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Virtusa Corporation (NASDAQ:VRTU)

F2Q09 (Qtr End 09/30/08) Earnings Call Transcript

October 29, 2008, 5:00 pm ET

Executives

Kori Doherty – IR, Integrated Corporate Relations

Kris Canekeratne – Chairman & CEO

Thomas Holler – EVP & COO

Ranjan Kalia – SVP, CFO, Treasurer & Secretary

Analysts

John Maietta – Needham & Company

David Cohen – JP Morgan

Tim Brown – Roth Capital

Bhavan Suri – William Blair & Company

Avishai Kantor – Cowen and Company

Operator

Good day, ladies and gentlemen. Welcome to the Virtusa Corporation's

Second Quarter 2009 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. I would like to remind everyone that this conference is being recorded.

And now, I would like to turn the conference over to Ms. Kori Doherty from Integrated Corporate Relations. Please go ahead, ma'am.

Kori Doherty

Thanks, Dan. Good evening, and welcome to Virtusa's second quarter 2009 earnings conference call, where we will be discussing our financial results for the quarter-ended September 30th, 2008.

On the call with me are Kris Canekeratne, Chairman and Chief Executive Officer, Tom Holler, Executive Vice President and Chief Operating Officer, and Ranjan Kalia, Chief Financial Officer of Virtusa.

Certain statements made in this call that are not based on historical information are forward-looking statements which are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. During this call, we may make expressed or implied forward-looking statements relating to, among other things, Virtusa's expectations and assumptions concerning management's forecast of financial performance, the performance of Virtusa's IT services, acquisition of new clients and growth of business, the ability of Virtusa's clients to realize benefits from the use of Virtusa's IT services, the planned Hyderabad Campus and management's plans, objectives and strategies.

These statements are neither promises nor guarantees, but are subject to a variety of risks and uncertainties, many of which are beyond Virtusa's control, which could cause actual results to differ materially from those contemplated in these forward-looking statements.

Existing and perspective investors are cautioned not to place undue reliance on these forward-looking statements which speak only as to the date hereof. Virtusa undertakes no obligation to update or revise the information disclosed during this call, whether as a result of new information, future events or circumstances or otherwise.

For additional disclosure regarding these and other risks faced by Virtusa, see the disclosure contained in Virtusa's public filings with the Securities and Exchange Commission.

With that, I'd like to turn the call over to Kris. Kris, please go ahead.

Kris Canekeratne

Thank you, Kori. Thank you for joining us on our second fiscal quarter conference call. We made good progress during our second quarter despite the turbulent economic environment. Specifically, we were very pleased with planned expansion activities and new client wins during the quarter.

Much of this is a direct result of our differentiated value proposition, which enables our clients to improve their internal efficiencies, accelerate the launch of new products and services to market and reduce their overall costs. All of which are high priorities and even more so in this economic climate.

Here are the highlights from the second quarter. Revenue for our second quarter came in at $44 million, an increase of 9% year-over-year and 3% sequentially. On a constant currency basis, revenue grew 13% year-over-year and 6% sequentially. Our operating income was $700,000, resulting in earnings per diluted share of $0.05.

Results exceeded the high end of our guided range for both the top line and the bottom line. It is particularly notable because our results include the negative impact caused by the British pound depreciating sharply against the U.S. dollar. We were profitable during the quarter, highlighting the continued progress we are making in our operation efficiencies and expense management. We repurchased $3.4 million worth of our shares through our share buyback program and ended the quarter with $91.9 million in cash.

Despite the tough economic environment, we continued to have success winning new clients and expanding our existing accounts, specifically, we started work with six new clients during our second quarter. New client additions and expanding existing relationships built a foundation for sustainable long-term growth and we are pleased to report that the new clients we added over the past year are contributing more meaningfully to our overall revenue.

In the second quarter, our non top ten clients grew 21% year-over-year, outpacing overall growth for the company, but in line with our expectations. We are pleased with how we have been able to continue to diversify and build a larger more stable client base from which to continue to grow our business.

Our financial services industry group continued to lead our growth, growing 22% year-over-year and 4% sequentially. While we are aware of the uncertainty in the financial markets, we continue to see ongoing commitments from our clients as a result of our differentiated value proposition, strength of our client management program and outstanding track record of service delivery.

As an example, we worked with one of our financial services clients to build a system that moved a manual paper-based claims processing environment to an automated web-based platform.

In conjunction with one of our BPM partner, we designed, developed and deployed a web-based platform that decreases the time it takes end users to enter information and greatly improves the accuracy of claims data entered. Specifically, this platform has increased claims processing productivity by four times, saving our client, both time and cost.

By combining our consulted platforming approach with our partnering strategy and content management, we have demonstrated significant time and cost savings for our clients and see content management as an area of opportunity for Virtusa.

Earlier this year, we commenced work with a large client in the media information space and after analyzing their content management environment we designed, developed and deployed a scalable content management platform in conjunction with the partner's technology. This platform now supports five times the number of concurrent connections, while reducing Web site support costs by over 60%.

In a relatively short period of time we have demonstrated our value proposition, our thought leadership and our ability to deliver conflict solutions through a best-in-class global delivery model. This combined with an outstanding track record of service excellence has enabled us to deepen and broaden our relationship with the client.

Turning to BT, our revenue for the second quarter was $8.8 million, representing 20% of our revenue for the quarter. On a constant currency basis, BT revenue grew sequentially $9.6 million ahead of our prior expectation.

During the quarter, we were successful in working with BT to ensure that our policies and procedures were in line with theirs enabling us to procure budget and execute on commitment. Our platforming approach remains strategically aligned with BT's direction. We continue to have an outstanding track record of service delivery and we remain a close strategic partner to British Telecom.

Within the second quarter, we executed well on our plan to bring utilization within our target range. Accordingly, we are pleased to report that we improved utilization by 10 percentage points quarter-over-quarter, up from 61% to 71%. This improvement had a positive impact on our gross margin, which increased 160 basis points quarter-over-quarter. It is our intent to continue to manage utilization towards the high end of our target range of 70% to 75% in the second half of this fiscal year.

As a company, we are continually looking to improve our own efficiencies and serve our clients better. To this end, I am pleased to announce some senior management appointments, which will further strengthen Virtusa. Effective immediately, Tom Holler, our current CFO has been named Executive Vice President and Chief Operating Officer of Virtusa.

As EVP and COO, Tom will be responsible for managing the operational aspects of our business. Tom will work closely with our new CFO and will continue to meet with investors during conferences and other IR related events.

Ranjan Kalia, our current Senior Vice President of Finance has been promoted to CFO and will also be our Secretary and Treasurer. Ranjan has extensive global finance experience. Before joining Virtusa, Ranjan was VP Finance at EMC Corporation an information infrastructure technologies company, and held various finance and operational roles including CFO for EMC's Asia-Pacific region.

I'm pleased to announce that Keith Modder has been named President of Asia and Executive Vice President of Global Services. In this expanded role, Keith will oversee global delivery, quality, and service excellence. Keith has played a pivotal role in building our world-class service capability, recognized by clients as the next generation service model with one of the most optimal onsite offshore ratios in our industry. Keith will focus on driving best practices across all parts of our global service operation and continue to improve our internal efficiencies.

And finally, I'm also pleased to announce that Raj Rajgopal has been named Executive Vice President of Business Development and Clients. Previously, Raj was the General Manager of Virtusa's Communications, Content and Technology Business Unit, our largest business unit. Raj has over 20 years of services industrial experience with large enterprises both in the U.S. and in Europe. In his expanded role, Raj's responsibilities will include expanding client relationships, acquiring new clients and bringing new solutions to market.

With these changes, I'm confident that we have the experience and the depth in our executive management team to effectively lead and profitably grow our business. Although we just completed a strong quarter, during which we added six new clients and expanded many of our existing relationships, it's very important that we take into consideration the increased level of uncertainty in the marketplace and the impact of the weakening British pound on our business.

For this reason, we are taking a more conservative approach to our guidance, which Tom and Ranjan will cover in more detail. However, we continue to see strong secular growth trends in global IT outsourcing, and we remain confident that we are well-positioned because we make a tangible difference for our clients through our abilities to:

One, improve our planned IT performance through rationalization, consolidation and modernization of the spread IT assets. This strength of ours resonates particularly well with clients that recently made acquisitions or clients who seek efficiencies through centralization of common business processes and automation of these core processes through software platforms.

Two, accelerate time to market for our clients. At one of our larger clients, as an example, we applied our platforming approach and reduced concept to market from 3 months to 9 months down to 3 weeks to 12 weeks. This greatly improved the rate at which they were able to introduce new products and services to market and fostered stronger business IT collaboration.

Three, reduce total cost of ownership for our clients. We believe our services through the most optimal global services model in our industry. Consistently, less than 20% of our services are performed onsite, which provides our clients with the most cost-effective global model in our space.

We find that our value proposition resonates particularly well in these difficult times and this is the reason we have been able to edge out competition, win new clients and expand many of our existing client relationship.

We are pleased with the progress we have made in diversifying and building a larger, more stable client base that provides us with a strong foundation from which to grow in fiscal year '10 and beyond.

Now, let me turn the call over to Tom and Ranjan who will provide more details on our business, financial performance and provide our updated guidance. Tom?

Thomas Holler

Thanks, Kris, and good evening to everyone. I would like to take this opportunity to mention how much I've enjoyed my role as CFO. As I take on my new responsibilities as COO, I will continue to partner with Ranjan in driving value for our clients and our shareholders. Ranjan is an excellent addition to Virtusa's executive team, and we are confident that his diverse background and leadership skills will complement our current team.

Now, I will summarize the results of our second quarter of fiscal 2009, following which, Ranjan will provide our current guidance.

Turning to our results for the quarter, revenue for the second quarter came in at $44 million. This represents year-over-year growth of 9% and a sequential increase of 3%. Our revenue was impacted in the quarter by the depreciation of the British pound against the U.S. dollar. On a constant currency basis, our revenue grew 13% year-over-year and 6% sequentially. Second quarter revenue was $1 million above the high end of our guidance as a result of strong performance from our BFSI and media and information industry groups as well as better than expected performance at British Telecom.

Our operating income for the quarter was approximately $700,000. This compares to an operating income of $4.7 million in the same period last year and breakeven in the prior quarter. Second quarter operating margin decreased 10 percentage points year-over-year.

Operating margin was impacted year-over-year by 500 basis points due to lower utilization, by approximately 300 basis points due to higher SG&A expenses, primarily related to public company expenses and additional infrastructure in Asia, and by approximately 200 basis points related to foreign exchange and other operating costs.

Operating margin improved 160 basis points sequentially. This quarter-over-quarter increase was primarily driven by increased utilization, coupled with the reduction in subcontractors. These improvements were partially offset by the net impact of foreign currencies, which negatively impacted operating margin by approximately 100 basis points sequentially.

Other income decreased by $1 million year-over-year, primarily driven by an $800,000 increase in foreign currency transaction losses. We had an income tax benefit of approximately $800,000 in our second quarter. This tax benefit includes a year-to-date adjustment to reflect our current forecasted annual effective tax benefit rate of 67%. This annual tax benefit rate reflects an increase from our prior guidance as a result of our revised forecasted geographical mix of profit.

Net income for our September quarter was $1.3 million, compared to $4.6 million in the prior fiscal year period. Diluted earnings per share were $0.05 in our second quarter of fiscal 2009, $0.04 above the high end of our guidance, primarily driven by higher revenue, improving utilization and a higher than expected tax benefit, partially offset by the $900,000 foreign transaction loss in our other income.

Turning to the balance sheet, ending cash was $91.9 million inclusive of cash equivalents, short-term and long-term investments. Our DSO including unbilled receivables was 76 days; this was a one day improvement from our June quarter.

Cash flows provided by operating activities were $5.4 million in the second quarter. Capital expenditures were $4 million in the quarter inclusive of $1.9 million for the construction of our Hyderabad campus. We currently expect our campus spending for the fiscal year to be approximately $9 million.

We commenced our share repurchase program in the quarter and repurchased 457,000 shares for approximately $3.4 million at an average price of $7.44. Depreciation and amortization expense in the quarter was $1.1 million.

Now, let me turn to some additional quarterly metrics beginning with those related to our fiscal second quarter revenue. Revenue by geography was as follows. North America was 72% of revenue, growing 16% year-over-year. Europe was 26% of our revenue, declining 9% year-over-year. Excluding British Telecom, our largest client, Europe grew 40% year-over-year. Other geographies contributed 2% of revenue.

Revenue growth across our industry groups was as follows. Banking, Financial Services and Insurance was once again our fastest growing industry group, growing 22% year-over-year, representing 42% of total revenue in the second quarter. Communications and Technology represented 33% of revenue and declined 8% year-over-year. Excluding British Telecom, Communications and Technology grew 12% year-over-year.

Media, information and other contributed the remaining 25% of revenue, growing 17% year-over-year. Revenue across our services offerings was as follows. Application outsourcing represents 70% of our revenue and grew 6% year-over-year. IT consulting and implementation services was 30% of revenue and grew 19% year-over-year. Time and material contracts were 74% of revenue, fixed price contracts represented 26% of revenue.

We are extremely pleased with our ability to win new business, having started work for six new clients during the quarter. We ended the quarter with 57 active clients, up from 43 active clients in the second quarter of last year. We are pleased with the quality and the revenue potential the new clients added over the last year. Our new clients further validate our value proposition is resonating well even during difficult economic times.

Our top client, British Telecom, contributed 20% of revenue in the quarter. Our top ten clients for the quarter represented 74% of revenue. 89% of our revenue came from clients we have partnered with for more than one year.

Turning to other operating metrics, we ended the quarter with 4,297 global team members, of which 4,006 were IT professionals. The total number of global team members decreased by 277 or 6% compared to prior quarter. Global utilization, excluding trainees was 71% in our second quarter, a significant improvement from 61% last quarter and within our target range of 70% to 75%.

Utilization increased due to a combination of resource deployment on revenue generating engagements as well as lower headcount through voluntary and involuntary attrition. Total employee attrition, calculated on a trailing 12-month basis excluding one-time managed attrition of 7%, was 22%.

While we remain focused on retaining our top IT talent, we will continue to balance hiring and attrition to help manage utilization within our target range. Consistent with past performance, we deliver our services using an industry leading highly efficient global delivery model. Our build effort mix was 83% offshore and 17% onsite.

Now, I would like to turn the call over to Ranjan Kalia to discuss our current guidance. Ranjan?

Ranjan Kalia

Thanks, Tom. It's a pleasure to be speaking with all of you for the first time. I'm excited about this new opportunity and look forward to working with Kris, Tom and the rest of the executive team, as well as getting to know our current and prospective investors.

Now, I will provide our current guidance for the December quarter and for full fiscal year 2009. As a reminder, all of our numbers are on a U.S. GAAP basis. Revenue in the third quarter of fiscal 2009 is expected to be $43 million to $44 million. Diluted earnings per share in the third quarter of fiscal 2009 is expected to be $0.08 to $0.12. Earnings per share assumes an average share count of approximately 23.8 million.

For the full fiscal year ending March 31st 2009, our revenue range is currently expected to be $170.6 million to $173.6 million. Fully diluted earnings per share for the full fiscal year 2009 is currently expected to be in the range o $0.19 to $0.29. Full year EPS assumes an average share count of approximately 23.8 million.

Our guidance is based on the following set of assumptions. In other income, we model interest income using an annual effective interest rate of 2.5% on an average projected cash balance including long and short-term investments. We have not considered any potential impact to other income associated with foreign exchange gains or losses on our intercompany balances.

Foreign currency hedges are in place for the remainder of the fiscal year, covering approximately 85% of our forecasted Indian born expenses at an average Indian rupee to US dollar conversion rate of 39.6.

We currently expect to have a tax benefit rate for the full fiscal year of 67%. Our effective tax rate is sensitive to the geographical mix of profit for the fiscal year across all of our operating entities as well as the fluctuation of foreign currencies against the U.S. dollar. If our geographical mix of profit for the full year changes from our current forecast, our effective tax rate is subject to change. In addition, fiscal 2009 guidance does not consider any future potential impact of the share repurchase program.

Before concluding, I'd like to share some additional insight into our current fiscal 2009 guidance. We continue to have a cautious outlook on the current economic environment, which is expected to have an impact on overall IT spending growth. Therefore, we continue to take a conservative approach to our guidance for the remainder of the fiscal year.

Our current fiscal year guidance takes into account the depreciation of British pound relative to the U.S. dollar, which is expected to impact our second half revenue by approximately $5 million compared to our prior guidance. Of this $5 million change from prior guidance, $1.5 million is reflected in the third quarter and $3.5 million is reflected in the fourth quarter.

Additionally, our current revenue guidance considers an uncertain demand environment as a result of weakening global economy and potential delays in our clients' calendar year budgeting cycles. We remain focused on resource optimization initiatives and believe we can continue to improve our utilization in the second half of the year towards the high end of our targeted range of 70% to 75%

We expect that even in the revenue environment that is flat to slightly down sequentially, we can realize slight gross margin improvements during the second half of the fiscal year. We continue to take measures to tightly manage our general and administrative expenses, however, as a reminder, we have made commitments to investing in our Hyderabad campus and expect it to open in our third quarter. These investments will provide us long-term tax advantages and operating leverage over time.

In summary, we believe the progress we have made with strategic client acquisitions, the opportunities for expansion within our existing clients and improvements in our global utilization will enable us to achieve more meaningful revenue growth and margin expansion in the future.

I will now turn the call over to the operator, to begin the Q&A session. Thanks for listening.

Question-and-Answer Session

Operator

(Operator instructions). And we'll take our first question that will come from John Maietta with Needham & Company. Your line is open. Go ahead sir.

John Maietta – Needham & Company

Hey, thanks very much, and congratulations to everyone on the promotions. The first question I had, Kris, or Tom or Ranjan, whoever it's appropriate for, I was wondering if you could comment on sort of the pricing environment there, and what you're seeing across different industry sectors.

Thomas Holler

Sure, John, it's Tom. As far as pricing goes, we continue to see a stable pricing environment as we've seen in the recent past. Newer clients that we've won over the last 12 months or so, we do see higher rates relative to the realized rates of the company. Those new clients are not yet contributing meaningfully enough to revenue to make a difference at the corporate level. So at a corporate level our overall realized bill rates are relatively flat sequentially in a year-over-year basis.

John Maietta – Needham & Company

Okay. And again you continue to add a good number of customers in the quarter. Can we continue at this pace in an uncertain environment?

Kris Canekeratne

John, so we certainly had a very strong group of clients that we've added. I believe we've added – we added six in the most recent quarter, six the quarter in Q1 and ten the quarter before that. Our stated goals have been to add between three and five – between three clients to five clients in a quarter. And we feel that given the pipeline visibility that we have, that we can manage to add about that number at least in the out quarters.

John Maietta – Needham & Company

Okay. And then just my final question, with regard to clients ramping, do you notice any patterns across your three primary industry verticals with regard to either folks pushing out projects or accelerating in certain projects, anything of note there?

Kris Canekeratne

We've certainly seen strong growth in our financial services sector and that has certainly led the growth across all industry segments. We have actually seen growth across all industry that includes financial services, media information and technology and telecommunications has been at our British Telecom. In media and technology and communications, we have slight quarter-over-quarter growth assuming they netted out BT. So overall, we've seen strong expansion within our existing client base. We've also seen good traction in terms of adding new clients. A large part of this is a direct result of our value proposition. We create a tangible difference for our clients where we can improve the internal efficiencies, we can accelerate their time to market and reduce their overall costs, all very important, specifically in this economic environment.

John Maietta – Needham & Company

Okay. And then just one quick final question with regard to attrition. Does this type of environment make it easier to manage attrition?

Kris Canekeratne

Clearly, the economic environment is very tough and we have both unforced and forced attrition. Our stated objectives have been to run attrition at between 16% and 18%, but as we take a look at managing our utilization we believe that our attrition is going to be slightly higher than that. Net-net, the hiring market which a year ago was somewhat overheated is certainly not overheated right now. I think we can certainly find the resources that we're looking for. And at the same time, our focus and our goal to make sure that we retain and preserve the key employees – the employees and team members that are doing a great job for us, and as we do that we will systematically continue to raise the performance by in the company as we manage our utilization up.

John Maietta – Needham & Company

Thank you.

Operator

And we'll move to our next question that will come from David Cohen with JP Morgan.

David Cohen – JP Morgan

Hi, thank you. You talked a little bit it sound like pricing is stable and even up on the new clients, if I understood that right and you signed a number of new customers, but yet you've maintained sort of a cautious outlook. Can you talk a little bit about how the economy, the softness is manifesting itself for Virtusa specifically?

Kris Canekeratne

Sure. So clearly, we've seen fairly strong number of new clientele and we have also seen expansion within our existing accounts. However, a large part of our second half growth has been impacted by the weakening of the British pound against the U.S. dollar. I think as Ranjan stated earlier, about $5 million of our second half has been a direct result of the pound weakening against the dollar. Beyond that, I believe it's very prudent for us, given the current economic environment for us to take a conservative approach, especially given the fact that many of our clients go into their first quarter, which happens to be our first quarter. And very often, especially in times like this, it's possible that some of their budget cycles lengthen and petition process takes longer. So we have obviously looked at that very carefully. We have included that in our revised guidance. And while we have clearly a much larger, very strong stable client base, larger client base than we had a year ago, we have 57 clients today, we had 43 a year ago. So we believe that we have a strong client base to continue to grow our business for the second half of this year, especially given that the first calendar quarter is when most of our large enterprise clients go into budgeting cycles. We looked at all of this as we came up with our guidance, our revised guidance for FY '09.

David Cohen – JP Morgan

Okay. Any contracts expected to wind down or run-off in the second half of the fiscal year?

Thomas Holler

Yes, Dave, this is Tom. As part of our normal operations there's always some projects coming to completion. Work orders run their course. You see that mostly in sort of the IT consult implementations area. So we certainly will see that, but that's ordinary course. There's nothing material that comes to mind that is coming to an end. As always, we have clients that go inactive, that's also a natural part of our business model. We've had several clients in the quarter, as we typically do, go inactive. It's not a concern to us. Those clients that have gone inactive in the quarter we view as non-strategic clients. They're relatively small and the reasons they go inactive, in this case, three of them had been acquired some time ago and the work was brought in-house and the other ones, essentially were not lost to competitors and was not performance reasons, but they also either stopped spending money offshore or brought the work in-house.

David Cohen – JP Morgan

Okay. Any thoughts on what to do with the cash repurchases going forward from here?

Thomas Holler

We continue to plan to repurchase shares in the market as aggressively as we can, subject to the Federal Securities laws which limit volumes that you can buy on any particular trading day. We can only buy shares in the open market during our open windows. We can't buy in blackout periods.

David Cohen – JP Morgan

Right. And Tom, what would you say your top three priorities are in the new role?

Thomas Holler

My top priorities are to really drive operational efficiencies, look to streamline business processes, and in doing that, have a heavy focus on leveraging automation. Essentially, all my efforts should further strengthen all aspects of our business.

David Cohen – JP Morgan

Great. Thanks, guys.

Operator

And we'll move to our next question that will come from Tim Brown with Roth Capital.

Tim Brown – Roth Capital

Hi, good afternoon, guys.

Thomas Holler

Hi, Tim.

Tim Brown – Roth Capital

And congratulations.

Thomas Holler

Thank you.

Tim Brown – Roth Capital

Couple of questions, I guess one just in terms – maybe you could just go over it, sort of what you see as the health of your current client base both from a financial perspective in terms of potential bankruptcies or anything like that. And then in terms of whether or not you see potential of more attrition I guess going forward from some of those clients.

Kris Canekeratne

Tim, so we have for the most part been very fortunate. Most of our larger financial services clients have been less impacted on a relative basis than some of the others, and clearly, that has been good for us as well. In some cases, actually to – because of consolidation, we've done relatively well. As an example, JPMC and Bear merged and through that merger we were preferred partner for JMPC and Bear and through the merger we've had an opportunity to continue to do well in the combined entity. Now, we've also continued to win a fairly good number of financial services clients over the year and we believe that a large part of that is directly attributable to our value proportion, which provides tangible business benefits for our clients. And specifically, as a result of our platforming approach, we believe that this – it positions us very well moving forward.

Now, in terms of clients and in terms of projects I think that it's fair to say that it's past it's prolong [ph] just looking at the current economic environment. it's possible that some projects that would normally be avoided in Q1 might take longer given the economic weakness. So we've obviously taken that into consideration in our revised guidance as well. But based on our value proposition, based on the execution track record that we have, and the relationships that we've nurtured and built with our clients, we believe that we will continue to grow our business on specifically as we start fiscal year '10.

Tim Brown – Roth Capital

Okay, and then, and then BT, at this point I guess if you look at your fiscal year 2009 guidance, are you still assuming they're going to be basically at their contractual minimum? Or is that now a little bit higher?

Thomas Holler

Yes, this is Tom. We're modeling British Telecom in the range that we provided to be at, maybe slightly above the minimum commitment. Clearly, the depreciation of the British pound lowers the revenue contribution from British Telecom because the contract is denominated in British pounds.

Tim Brown – Roth Capital

Right.

Thomas Holler

We believe for the fiscal year BT revenue will come in right around the 20% level of total revenue.

Tim Brown – Roth Capital

Okay. And then – just again on the '09 guidance, it sounds like the majority of the downward revision is really related to currency on the revenue side. Is that true on the EPS side as well?

Thomas Holler

Yes, on the EPS side, the depreciation of the pound does impact gross margins slightly. We have a relatively fixed SG&A cost structure. We are committed to investing in our Asia infrastructures, as we have stated in the past, and we believe that our level of other investments in sales and marketing programs is at a sufficient level and we're holding it at that level going forward. So having lower revenue, primarily as a result of the depreciating pound, with the relatively flat SG&A is what's driving – holding the EPS down.

Tim Brown – Roth Capital

Okay. So fair so say that a majority of that is currency related as well on the EPS side?

Thomas Holler

Yes, as it – yes, because particularly because of the $5 million change in guidance due to the depreciating pound.

Tim Brown – Roth Capital

Yes, yes, okay. And then just looking at the gross margins, we saw a good uptick from Q2, was any of that currency related?

Thomas Holler

No, it really wasn't. As you might recall, we have a hedging program in place. So we're hedged at an Indian rupee to US dollar rate of 39.6 on 85% of our Indian born spending. So we really don't see much of a benefit from the weakening of the Indian rupee near term. Now, having said that, because our program is an eight quarter rolling and layering program, we are about 70% hedged in next fiscal year, FY 2010 of our estimated Indian spend. And just to help you out there, that rate that we're locked in at is about 43.4 for that 70%. So that will benefit us going forward as we move into next fiscal year our hedging program.

Tim Brown – Roth Capital

And then, I guess in the year following that, you should even see more of a benefit, because I think we're out of that about 50 at this point.

Thomas Holler

Yes, I mean the benefit clearly increases at this time the further out we look because given our rolling and layering strategy. So we are actually into the fist six months of fiscal 2011 at this point. We're probably at about 30% for that period.

Tim Brown – Roth Capital

Okay. Thanks, guys.

Kris Canekeratne

Thank you, Tim.

Operator

And we'll move to our next question that will come from Bhavan Suri with William Blair & Company.

Bhavan Suri – William Blair & Company

Thanks, guys. Congratulations, Tom, on that exciting transition, and congrats on the good quarter.

Thomas Holler

Thank you.

Bhavan Suri – William Blair & Company

I had a couple of quick questions, just continuing on the previous question just a little bit of guidance. It implies relatively flattish revenue for the next couple of quarters, obviously taking BT into account. But I guess I'm a little surprised given the number of customers that Virtusa's added over, say, the past four quarters or five quarters, the ramp hasn't led to a greater sequential increase in revenue in – or accounted for more of that. Can you talk a little bit about the ramp? Is that slower, or am I just expecting it to accelerate faster than it should?

Thomas Holler

Yes, so we're actually quite pleased with the ramp of new clients. It takes time from the time we win a new client to the time that the revenue from a new client starts contributing meaningfully. Typically, it's not about the first year, it's about year plus one, two, three as new clients get to different stages in their growth phase with us. Having said that, we are pleased with the performance of the new clients that we've added. Just by way of example, the new clients that we've added in 2008, we added 24 clients and we've added quite a few clients so far this fiscal year. And we're seeing – I think there is ten or so clients that have actually expanded quite nicely on an annualized run rate coming off the second quarter results. There is ten clients that are running at an annualized rate of between $1 million and $3 million, which is actually very nice performance.

Bhavan Suri – William Blair & Company

Yes, that is – that's pretty good.

Kris Canekeratne

Actually a large part of the flattish second half is also attributable to the weakening of the British pound.

Bhavan Suri – William Blair & Company

Right. Obviously, interesting. Out of the revenue, the bulk of revenue, could you provide some color on what portion is from sort of ongoing support and maintenance work versus projects? Meaning what's little more discretionary and needs to be budgeted and renewed because you're going to create something new, versus something that's ongoing maintenance of platform.

Thomas Holler

Yes, the way we report revenue is application outsourcing and IT consulting implementation services. The application outsourcing we do is the recurring book of business.

Bhavan Suri – William Blair & Company

Okay.

Thomas Holler

You know, that has – it's really ADM. It's the sticky revenue. That's about 70% of our revenue. The other 30% is more project-based with different durations. And so, I guess if you think of discretionary spending as embedded within the 30%, but even that 30% has some element of stickiness to it based on the nature of the types of systems, implementations that we're doing.

Bhavan Suri – William Blair & Company

Right, right, right. Yes, that's helpful. And then, just a slightly different track, how is the channel doing? Can you provide a little color paga [ph] and how the channel is driving sort of new customers, especially in this time?

Kris Canekeratne

I think, Bhavan, the combination of our channel partners combined with strengthened platforming and (inaudible) model is a very strong combination. And clearly has been and together the contribution to our pipeline and contribution to new client wins have been very strong.

Bhavan Suri – William Blair & Company

Great. And so, if you look at the pipeline today, given what's happened over the last month or so, and you look at it three months back, how do you compare the two?

Kris Canekeratne

In this environment it's difficult to tell. On an aggregate basis, our pipeline continues to grow. I think when we apply the filters that we apply as we take a look at the economic weakness it's hard to tell how quickly some of these things might come to fruition.

Bhavan Suri – William Blair & Company

Right, right.

Kris Canekeratne

We've certainly seen some projects getting delayed, but at the same time, we've won a large number of new clients even in the most recent quarter.

Bhavan Suri – William Blair & Company

Yes. One thing that was kind of surprising in the results, BFSI was the strongest in terms of growth and that's kind of counterintuitive almost to what's happening. And you've talked about sort of customers realizing the cost advantages and things like that. But could you maybe go through a little bit more of what's going on there?

Kris Canekeratne

Yes. So I think a large part of this has to deal with the strength that we already have within our clients and like I mentioned earlier, we've been pretty fortunate that most of our clients have been relatively less impacted than others, right? And even where there has been consolidation we've actually been on the right side of that. So that's been beneficial. Then beyond that, we've certainly had a strong crop of new clients that we closed over the last 12 months or towards the latter part of fiscal '08 and the earlier part of fiscal '09 in the financial services space and those clients are starting to contribute more meaningfully now.

Bhavan Suri – William Blair & Company

Great. Great.

Kris Canekeratne

So all of that's been pretty – certainly been in the right direction for us.

Bhavan Suri – William Blair & Company

Yes, that's great. Good, well, thanks for taking my questions.

Kris Canekeratne

Thank you, Bhavan.

Operator

And we'll move to our next question that will come from Moshe Katri with Cowen and Company.

Avishai Kantor – Cowen and Company

Yes, hi, it's Avishai for Moshe. First question I guess, in which verticals are there six new clients?

Thomas Holler

Yes, the six new clients closed in our second quarter, five were in our communications and technology industry and one in our financial services industry group.

Avishai Kantor – Cowen and Company

Thank you. And I guess the next question – do you have any additional comments that you can make maybe on BT specifically with regard to pipeline and possibility of delays, further delays et cetera?

Kris Canekeratne

As you know we've aligned our processes and that alignment went very well to the extent that BT's revenue growth it produced was slightly ahead of our expectation. I think that as we take a look at our relationship at BT we have a very strong relationship there. Our platforming approach and their strategic direction is extremely synergistic. They also happen to be an investor at producer, and we've had an outstanding track record of service excellence at BT. So all of that augurs extremely well for our continuing aspiration to grow at BT. We remain a strategic partner to BT and as a result of that, we receive several new opportunities as the – as we go through the typical sales acquisition process with them. And we remain confident in BT's ability to continue to provide us with revenue at the contracted level, both towards the end of this year as well as into the future. So we have a very strong relationship at BT, our work has been extremely well received, strategically aligned and we believe that BT will continue to be our largest client, at least for the foreseeable future.

Avishai Kantor – Cowen and Company

And I guess, does the guidance include any project delays or cancellations in the second half of '09? What – if you can tell, but what assumptions for headcount utilization (inaudible) I guess you talked about pricing you have for the second half.

Thomas Holler

Yes. Our second half guidance – we are assuming that there will be some delays in decision making. There is historically a seasonal effect as a result of calendar year budget cycles which can resolve in slowing sequential growth in our March quarter. And while we have a healthy pipeline of opportunities, both at existing and new clients, we are being very conservative in our guidance about realizing those opportunities. And so, in our guidance we are anticipating some decision delays given that combining the historical seasonal effect of budget cycles in the beginning – first quarter of the calendar with an uncertain economy, we've taken a cautious approach on how we've looked at our guidance, particularly in our March quarter. Regarding pricing, as I said, it's been stable and so we're reflecting our current rates in our modeling for the second half.

Kris Canekeratne

Thomas I can add to that. We're not seeing any material project cancellation. A large part of this is a direct result of as you well know, the first quarter for most of our clients and it's prudent for us to expect their budget cycles might lend them because of the economic environment.

Avishai Kantor – Cowen and Company

Okay.

Thomas Holler

And I think you asked a headcount question as well. And we are focused on improving utilization, even above the 71% that we achieved in the second quarter through the second half of our fiscal year and in doing that, based on our current revenue guidance, we anticipate a slightly lower headcount sequentially.

Avishai Kantor – Cowen and Company

Great. Thank you. And then I will ask last question, just couple numbers (inaudible). You said that Europe was down 9% year-over-year and how much was it down excluding BT?

Thomas Holler

No, Europe – Europe without BT grew 40% year-over-year and 12% sequentially.

Avishai Kantor – Cowen and Company

12% sequentially. And communications and technology accounted for how much of revenues?

Thomas Holler

Communications and technology was 33% of revenue in the quarter.

Avishai Kantor – Cowen and Company

Great. Thank you very much.

Operator

And at this time, we have no additional questions in the queue. I would like to turn the conference back over to our speakers for any additional or closing remarks.

Kris Canekeratne

Thank you, Dan. Thank you all for joining us. While we are pleased with our better than expected performance in the second quarter, the uncertainty in the current economic environment, combined with the sharp decline of the British pound, caused us to remain justifiably conservative in our outlook.

However, I'm confident in Virtusa's ability to continue to execute effectively in these difficult times, demonstrate our unique value proposition and build a business with long-term sustainable profitability and cash flow. Our recent management appointments further enhance the strength of our executive team and we remain confident that the broader, more diversified client base we have built provides us with a terrific foundation from which to grow in FY '10 and beyond. Thanks again for joining us, and I look forward to speaking with you again soon. Thank you.

Operator

Once again, ladies and gentlemen, that does conclude today's conference. We'd like to thank you for your participation, and have a wonderful day.

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Source: Virtusa Corporation F2Q09 (Qtr End 09/30/08) Earnings Call Transcript

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