We anticipate that a significant portion of our revenue growth during the remainder of 2005 will come from increased penetration of existing clients. During the nine months ended September 30, 2005, 87.0 % of our revenue came from clients in North America. We will continue to expand our presence in Europe as we are starting to see an increased level of interest for offshore services in that region from European divisions of our global clients as well as an increasing number of local clients. Our operating margin was 20.0 % for the three month period ended September 30, 2005 compared to 19.9% for the three month period ended September 30, 2004. This was consistent with our targeted operating margin range of 19% to 20% of total revenues.
At September 30, 2005, we had cash and cash equivalents and short-term investments of $368.5 million, an increase of approximately $53.7 million compared to December 31, 2004. Our most recent building plans provide for construction of over 900,000 square feet of space in new fully-owned development and training centers located in Chennai, Pune, Calcutta and Bangalore, India. Total construction costs related to this program are currently estimated to be approximately $76.0 million, which we expect to fund from current operations. We believe our financial condition will remain strong. In addition, we will continue to consider acquisitions of companies that can improve our capabilities in certain market niches or geographic areas.
Critical Accounting Estimates and Risks
Management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the amounts reported for assets and liabilities, including the recoverability of tangible and intangible assets, disclosure of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reported period. On an on-going basis, we evaluate our estimates. The most significant estimates relate to the recognition of revenue and profits based on the percentage of completion method of accounting for certain fixed-bid contracts, the allowance for doubtful accounts, income taxes, valuation of goodwill and other long-lived assets, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual amounts will differ from the estimates used in the preparation of the accompanying condensed consolidated financial statements. Our significant accounting policies are described in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.
We believe the following critical accounting policies require higher level of management judgments and estimates than others in preparing the consolidated financial statements:
Revenue Recognition. Revenues related to our fixed-price contracts are recognized as the service is performed using the percentage of completion method of accounting, under which the total contract revenue during the term of an agreement is recognized on the basis of the percentage that each contract’s cost to date bears to the total estimated cost (cost to cost method). Estimates of total contract revenues and costs are continuously monitored during the term of the contract, and recorded revenues and costs are subject to revision as the contract progresses. Such revisions may result in increases or decreases to revenues and income and are reflected in the consolidated financial statements in the periods in which they are first identified.
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Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is determined by evaluating the relative credit-worthiness of each customer, historical collections experience and other information, including the aging of the receivables. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Income Taxes. Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and related valuation allowance, if any, involves judgment. As a global company, we are required to calculate and provide for income taxes in each of the jurisdictions where we operate. This involves estimating current tax exposures in each jurisdiction as well as making judgments regarding the recoverability of deferred tax assets. Tax exposures can involve complex issues and may require an extended period to resolve. In the period of resolution, adjustments may need to be recorded that result in increases or decreases to income. Changes in the geographic mix or estimated level of annual pre-tax income can also affect the overall effective income tax rate.
On an on-going basis, we evaluate whether a valuation allowance is needed to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and on-going prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we determine that we will be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we will not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income or equity (if the deferred tax asset is related to tax benefits from stock option exercises that have not been realized) in the period such determination was made.
Our Indian subsidiary, Cognizant India, is an export-oriented company, which, under the Indian Income Tax Act of 1961, is entitled to claim tax holidays for a period of ten consecutive years for each Software Technology Park (STP) with respect to export profits for each STP. Substantially all of the earnings of Cognizant India are attributable to export profits. In 2004, the ten-year tax holiday expired for one STP and, accordingly, the export profits for that STP are subject to Indian income tax. Export profits from the remaining STPs in India are currently entitled to a 100% exemption from Indian income tax. Under current law, these tax holidays will be completely phased out by March of 2009. The tax holiday will not be expiring for any STPs in 2005. Prior to 2002, it was management’s intent to repatriate all accumulated earnings from India to the United States; accordingly, we provided for deferred income taxes in the amount of approximately $24.8 million on all such undistributed earnings through December 31, 2001. During the first quarter of 2002, we made a strategic decision to pursue an international strategy that includes expanded infrastructure investments in India and geographic expansion in Europe and Asia. As a component of this strategy, beginning in 2002, we intend to use Indian earnings to expand operations outside of the United States instead of repatriating these earnings to the United States. Accordingly, effective January 1, 2002, pursuant to Accounting Principles Board Opinion (APB) No. 23, “Accounting for Income Taxes – Special Areas”, we no longer accrue incremental U.S. taxes on Indian earnings as these earnings are considered to be indefinitely reinvested outside of the United States. As of September 30, 2005, the amount of unrepatriated Indian earnings upon which no incremental U.S. taxes have been recorded is approximately $240.9 million. If such earnings are repatriated in the future or are no longer deemed to be indefinitely reinvested, we will accrue the applicable amount of taxes associated with such earnings.
On October 22, 2004, the American Jobs Creation Act of 2004 (the “Act”) was enacted into law. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. We are currently reviewing whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S. Under the provisions of the Act and subject to the operating results of its controlled foreign corporations during 2005, we will be eligible to repatriate an amount between $0 and $500 million. However, we are evaluating repatriating an amount between $0 and $140 million. We have estimated the blended income tax rate, including domestic and foreign taxes, to be in the range of 17% to 19% of the amount repatriated. If we elect to repatriate accumulated foreign earnings under the Act, we will record an income tax benefit in the fourth quarter of 2005 principally because we have previously accrued income taxes on undistributed Indian earnings through December 31, 2001 at an income tax rate higher than the rate we will have to pay under the Act. The amount of the income tax benefit will vary based on the amount elected for repatriation. We will finalize our assessment by the end of 2005 and, if we elect to repatriate any accumulated foreign earnings, the funds will be repatriated by December 31, 2005.
Goodwill. We evaluate goodwill for impairment at least annually, or as circumstances warrant. When determining the fair value of our reporting units, we utilize various assumptions, including projections of future cash flows. Any adverse changes in key assumptions about our businesses and their prospects or an adverse change in market conditions may cause a change in the estimation of fair value and could result in an impairment charge. As of September 30, 2005, our goodwill balance was approximately $18.3 million.
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Long-lived Assets. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, we review long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In general, we will recognize an impairment loss when the sum of undiscounted expected future cash flows is less than the carrying amount of such asset. The measurement for such an impairment loss is then based on the fair value of the asset. If such assets were determined to be impaired, it could have a material adverse effect on our business, results of operations and financial condition.
Risks. Most of our IT development centers, including a majority of our employees, are located in India. As a result, we may be subject to certain risks associated with international operations, including risks associated with foreign currency exchange rate fluctuations and risks associated with the application and imposition of protective legislation and regulations relating to import and export or otherwise resulting from foreign policy or the variability of foreign economic or political conditions. Additional risks associated with international operations include difficulties in enforcing intellectual property rights, the burdens of complying with a wide variety of foreign laws, potential geo-political and other risks associated with terrorist activities and local and cross border conflicts, potentially adverse tax consequences, tariffs, quotas and other barriers. We are also subject to risks associated with our overall compliance with Section 404 of the Sarbanes-Oxley Act of 2002. The identification of a material weakness in our internal controls or the inability of our independent auditor to provide us with an unqualified report as to the adequacy of our internal controls over financial reporting for future year ends could result in adverse consequences to us, including, but not limited to, a loss of investor confidence in the reliability of our financial statements, which could cause the market price of our stock to decline. See Item 1 “Business – Additional Factors That May Affect Future Results” included in our Annual Report on Form 10-K for the year ended December 31, 2004 for a discussion of additional risks that may affect our business, operations or financial results.
Results of Operations
Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004
The following table sets forth, for the periods indicated, certain financial data for the three months ended September 30:
(Dollars in thousands)
% of
Selling, general and administrative
Other income (expense), net
Revenue. Revenue increased by 51.5 %, or approximately $80.1 million, from approximately $155.4 million during the three months ended September 30, 2004 to approximately $235.5 million during the three months ended September 30, 2005. This increase is primarily attributed to greater acceptance of the on-site/offshore delivery model, increased revenue from existing customers, and revenue from new customers added since September 30, 2004, including the acquisition of Fathom. In addition, we experienced strong demand across all of our business segments for an increasingly broad range of services. In the third quarter of 2005 and 2004, JPMorgan Chase and a second customer each individually accounted for sales in excess of 10% of revenues. This second customer is not expected to account for more than 10% of sales on a full-year basis for the year ended December 31, 2005.
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Gross Profit. Our cost of revenues consists primarily of the cost of salaries, payroll taxes, benefits, immigration and travel for technical personnel, and the cost of sales commissions related to revenues. Our cost of revenues increased by 51.5%, or approximately $43.6 million, from approximately $84.6 million during the three months ended September 30, 2004 to approximately $128.2 million during the three months ended September 30, 2005. The increase was due primarily to higher compensation costs from the increase in the number of our technical professionals. The increased number of our technical professionals is a direct result of greater demand for our services. Our gross profit increased by 51.5%, or approximately $36.5 million, from approximately $70.8 million during the three months ended September 30, 2004 to approximately $107.4 million during the three months ended September 30, 2005.
Gross profit margin remained constant at 45.6% of revenues during the three months ended September 30, 2004 and September 30, 2005.
Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of salaries, employee benefits, travel, promotion, communications, management, finance, administrative and occupancy costs as well as depreciation and amortization expense. Selling, general and administrative expenses, including depreciation and amortization, increased by 51.0%, or approximately $20.4 million, from approximately $40.0 million during the three months ended September 30, 2004 to approximately $60.3 million during the three months ended September 30, 2005, and decreased as a percentage of revenue from 25.7% to 25.6%. The percentage decrease in such expenses was achieved from our growing economies of scale.
Income from Operations. Income from operations increased by 52.3%, or approximately $16.1 million, from approximately $30.9 million during the three months ended September 30, 2004 to approximately $47.0 million during the three months ended September 30, 2005, representing an increase in the operating margin from 19.9% during the three months ended September 30, 2004 to approximately 20.0% during the three months ended September 30, 2005. Operating margin increased due primarily to leverage achieved from increased revenues that resulted from our expanded sales and marketing activities in the current and prior years.
Other Income/Expense, Net.Other income/expense, net consists primarily of interest income and foreign currency transaction gains or losses. Interest income increased from $1.3 million during the three months ended September 30, 2004 to approximately $2.2 million during the three months ended September 30, 2005 due primarily to higher invested global cash balances as well as an increase in short-term interest rates.
Provision for Income Taxes. The provision for income taxes increased from approximately $5.8 million during the three months ended September 30, 2004 to approximately $8.8 million during the three months ended September 30, 2005. The effective tax rate of 18.3% for the three months ended September 30, 2004 decreased to 17.8% for the three months ended September 30, 2005 primarily due to overall growth in our business which resulted in a greater percentage of Cognizant India’s income falling under the income tax holiday.
Net Income. Net income increased from approximately $26.1 million for the three months ended September 30, 2004 to approximately $40.6 million for the three months ended September 30, 2005, representing 16.8% and 17.2% of revenues, respectively. The increase in net income as a percentage of revenues compared to the prior period was primarily due to the increase in operating margin described above and the decrease in the overall effective income tax rate.
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Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004
The following table sets forth, for the periods indicated, certain financial data for the nine months ended September 30:
Revenue. Revenue increased by 52%, or approximately $215.0 million, from approximately $413.9 million during the nine months ended September 30, 2004 to approximately $628.9 million during the nine months ended September 30, 2005. This increase is primarily attributed to greater acceptance of the on-site/offshore delivery model, increased revenue from existing customers and revenue from new customers added since September 30, 2004, including the acquisition of Fathom. In addition, we experienced strong demand across all of our business segments for an increasingly broad range of services. In the first nine months of 2005 and 2004, JPMorgan Chase accounted for sales in excess of 10% of revenues.
Gross Profit. Our cost of revenues consists primarily of the cost of salaries, payroll taxes, benefits, immigration and travel for technical personnel, and the cost of sales commissions related to revenues. Our cost of revenues increased by 52.8%, or approximately $118.8 million, from approximately $225.2 million during the nine months ended September 30, 2004 to approximately $343.9 million during the nine months ended September 30, 2005. The increase was due primarily to higher compensation costs from the increase in the number of our technical professionals. The increased number of our technical professionals is a direct result of greater demand for our services. Our gross profit increased by 51.0%, or approximately $96.3 million, from approximately $188.7 million during the nine months ended September 30, 2004 to approximately $285.0 million during the nine months ended September 30, 2005.
Gross profit margin decreased from 45.6% of revenues during the nine months ended September 30, 2004 to 45.3% of revenues during the nine months ended September 30, 2005. The decrease in gross profit margin was due primarily to annual compensation increases that were effective April 1, 2005 and our acquisition of Fathom.
Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of salaries, employee benefits, travel, promotion, communications, management, finance, administrative and occupancy costs as well as depreciation and amortization expense. Selling, general and administrative expenses, including depreciation and amortization, increased by 48.9%, or approximately $52.0 million, from approximately $106.4 million during the nine months ended September 30, 2004 to approximately $158.4 million during the nine months ended September 30, 2005, and decreased as a percentage of revenue from 25.7% to 25.2%. The percentage decrease in such expenses was achieved from our growing economies of scale.
Income from Operations. Income from operations increased 53.7%, or approximately $44.2 million, from approximately $82.3 million during the nine months ended September 30, 2004 to approximately $126.6 million during the nine months ended September 30, 2005, representing operating margins of 19.9% and 20.1% of revenues, respectively. The increase in operating margin was due primarily to the leverage achieved from increased revenues that resulted from our expanded sales and marketing activities in the current and prior years partially offset by the effect of annual compensation increases effective April 1, 2005.
Other Income/Expense, Net. Other income/expense, net consists primarily of interest income and foreign currency transaction gains or losses. Interest income increased from $2.9 million during the nine months ended September 30, 2004 to approximately $6.1 million during the nine months ended September 30, 2005 due primarily to higher invested global cash balances as well as an increase in short-term interest rates.
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Provision for Income Taxes. The provision for income taxes increased from approximately $15.6 million during the nine months ended September 30, 2004 to approximately $23.5 million during the nine months ended September 30, 2005. The effective tax rate of 18.3% for the nine months ended September 30, 2004 decreased to 17.8% for the nine months ended September 30, 2005 primarily due to overall growth in our business which resulted in a greater percentage of Cognizant India’s income falling under the income tax holiday.
Net Income. Net income increased from approximately $69.6 million for the nine months ended September 30, 2004 to approximately $108.6 million for the nine months ended September 30, 2005, representing 16.8% and 17.3% of revenues, respectively. The increase in net income as a percentage of revenues compared to the prior period was primarily due to the percentage decrease in selling, general and administrative expenses described above and the decrease in the overall effective income tax rate, offset, in part by the decrease in the gross profit as a percentage of revenues.
Results by Business Segment
Our reportable segments are: Financial Services, which includes customers providing banking / transaction processing, capital markets and insurance services; Healthcare, which includes healthcare providers and payers as well as life sciences customers; Manufacturing / Retail / Logistics, which includes manufacturers, retailers, travel and other hospitality customers, as well as customers providing logistics services; and Other, which is an aggregation of industry operating segments which, individually, are less than 10% of consolidated revenues and segment operating profit. The Other reportable segment includes media, information services, telecommunications and high technology operating segments. Our sales managers, account executives, account managers and project teams are aligned in accordance with the specific industries they serve.
The Company’s chief operating decision maker evaluates Cognizant’s performance and allocates resources based on segment revenues and operating profits. Segment operating profit is defined as income from operations before unallocated costs. Generally, operating expenses for each operating segment have similar characteristics and are subject to the same factors, pressures and challenges. However, the economic environment and its effects on industries served by our operating groups may affect revenue and operating expenses to differing degrees. Expenses included in segment operating profit consist principally of direct selling and delivery costs as well as a per seat charge for use of the development centers. Certain expenses, such as general and administrative, and a portion of depreciation and amortization, are not specifically allocated to specific segments as management does not believe it is practical to allocate such costs to individual segments because they are not directly attributable to any specific segment. Accordingly, these expenses are separately disclosed as “unallocated” and adjusted only against the total income from operations.
Revenues from external customers and segment operating profit, before unallocated expenses, for the Financial Services, Healthcare, Manufacturing / Retail / Logistics, and Other reportable segments for the three months ended September 30, 2005 and 2004 are as follows:
Manufacturing/retail/logistics
Total revenues
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Quarter Ended September 30, 2005 Compared to Quarter Ended September 30, 2004
Financial Services Segment
Revenue. Revenue increased by 55.1%, or approximately $41.9 million, from approximately $76.1 million during the three months ended September 30, 2004 to approximately $ 118.0 million during the three months ended September 30, 2005. The increase in revenue was attributable primarily to greater acceptance of the on-site/offshore IT services delivery model as a means of reducing a customer’s internal IT costs, as well as increased sales and marketing activities directed at both the U.S. and European markets for our services.
Segment Operating Profit. Segment operating profit increased 49.1%, or approximately $13.8 million, from approximately $28.2 million during the three months ended September 30, 2004 to approximately $42.1 million during the three months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues partially offset by continuing investments in sales and marketing.
Healthcare Segment
Revenue. Revenue increased by 50.0%, or approximately $15.7 million, from approximately $31.3 million during the three months ended September 30, 2004 to approximately $47.0 million during the three months ended September 30, 2005. The increase in revenue was primarily attributable to the continued expansion of services within our existing North American customers.
Segment Operating Profit. Segment operating profit increased 63.9%, or approximately $8.0 million, from approximately $12.5 million during the three months ended September 30, 2004 to approximately $20.5 million during the three months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues and achieving continued leverage on prior sales and marketing investments.
Manufacturing/Retail/Logistics Segment
Revenue. Revenue increased by 40.8%, or approximately $11.2 million, from approximately $27.3 million during the three months ended September 30, 2004 to approximately $38.5 million during the three months ended September 30, 2005. The increase in revenue was driven both by continued expansion of existing customer relationships as well as a significant number of new customers. The increase can also be attributed to leveraging sales and marketing investments in this area as well as greater acceptance of the onsite/offshore IT services delivery model.
Segment Operating Profit. Segment operating profit increased 14.8%, or approximately $1.5 million, from approximately $10.1 million during the three months ended September 30, 2004 to approximately $11.7 million during the three months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues largely offset by significant investments in sales and marketing, client relationship and program management personnel, and program development to accelerate the acquisition and growth of new and existing clients.
Other Segment
Revenue. Revenue increased by 55.2%, or approximately $11.4 million, from approximately $20.7 million during the three months ended September 30, 2004 to approximately $32.1 million during the three months ended September 30, 2005. The increase in revenue was attributable primarily to greater acceptance of the on-site/offshore consulting services delivery model and the acquisition of Fathom. The majority of Fathom’s business was folded into the telecommunications segment which is included as part of “Other” segments.
Segment Operating Profit. Segment operating profit increased 11.2%, or approximately $1.0 million from approximately $9.1 million during the three months ended September 30, 2004 to approximately $10.1 million during the three months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues, including the acquisition of Fathom, largely offset by significant investments in sales and marketing, client relationship and program management personnel, and program development to accelerate the acquisition and growth of new and existing clients.
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Revenues from external customers and segment operating profit, before unallocated expenses, for the Financial Services, Healthcare, Manufacturing / Retail / Logistics, and Other reportable segments for the nine months ended September 30, 2005 and 2004 are as follows:
Revenue. Revenue increased by 53.2%, or approximately $108.2 million, from approximately $203.4 million during the nine months ended September 30, 2004 to approximately $311.6 million during the nine months ended September 30, 2005. The increase in revenue was attributable primarily to greater acceptance of the on-site/offshore IT services delivery model as a means of reducing a customer’s internal IT costs, as well as increased sales and marketing activities directed at both the U.S. and European markets for our services.
Segment Operating Profit. Segment operating profit increased 50.0%, or approximately $35.7 million, from approximately $71.5 million during the nine months ended September 30, 2004 to approximately $107.2 million during the nine months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues partially offset by continuing investment in sales and marketing.
Revenue. Revenue increased by 49.6%, or approximately $40.4 million, from approximately $81.6 million during the nine months ended September 30, 2004 to approximately $122.0 million during the nine months ended September 30, 2005. The increase in revenue was primarily attributable to the continued expansion of services within our existing North American customers.
Segment Operating Profit. Segment operating profit increased 52.8%, or approximately $17.3 million, from approximately $32.9 million during the nine months ended September 30, 2004 to approximately $50.2 million during the nine months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues and achieving continued leverage on prior sales and marketing investments.
Revenue. Revenue increased by 52.5%, or approximately $38.7 million, from approximately $73.7 million during the nine months ended September 30, 2004 to approximately $112.4 million during the nine months ended September 30, 2005. The increase in revenue was driven both by continued expansion of existing customer relationships as well as a significant number of new customers. The increase can also be attributed to leveraging sales and marketing investments in this area as well as greater acceptance of the onsite/offshore IT services delivery model.
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Segment Operating Profit. Segment operating profit increased 24.3%, or approximately $6.7 million, from approximately $27.6 million during the nine months ended September 30, 2004 to approximately $34.3 million during the nine months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues largely offset by significant investments in sales and marketing, client relationship and program management personnel, and program development to accelerate the acquisition and growth of new and existing clients.
Revenue. Revenue increased by 50.3%, or approximately $27.7 million, from approximately $55.1 million during the nine months ended September 30, 2004 to approximately $82.9 million during the nine months ended September 30, 2005. The increase in revenue was attributable primarily to greater acceptance of the on-site/offshore consulting services delivery model and the acquisition of Fathom.
Segment Operating Profit. Segment operating profit increased 32.4%, or approximately $6.8 million from approximately $21.1 million during the nine months ended September 30, 2004 to approximately $27.9 million during the nine months ended September 30, 2005. The increase in segment operating profit was attributable primarily to increased revenues, including the acquisition of Fathom, largely offset by significant investments in sales and marketing, client relationship and program management personnel, and program development to accelerate the acquisition and growth of new and existing clients.
Liquidity and Capital Resources
At September 30, 2005, we had cash and cash equivalents and short-term investments of approximately $368.5 million. We have used, and plan to use, such cash for (i) expansion of existing operations, including our offshore software development centers; (ii) continued development of new service lines; (iii) possible acquisitions of related businesses; (iv) formation of joint ventures; and (v) general corporate purposes, including working capital. As of September 30, 2005 and December 31, 2004, we had no third party debt and had working capital of approximately $461.8 million and $338.9 million, respectively. Accordingly, we do not anticipate any near-term liquidity issues.
Net cash provided by operating activities was approximately $93.6 million during the nine months ended September 30, 2005 as compared to cash provided by operations of approximately $75.5 million during the nine months ended September 30, 2004. The increase is primarily attributed to increased net income in 2005, offset, in part, by slower collections of receivables and the timing of payment of accrued expenses. Trade accounts receivable increased from approximately $96.4 million at December 31, 2004 to approximately $146.9 million at September 30, 2005. Unbilled accounts receivable increased from approximately $14.2 million at December 31, 2004 to approximately $24.7 million at September 30, 2005. The increase in trade accounts receivable was attributed to increased revenues and a higher number of days of sales outstanding. Unbilled receivables increased primarily due to increased revenue and the timing of milestone billings for certain fixed price contracts. We monitor turnover, aging and the collection of accounts receivable through the use of management reports that are prepared on a customer basis and evaluated by our finance staff. At September 30, 2005, our days of sales outstanding, including unbilled receivables, was approximately 67 days as compared to 59 days at December 31, 2004 and 61 days at September 30, 2004.
Our investing activities used net cash of approximately $108.9 million during the nine months ended September 30, 2005 as compared to $68.0 million during the nine months ended September 30, 2004. The increase in net cash used in investing activities primarily relates to greater investments in property and equipment in 2005 to expand our offshore development structure and the acquisition of Fathom partially offset by lower net purchases of short-term investments in 2005.
Our financing activities provided net cash of approximately $34.5 million during the nine months ended September 30, 2005 as compared to $23.7 million during the nine months ended September 30, 2004. The increase relates to a higher level of cash proceeds from the exercise of stock options and employee purchases of stock.
We believe that our available funds and the cash flows expected to be generated from operations will be adequate to satisfy our current and planned operations and needs for at least the next 12 months, including payment of income taxes if we elect to repatriate undistributed foreign earnings under the Act in the fourth quarter of 2005. Our ability to expand and grow our business in accordance with current plans, to make acquisitions and form joint ventures and to meet our long-term capital
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requirements beyond this 12-month period will depend on many factors, including the rate, if any, at which our cash flow increases, our ability and willingness to accomplish acquisitions and joint ventures with capital stock, our continued intent not to repatriate earnings from India other than amounts, if any, under the Act, our ability not to breach the Distribution Agreement between IMS Health and us, especially as it relates to our tax indemnities, and the availability of public and private debt and equity financing. We cannot be certain that additional financing, if required, will be available on terms favorable to us, if at all.
During July 2004, we entered into a foreign currency forward contract, with a six-month term and notional amount of $12.5 million, to sell the Indian Rupee for U.S. dollars that was settled in January 2005. We entered into this forward contract to manage a portion of our foreign currency risk related to Indian Rupee denominated asset balances, primarily cash investments, at our Indian subsidiary, Cognizant India. Movement in the exchange rate for the Indian Rupee results in foreign currency gains or losses upon remeasurement of the Cognizant India’s financial statements into its functional currency, the U.S. dollar. Our objective was to reduce foreign currency exposure to appreciation or depreciation in the value of the Indian Rupee by offsetting a portion of such exposure with gains or losses on the forward contract, referred to above. The forward contract was marked to market and recorded at fair value with unrealized gains and losses reported along with foreign currency gains or losses in the caption “other income (expense), net” on our condensed consolidated statements of income and comprehensive income.
Other than the aforementioned forward contract, we have not engaged in hedging activities nor have we entered into off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons that are likely to affect liquidity or the availability of or requirements for capital resources.
As of March 31, 2005, we completed the wind-down of our development facility in Limerick, Ireland. During the nine months ended September 30, 2005, we recorded additional expenses of approximately $0.1 million and made payments of approximately $0.6 million primarily for severance and retention bonuses. Substantially all costs have been paid as of March 31, 2005.
In April 2005, we acquired substantially all the assets of Fathom for initial consideration of approximately $23.3 million (including deal fees and consideration for delivery by sellers of net assets above the contractual target) in cash and stock. During the quarter ended June 30, 2005, the Company made cash payments of approximately $14.1 million and issued 113,225 shares of Class A common stock valued at approximately $4.7 million related to the acquisition. The remaining portion of the initial consideration of approximately $4.5 million was paid in cash during the quarter ended September 30, 2005. Additional purchase price, not to exceed $16.0 million, payable in 2007, is contingent on Fathom achieving certain financial and operating targets over the two years ended April 30, 2007.
We have contingent liabilities to pay additional purchase price of approximately $20 million relating to the Fathom and Infopulse acquisitions. Contingent purchase price payments relating to acquisitions are recorded when the contingencies are resolved. The contingent consideration, if paid, will be recorded as an additional element of the cost of the acquired company. Any additional payments relating to the achievement of post-acquisition financial and operating targets is expected to be funded by cash flows from operations.
Commitments and Contingencies
We have plans to construct additional fully-owned development and training centers located in Chennai, Pune, Calcutta and Bangalore, India. Total construction costs related to this program are expected to be approximately $76.0 million, which we expect to fund internally. As of September 30, 2005, we have entered into fixed capital commitments of approximately $66.2 million related to this India development center expansion program, of which approximately $37.1 million has been spent to date. The remaining fixed capital commitments are payable by the end of 2006.
We are involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the outcome of such claims and legal actions, if decided adversely, is not expected to have a material adverse effect on our quarterly or annual operating results, cash flows, or consolidated financial position. Additionally, many of our engagements involve projects that are critical to the operations of our customers’ business and provide benefits that are difficult to quantify. Any failure in a customer’s computer system could result in a claim for substantial damages against us, regardless of our responsibility for such failure. Although we attempt to contractually limit our liability for damages arising from negligent acts, errors, mistakes, or omissions in rendering our application design, development and maintenance services, there can be no assurance that the limitations of liability set forth in our contracts will be enforceable in all instances or will otherwise protect us from liability for damages. Although we have general liability insurance coverage, including coverage for errors or omissions, there can be no assurance that such coverage will continue to be available on reasonable
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terms or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims against us that exceed available insurance coverage or changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our quarterly and annual operating results, financial position and cash flows.
In connection with the split-off from IMS Health Incorporated (“IMS Health”), we entered into a Distribution Agreement, dated January 7, 2003, with IMS Health, referred to as the Distribution Agreement. The Distribution Agreement provides, among other things, that IMS Health and we will comply with, and not take any action during the relevant time period that is inconsistent with, the representations made to and relied upon by McDermott, Will & Emery in connection with rendering its opinion regarding the U.S. Federal income tax consequences of the exchange offer. In addition, pursuant to the Distribution Agreement, we indemnified IMS Health for any tax liability to which they may be subject as a result of the exchange offer but only to the extent that such tax liability resulted solely from a breach in the representations we made to and were relied upon by McDermott, Will & Emery in connection with rendering its opinion regarding the U.S. Federal income tax consequences of the exchange offer. If we breach any of our representations in connection with the Distribution Agreement, the related indemnification liability could be material to our quarterly and annual operating results, financial position and cash flows.
Foreign Currency Translation
A portion of our costs in India are denominated in local currency and subject to exchange fluctuations, which has an impact on our results of operations.
Effects of Inflation
Our most significant costs are the salaries and related benefits for our programming staff and other professionals. Competition in India, the United States and Europe for professionals with advanced technical skills necessary to perform our services offered have caused wages to increase at a rate greater than the general rate of inflation. As with other IT service providers, we must adequately anticipate wage increases, particularly on our fixed-price contracts. There can be no assurance that we will be able to recover cost increases through increases in the prices that we charge for our services in the United States and elsewhere.
Recent Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 replaces Accounting Principles Board Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and changes the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when specific transition provisions are not provided. SFAS No. 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless it is impracticable to determine the period specific or cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123(R)), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123). SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25), and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options and issuances under employee stock purchase plans, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative under the new standard.
In accordance with the Securities and Exchange Commission’s amendment in April 2005 of the compliance dates of SFAS No. 123(R), we must adopt SFAS No. 123(R) no later than January 1, 2006. Early adoption is permitted in periods in which financial statements have not yet been issued. We expect to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) allows for two transition methods. The basic difference between the two methods is that the modified-prospective transition method does not require restatement of prior periods, whereas the modified-retrospective transition method will require restatement.
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As permitted by SFAS No. 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options or stock issuances under the employee stock purchase plan. Although the full impact of our adoption of SFAS No. 123(R)’s fair value method has not yet been determined, we expect that it will have a significant impact on our results of operations. The disclosure under SFAS No. 123 of pro forma net income and earnings per share as if we had recognized compensation cost for share-based payments under SFAS No. 123 for the three and nine months ended September 30, 2005 and 2004 is not necessarily indicative of the potential impact of recognizing compensation cost for share-based payments under SFAS No. 123(R) in future periods. The potential impact of adopting SFAS No. 123(R) is dependent on levels of share-based payments granted, the specific option pricing model utilized to determine fair value and the transition methodology selected.
Forward Looking Statements
The statements contained in this Quarterly Report on Form 10-Q that are not historical facts are forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended) that involve risks and uncertainties. Such forward-looking statements may be identified by, among other things, the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. From time to time, we or our representatives have made or may make forward-looking statements, orally or in writing. Such forward-looking statements may be included in various filings made by us with the Securities and Exchange Commission, or press releases or oral statements made by or with the approval of one of our authorized executive officers. These forward-looking statements, such as statements regarding anticipated future revenues, net income, contract percentage completions, capital expenditures, and other statements regarding matters that are not historical facts, involve predictions. Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. There are a number of important factors that could cause our results to differ materially from those indicated by such forward-looking statements. These factors include those set forth in the section entitled “Additional Factors That May Affect Future Results” included in our Annual Report on Form 10-K for the year ended December 31, 2004.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to foreign currency exchange rate risk in the ordinary course of doing business as we transact or hold a portion of our funds in foreign currencies, particularly the Indian Rupee. Accordingly, we periodically evaluate the need for hedging strategies to mitigate the effect of foreign currency fluctuations. During July 2004, we entered into a foreign currency forward contract, with a six-month term and notional amount of $12.5 million, to sell the Indian Rupee for U.S. dollars. We may continue to enter into such instruments in the future to reduce foreign currency exposure to appreciation or depreciation in the value of certain foreign currencies. Other than the aforementioned forward contract, we have not engaged in hedging activities nor have we entered into off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons that are likely to affect liquidity or the availability of or requirements for capital resources.
We do not believe we are exposed to material direct risks associated with changes in interest rates other than with our cash and cash equivalents and short-term investments. As of September 30, 2005, we had approximately $368.5 million of cash and cash equivalents and short-term investments which are impacted almost immediately by changes in short-term interest rates.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures and Changes in Internal Control over Financial Reporting
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2005. In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2005, our disclosure controls and procedures were (1) effective in that they were designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our chief executive officer and chief financial officer by others within those entities, as appropriate to allow timely decisions regarding required disclosures, and (2) effective in that they provide that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
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No changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 6. Exhibits.
(a) Exhibits.
Description
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Lakshmi Narayanan
/s/ Gordon Coburn
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