Earnings Labs

ExlService Holdings, Inc. (EXLS)

Q3 2008 Earnings Call· Thu, Nov 6, 2008

$30.70

+1.05%

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Transcript

Operator

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 ExlService Holdings Incorporated Earnings Call. My name is Nikita and I will be your operator for today. (Operator Instructions). I would now like to turn the call over to Mr. Jarrod Yahes, Head of Investor Relations. You may begin, sir.

Jarrod Yahes

Management

Thank you, Nikita. Thanks everyone for joining us today on our third quarter 2008 earnings announcement. Joining us this morning in New York are Rohit Kapoor, our President and Chief Executive Officer and Matt Appel, our Chief Financial Officer. We hope that you have had an opportunity to review the news release we issued this morning as well as the PowerPoint presentation that is available for review on the Investor Relations section of EXL's website. Let me quickly outline the agenda for the call this morning. Rohit will first talk about the economic environment and the effect that we see that having on EXL's business, as well as some of the recent exciting client wins that we have experienced. Matt will then take you through the financial details of the third quarter, and provide an update on the remainder of 2008 and then close the presentation before we take any questions. As you know some of the matters we will discuss in this call are forward-looking, and you should keep in mind that these forward looking statements are subject to known and unknown risks and uncertainties that could cause actual results to materially differ from those expressed or implied by such statements. Such risks and uncertainties include, but are not limited to, general economic conditions and those factors set forth in today's press release, discussed in the company's periodic reports and other documents filed with the SEC from time to time. EXL assumes no obligations to update the information presented on this conference call. During our call today, we may reference certain non-GAAP financial measures which we believe provide useful information for investors and you can find reconciliations of those measures to US GAAP on our press release. Now, let me turn the call over to Rohit Kapoor, our CEO and President. Rohit?

Rohit Kapoor

Management

Thanks, Jarrod, and good morning, everyone. The last quarter has been one of the most challenging economic environments in recent history. In this difficult economic environment, there have been a number of concerns around the sustainability of growth rate for the BPO business. However, in our viewpoint, we believe that outsourcing will continue to be embraced by clients and the secular growth trend in our industry will continue with Tier 1 service providers. We believe that the penetration rate of offshoring amongst our clients is relatively low as compared to IT outsourcing. Further, BPO is not a discretionary expense and the benefits to our clients by offshoring are immediate and substantial. We would expect to see clients and prospects gravitate their choice of outsourcing partners to more, well-established and financially secure service providers. As such, we are seeing that our clients and prospects are becoming even more aggressive in cutting their costs, and therefore, we would expect them to increase their usage of EXL's transformation and outsourcing services. Our business model continues to demonstrate resilience and renewed growth momentum even in this difficult business environment. Fortunately, for us, EXL derives almost 45% of its revenues from clients in the insurance industry vertical and 23% from the utility industry. These are relatively safer industry verticals that are well regulated. We also have two primary lines of business outsourcing and transformation which provides the much needed diversification in our overall business. Consistent with the last several quarters, EXL experienced another quarter of exceptionally strong demand for our transformation services. EXL's transformation business has seen a continual acceleration since the end of 2007, and we believe this has become a huge competitive advantage for EXL in the marketplace. Nobody else in our competitor set can provide this level of client engagement with skills…

Matt Appel

Management

Thanks Rohit and good morning everyone. With the sale of the Aviva BOT during the third quarter, this operation is now accounted for as a discontinued operation. What this means is that our financial statements now separately report our continuing operations from our discontinued operation and that all financial measures will now be based on the continuing operations of the company. Please keep in mind that this method of reporting is applicable to all periods reported, including prior periods. Therefore, certain amounts have been recast for reporting and comparability purposes. A full bridge of our prior and current income statements has been posted online to aiding your understanding of the changes and there will be additional information, you may find useful in our 10-Q filing that is schedule for next Monday. As an example, in the third quarter of 2008, the Aviva BOT generated approximately $3.1 million in revenue. Therefore, our revenue for the third quarter will be $49.7 million on our prior basis of reporting. We hope this information will be helpful to you in updating your models to include just the continuing operations of the company. Revenues for the quarter ended September 30, 2008 were $46.6 million, up 17.9% from $39.5 million in the quarter ended September 30, 2007 and we are essentially unchanged as compare to $47 million in the second quarter of 2008. In the third quarter the U.K pound depreciated 9.2% as compared to the US dollar and has continued this trend subsequent to quarter end falling an additional 10%. The depreciation of the UK pound had a year-over-year impact of $1.7 million or 4.3% on revenue and a sequential impact of $1.1 million or 2.3%. This quarter our transformation services business posted revenues of $12 million, which represents 10.7% sequential growth and growth of…

Operator

Operator

(Operator Instructions). Our first question comes from the line of Dave Koning with R.W. Baird. You may proceed. David Koning - Robert W. Baird & Co.: Yeah, good morning guys. My first question just on the revenue in Q4 of $41 million, is that a good base to grow off of, I know you're experiencing a headwind in the UK sequentially and the UK telecom client. You do get let's say one month of revenue from that telecom client in Q4, but I'm just wondering if Q1 we should expect everything to start improving sequentially after that base.

Rohit Kapoor

Management

Hi Dave, this is Rohit. I think you're right in your assessment. I think the Q4 guidance of $41 million would be a good base to start building up again on, and we would expect to grow sequentially off that base. David Koning - Robert W. Baird & Co.: Okay, great. Secondly, as we think of Q4 margin and knowing that you're going to have FX losses of $3 million and those seem to be separate from the more, one time FX losses. It would seem like the whole point of a hedging program is to offset the benefits above the line of the rupee going in the right direction. It seems to me like you have a pretty big operating margin benefit above the line that would just be offset by those hedge losses below the line, so I guess a little surprised that the margin's down so much offset sequentially if the point of the hedging program is just to offset the fluctuation?

Rohit Kapoor

Management

Right. I think the big reason for that is the decline in the volume of business and because of the decline in the volume of business and the fact that we are maintaining our existing support and corporate overhead, as well as the fact that we will be making additional new investments in infrastructure in the fourth quarter to be able to support client growth activity in the first quarter and second quarter of 2009. Those investments are the one that depress our operating profit in the fourth quarter of 2009. David Koning - Robert W. Baird & Co.: Okay. Then is that fair to say that we should get some pretty nice operating income benefit or operating margin benefit to start again already by Q1 ’09.

Rohit Kapoor

Management

That is absolutely correct. As we start pickup on volume, we will start to see an improvement in the margins of our business and the operating guidance would be provided for the fourth quarter of 2008 is by no means of representative for what we will able to accomplish in 2009. David Koning - Robert W. Baird & Co.: All right great, thank you.

Operator

Operator

Our next question comes from the line of Joseph Foresi with Janney Montgomery Scott. You may proceed.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

Hello. My first question is, you talked about demand from the insurance verticals being very strong. What if you can just maybe tell us what is driving that right now in economy where I think a lot of clients are skittish to spend money?

Rohit Kapoor

Management

Hi, Joe. I think the big reason for the demand in the insurance industry vertical is that, the insurance industry has generally been slow adopter of offshoring services and in the past they have been a number of internal obstacles that the insurance industry faced which did not allow them to move forward much more aggressively in terms of adopting offshoring, whereas if you take a look at the banking industry verticals they adopted offshoring far more aggressively. I think given the current economic environment, the fact is that every single company in order to be able to sustain and survive needs to be competitive in terms of their cost structure. Particularly for them, as their volumes come down and as their returns on investments from the equity markets come down, they are looking to cut cost and to be able realize those gains immediately in 2009. As such, we are seeing faster decision making by our clients in the insurance industry vertical, and they are also making much larger transaction decisions than we would have expected them in the past. Therefore, today they are not looking at just doing a pilot with us, but instead they are thinking about launching their programs on a full-fledged basis right from the very first month. Therefore, I think this demand environment is very encouraging for us.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

Geographically where are the new insurance wins?

Rohit Kapoor

Management

The two new insurance wins that we've had are both in the US and these are US clients that we have signed up and they are both large insurance carriers in the US.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

I know you talked a little bit about acquisition, you guys have some cash. It sounded like you're waiting for the right opportunity. Maybe you could talk a little bit about what that opportunity looks like, and what the valuations are that you are looking at and maybe what in terms offering they are in?

Rohit Kapoor

Management

Sure. In terms of acquisition opportunities, we are looking at acquisitions in select industry verticals. For us the verticals in which we currently have a leadership position in are the verticals that are attractive. We're also looking at acquisitions that will allow us to diversify our service delivery location capability and an expansion into Eastern Europe, as we've always stated would make a lot of sense to us. What we are finding is that the acquisitions that we would have to do in this kind of an environment are largely going to be cash driven transactions. Regarding cash driven transactions; we would like to structure them in a manner that provide for an appropriate integration and the longevity of the management team of the acquired entity to stay with us. The valuation expectations of private companies have not come down very significantly, and I think that's where we typically have difficulty where we want to be able to acquire these strategic assets at the right level rather than to over pay for these assets.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

Just one last question. You guys have talked about the build-out. I'm curious, it's obviously changing your cost structure a little bit. Should we think of that being an absolutely necessary build-out? In other words, would you be at capacity if you didn't do the particular build-out. I'm just curious because from a cost standpoint to, I would think that you probably want to, utilize your present facility and your present people before you end out and put out some additional CapEx, just given what's going on in the economy?

Rohit Kapoor

Management

I think you're absolutely right. I think, clearly from our standpoint we've thought about this and we are only making necessary capital investments at this point of time where we are certain about getting new business. Based upon the fact that we've signed up four new strategic clients in outsourcing, and the business that we would anticipate from these clients which is on a committed basis, we are making the necessary investments in infrastructure to support that volume growth which would take place.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

I'm sorry, go ahead.

Rohit Kapoor

Management

Yes, in terms of timing of these investments, the 300-seat center in Noida, we've already taken up and we would expect to make the investment into the new SEZ facility in Pune sometime during the fourth quarter of this year.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

How soon will the 300-seat facility be filled?

Rohit Kapoor

Management

The 300-seat facility actually will be ready and operational very soon because this is a pre-fitted facility that we are taking on, and therefore we will be able to bring this operational very, very rapidly.

Joseph Foresi - Janney Montgomery Scott

Analyst · Janney Montgomery Scott. You may proceed.

Okay. Thank you.

Operator

Operator

Our next question comes from the line of Bryan Keane with Credit Suisse. You may proceed.

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

Yes. Hi, good morning. When do the three large deals that you signed in the quarter, when do they start ramping up and what's the margin profile you are expecting for those clients?

Rohit Kapoor

Management

Sure Bryan, the three deals that we signed up which are part of the original six, will start to ramp up in Q1 and Q2 of 2009; however, some of the initial work pertaining to the transition and migration is already beginning and will begin in the fourth quarter of 2008. We would expect to make the investments in terms of the infrastructure but also in terms of the transition and migration. We would start enabling that in the fourth quarter of 2008. In terms of pricing, margin, and commercial terms we have been very, very disciplined in terms of our pricing for getting new business. All of these clients that we have won, we have won them at full pricing and at full margins, and there is no upfront consideration that we are paying for acquiring this business. This is normal third party business that we have won against competition and in a number of cases it is actually at a price premium to competition.

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

Okay. Regarding the adjusted operating margin; I understand some of the reasons why it drops this quarter. Does it go back to more normalized range in any kind of a long-term target you want to stick with for adjusted operating margin going forward?

Rohit Kapoor

Management

Yes. I think we've always stated that our goal in terms of a long-term operating margin on an adjusted basis would be approximately 12% and…

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

There is no change there?

Rohit Kapoor

Management

No. We believe that the business that we are winning and when we get through this hiccup that we're going to experience in the fourth quarter, which we had already disclosed at the end of the second quarter, we would be back to normal operating margins.

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

Okay. Finally, I understand the loss of the UK client, but you also talked about some reduction in other clients and volumes. Can you just talk about what you're seeing in volumes from your clients?

Rohit Kapoor

Management

Sure. There are a couple of clients that we have for example in the mortgage space and there is a slowdown of activity and certainly the volumes have come down and they continue to come down there. We also have a large client in the UK where the business has become quite mature. Therefore, there is no further growth opportunity there. There are some isolated cases where clients have been impacted by the dislocation in the financial and credit markets. Those client situations would be impacting us negatively as well.

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

Finally, it sounds like from wining these deals, you've been able to keep pricing, it sounds like that the market still being rational on pricing and nobody is coming in trying to low the ball the waiting clients.

Rohit Kapoor

Management

I think that is the first part of your comment is accurate, which is that we've been able to maintain pricing at normal levels and to be able to get this new business on the right commercial terms. As far as competition is concerned, some players are trying to compete on irrational pricing terms, given the fact that they've not been able to win business, and I think clients are just making a conscious choice to go with service providers, which are well referenced, have capability and have got strong financial balance sheet and will be able to support them in terms of the sharp ramp ups that are likely to take place in 2009 and therefore they are not going to other companies, which may not be able to deliver these factors to them.

Bryan Keane - Credit Suisse

Analyst · Credit Suisse. You may proceed.

Okay. That's it for me. Congratulations on the three large deal wins.

Rohit Kapoor

Management

Thank you.

Operator

Operator

Our next question comes from the line of David Grossman with Thomas Weisel Partners. You may proceed.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Hi this is actually, Nicole Conway in for David. He had jumped on another call. I had just a couple of question. In terms of stock comp, do you guys, are you still expecting the same level of stock comp in the year [and of course if you], anything for 2009? Any guidance there?

Matt Appel

Management

Hi, Nicole this is Matt. Stock compensation expense for the year, we are now expecting to be around $6.1 million.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Sorry?

Matt Appel

Management

$6.1 million for the full year 2008, and we are not, really releasing any 2009 numbers at this time.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Okay.

Matt Appel

Management

It's down slightly for the reasons that I had indicated before.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Right, okay. Regarding your guidance for 4Q for revenue; could you kind of break that out into how much that thing affected by FX, how much is the loss of the telecom and how much is slowing growth, your changing guidance there?

Matt Appel

Management

As I discussed before the UK pound has continued it's free fall since the end of the third quarter. The average rate for the pound in the third quarter that we have embedded in our financials is $1.87 and for this Q, we're now at $1.60. We’ve seen over a 10% reduction on all, across the board on all UK business. The UK telecom client that we’ve discussed that work ceased on October the 31st. There is a small fee that we’ll collect for November and December related to the cancellation of the transaction, but those revenues are going to be approximately 40% of what they had been in the prior quarter. The company’s largest client, British Gas is UK based and at the level of activity that we continue with this large mature client there’ll be a, the FX has a pretty sizable impact on that and so the way to think about this is pretty equal division of FX, the UK telecom client and the impact on FX on this large UK based client. Those three reasons are about equal and we're not breaking it down any further than that, but depending on where the pound should go for November and December could affect us.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Got it. Okay. You said that your outsourcing base was growing about 50% excluding Aviva, First Cash and Mortgage; is that also excluding the telecom client?

Matt Appel

Management

No. It is not.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Okay. So it's like kind of a run rate going forward, what would you expect that base to grow at?

Rohit Kapoor

Management

I think we talk about our business in terms of 25% plus long-term growth rate.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Okay.

Rohit Kapoor

Management

What I was pointing out, Nicole, in that figure point is that really if you look at the parts of our business base that aren't so large, we are continuing to experience very significant growth which we will certainly maintain based on the deals that we were talking about this morning. So that underlying health of our revenue is intact.

Nicole Conway - Thomas Weisel Partners

Analyst · Thomas Weisel Partners. You may proceed.

Great. Okay. Thank you for taking my questions.

Operator

Operator

Our next question comes from the line of Jon Maietta with Needham and Company. You may proceed.

Jon Maietta - Needham and Company

Analyst · Needham and Company. You may proceed.

Thanks very much. Rohit, I was just wondering if you could comment on the pipeline and sort of the size of the pipeline today versus three or six months ago. It sounds like it's larger. How you think about the pipeline nationally, do you assume sort of lower growth rate today given the economic environment than maybe you would have three or six months ago?

Rohit Kapoor

Management

Yes. Hi, Jon. We've stated that the pipeline for us has actually become much stronger in the second quarter and the third quarter of this year; and really there was a bunching up of activity which took place in the third quarter. Fortunately for us all the decisions came out to be in our favor, and we are very pleased about that because we won that on appropriate pricing terms. I'd say that our pipeline continues to develop quite nicely and even after winning the three strategic client relationships, we have added on three more new strategic client relationships where we are in the final shortlist. The value and the term of these contracts are very meaningful and substantial. From our vantage point, where we see these prospects and our pipeline, we would say that actually clients are quickening their decision making. They are also making decisions on larger value contracts for longer terms. We are actually quite happy with the way the pipeline is progressed and the way clients are making their decisions at this point of time.

Jon Maietta - Needham and Company

Analyst · Needham and Company. You may proceed.

Got it. Okay. Matt, just one housekeeping item, did you disclose, I may have missed, the total number of new clients signed in the quarter?

Matt Appel

Management

We did not.

Jon Maietta - Needham and Company

Analyst · Needham and Company. You may proceed.

Okay. Could you have okay, I'm sorry.

Rohit Kapoor

Management

Yes. I think the total number of clients we have signed up are four in outsourcing, and there are an additional three clients or so in the transformation business.

Jon Maietta - Needham and Company

Analyst · Needham and Company. You may proceed.

Got it, okay. Thanks very much.

Operator

Operator

It appears there are no additional questions. I will now turn the call over to Rohit Kapoor for closing remarks.

Rohit Kapoor

Management

Thank you. Well, I just wanted to thank everybody for joining our call. I think I'd just like to say in closing that we had already anticipated that they would be a slowdown in our business in the second half of 2008, and most of that really gets felt in the fourth quarter of 2008. We do believe that this is really the base that we would build up on, and rebuild our company from here. I think we are very excited by the fact that we've won several large strategic clients that give us adequate visibility into 2009. You can see from the investments that we are making in our infrastructure that we are now going to be poised in terms of focusing in on execution and growing our business once again. Thank you very much for joining and we will see you later next time.

Operator

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.