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Executives

Betsy Brod - MBS Value Partners

Vince Paccapaniccia - EVP and CFO

John Brennan - Chairman and CEO

Analysts

David Koning - Robert W. Baird

Josh Vogel - Sidoti & Company

Bill Sutherland - Boenning & Scattergood

Troy Mastin - William Blair & Company

Bob Evans - Craig-Hallum Capital

Shlomo Rosenbaum - Stifel Nicolaus

Howard Smith - First Analysis Securities

ICT Group Inc. (OTCPK:ICTG) Q3 2008 Earnings Call Transcript November 6, 2008 9:00 AM ET

Operator

Greetings, and welcome to the ICT Group Incorporated Third Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Betsy Brod of MPS Value Partners. Thank you, Ms. Brod. You may begin.

Betsy Brod

Thank you, operator, and good morning, everyone. Thank you for joining us for today's third quarter conference call with the management of ICT Group. Since we will be discussing certain forward-looking statements during today's conference call that are subject to risks and uncertainties, including those related to ICT Group's future revenues and earnings projections, the company claims protection of the Safe Harbor forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Now I would like to turn the call over to John Brennan, Chairman, Chief Executive Officer and President of ICT Group. John, you may begin.

John Brennan

Thank you, Betsy, and welcome, everybody. With me this morning is Vince Paccapaniccia, our Executive Vice President of Finance and our Chief Financial Officer.

I want to thank you for joining us on this call this morning, and I will review with you the highlights of ICT Group's third quarter performance including key operational and business development accomplishments.

Vince will, then, review with you the details of our third quarter financials and provide guidance for the fourth quarter of 2008. I will then follow up with a brief outlook for 2009, which will be followed by a Q&A session.

I'd like to begin by reviewing our third quarter performance. We are pleased with our third quarter performance, which was in line with company expectations that we reviewed with you in late July. We've been successful in restarting our growth momentum, which was interrupted in mid 2007 through a combination of softness in the financial services sector, our shift to rapidly grow our offshore production capability and the downturn in the US economy.

Production volumes increased 3% sequentially in the third quarter as the growth of our customer care and BPO business has begun to more than compensate for the decline in our sales and marketing services business over the past four quarters. On a year-over-year basis, production volumes in the third quarter for our customer care and BPO programs increased 15% compared to a 30% decline in our sales and marketing services programs.

However, it's worth noting that at this time our customer care and BPO business volumes are three times those of our sales and marketing services business volumes.

Revenue of $108.3 million was slightly below our projected range of $110 million to $113 million. Reduced call volumes on certain program and, more importantly, the impact of foreign exchange rates resulted in lower revenue measured in US dollars in the international markets we serve.

Our diluted earnings per share, excluding restructuring charges, were $0.09. This was above our third quarter guidance range of $0.03 to $0.07. This occurred primarily as a result of improved operating performance, a stronger US dollar, which enabled us to better leverage our offshore capacity and a tax benefit from losses in certain international markets we serve. Our financial results also included the benefit of a government grant, which we previously discussed in July.

Overall, we believe we executed well in the quarter and were successful in accomplishing a number of key objectives we set for the company, which include, number one, maintaining strong sales momentum through new business wins, diversifying and broadening our vertical market mix, preserving strong client relationship, continuing to right-size and right-shore our operations, improving our operating margins and workstation utilization and maintaining tight expense controls and generating positive free cash flow.

We closed approximately $25 million of new business during the quarter, measured on an annualized basis from new and existing clients despite the challenging environment. Our ability to backfill our pipeline, especially as we've experienced changes in certain segments of the financial services vertical, has helped us to better balance our business among the vertical markets we serve, as well as shift our business mix into more stable services work in the customer care and BPO areas, as I previously alluded to.

We are especially pleased with our success over the past 12 months in securing significant new business both domestically and internationally within the telco/technology vertical. During this time period, we added seven new clients, both domestically and internationally.

In the banking and financial services sector, we have retained all of our major services programs despite the mergers and disruptions within in this sector, and we continue to enjoy good working relationships with major surviving entities such as JPMorgan Chase, Wells Fargo, Citibank and Bank of America, among others.

In addition, we just renewed our largest BPO contract with one of our financial clients.

We continue to improve our operating margins in the quarter as we increased our labor productivity, contained costs and reduced capital expenditures. As you are aware, we closed or downsized several North American call center operations and cut back staff during the quarter to be better positioned to compete in the current environment.

65% of our US production was handled offshore in the third quarter of 2008, up from 54% in last year's third quarter. We've begun building out two provincial centers in the Philippines and expect an increasing share of our Philippine production will be handled at these lower-cost sites in 2009.

With fewer workstations and higher production volumes, we were able to increase capacity utilization, company-wide, to 76% this quarter from 73% in the second quarter of 2008.

Our utilization in the Philippines increased to 91% in quarter three from 86% in quarter two as we increased production volumes during both normal and off-shift hours. In North America, that's the US and Canada, we saw utilization rise to 66% in the third quarter from 62% in quarter two and expect further improvements in future quarters as North America program production is increasing, and capacity continues to be constrained or reduced.

We believe we have made significant progress during the quarter in right-sizing and right-shoring our capacity, which we believe will lead to improved profitability in the future as production volumes continue to grow.

Equally important, we generated $14 million of free cash flow in the quarter as we focused on reducing days sales outstanding of our receivables, maintaining tight cost controls and reducing CapEx. We believe we have more than sufficient liquidity to fund our ongoing business, as well as projected growth for the foreseeable future.

Overall, I believe we've managed our business well in the quarter and believe we are properly positioned both in terms of business mix and financial strength to continue improving upon our operating and financial performance.

I’d just like to cover some of the key third quarter business trends. We continue to see a strong pipeline of new business across the vertical markets we serve, although sales cycles have been longer, and we have seen programs canceled during the late stages of the sales cycle due to budgetary constraints.

As I previously mentioned, we captured a number of new business wins during the quarter, which represent approximately $25 million of revenue on an annualized basis when fully ramped up. This business comes from new and existing clients in the telecommunications, financial services and pharmaceutical sectors. These wins will help us maintain and grow business levels, as well as replace certain programs that have been cutback or eliminated.

During the past year, we made a concerted effort to upgrade our marketing team in order to maintain our sales momentum as we move into 2009. We recruited a new head of marketing and added four seasoned sales executives experienced in the telecommunications, technology, government, and financial services sectors that help us meet this objective.

With our targeted verticals, financial services sector revenue was down 5% on a year-over-year basis, but down only 1% sequentially from the second quarter. The expected decline in credit card and mortgage-related programs was offset by increases in customer care and BPO work for banking clients, in particular. Despite the turmoil in this sector, we have maintained our position and strengthened our client relationships.

So in the telecommunications sector, revenue is up 10% on a year-over-year basis and up 4% from the previous quarter. We've been very successful, as I mentioned, in capturing and growing business within this vertical both domestically and internationally, using onshore facilities, as well as offshore centers, as well as home-based agents.

In the healthcare sector, revenue was down 17% on a year-over-year basis and 10% sequentially due a decline in call volumes from health insurance and pharmaceutical industry sponsored patient assistant programs. I expect certain segments of the healthcare sector to remain under pressure. We are seeing and winning new business from pharmaceutical clients who need to reduce their infrastructure cost.

Revenue from other sectors declined 16% on a year-over-year basis primarily due to elevated revenues in the middle of 2007 that we received from a short-term government project. Sequentially, revenue from clients in other sectors was flat.

Again, the domestic versus the international markets, domestic revenue is down 12% on a year-over-year basis but up 2% sequentially from the second quarter. This makes the first sequential increase in domestic revenue since the fourth quarter of 2006 when the accelerated migration of US work to our lower-cost, lower-priced offshore facilities began, and which is followed by the decline in our mortgage and credit card business.

Sequentially, production volume for domestic clients was up 4% in the third quarter of '08 from the second quarter of this year. We expect to see a continued sequential growth in our domestic business as new programs ramp up, onshore and offshore, and as our exposure to the mortgage and credit card segments of our financial services sector is now greatly reduced.

International revenue is up 10% compared to last year's third quarter. It was down 6% from the second quarter, largely as a result of the sudden drop in the value of foreign currencies when measured in US dollars, which began in the third quarter. We expect the stronger US dollar will further impact revenue from the international markets we serve in this year's fourth quarter.

We are continuing to experience strong demand for our services in Canada where we rationalized the capacity that previously serviced US customers, and which is now supporting our growing base of Canadian business. This past week, in fact, we recruited a seasoned Canadian executive to be president of ICT Canada responsible for our Canadian operations and business development efforts.

Our Mexican business continues to grow and is now running at full capacity, supporting both local businesses, as well as offshore support for the US customers. Current plans call for opening a second center in early 2009 if business conditions continue to warrant it.

In the UK and Australia, we've begun to see the effects of the global economic crisis. Over on the positive side, we are seeing increased interest in business from clients and prospects in both of these countries that want to be serviced from ICT's lower-priced offshore facilities.

At this point, I'd like to turn the call over to Vince to provide you with more detailed financial information on our third quarter performance and provide you also with our fourth quarter guidance.

Vince Paccapaniccia

Thank you, John. For your reference, reconciliation tables for non-GAAP financial measures and quarterly call volume statistics may be found at the company's website. In addition, my discussion of EBITDA, operating profit, net income and diluted earnings per share in the third quarter of 2008 was before the impact of restructuring charges that will be addressed separately.

I want to start my discussion by addressing two key areas that we have focused upon during the third quarter, first, improving the company's profitability and, second, enhancing our balance sheet and liquidity.

Company profitability highlights for the third quarter of 2008 include adjusted EBITDA reached 7.1% of revenue, up from 5.4% in the second quarter of this year. We generated significant increases in capacity utilization. The company recognized a grant benefit of $820,000, pretax. Even before the impact of this grants, we increased our operating margin sequentially by over 90 basis points for the second straight quarter.

We also recorded a $241,000 income tax benefit, which helped us to achieve $0.09 in adjusted earnings per share. And at the 35% effective tax rate that we used in our guidance in July, adjusted EPS for the third quarter would've been in line with guidance at $0.05.

Our company liquidity highlights for the third quarter of 2008 include, we increased our net cash position by $11.6 million sequentially, decreased our DSO to 62 days. We generated $19 million of cash flow from operations, reduced our CapEx spending, generated $14 million of positive free cash flow, and we retained $120 million unused under our line of credit facility.

Now I'll provide you with some additional details. Revenue for the third quarter of 2008 totaled $108.3 million, and adjusted EBITDA for the third quarter increase 28% sequentially and 2% on a year-over-year basis to $7.7 million or 7.1% of revenue, which resulted in operating income of $1.1 million, 1% of revenue. And again, the third quarter 2008 adjusted operating income included an $820,000 benefit from the previously discussed government grant.

During the third quarter of this year, the Philippine peso strengthened against the US dollar by 1% versus the third quarter of last year. The year-over-year negative impact of changes in the foreign exchange rates, inclusive of our headed hedging program, was approximately $500,000, which represents 50 basis points of operating margin and $0.025 of earnings per share. In the third quarter of 2008, Philippine peso denominated cost comprised 19% of the company's consolidated cost structure.

We continue to experience low single-digit wage inflation in the United States and base wage rates in the Philippines are increasing in the mid single-digit range. We have been able to offset the hourly revenue rate -- excuse me, we've been able to increase the hourly revenue rate for the Philippines work that has been able to offset these wage increases.

Net interest income of $48,000 in the third quarter of 2008 was lower than the third quarter of last year due to lower cash balances and interest rates.

For the third quarter of '08, we recognized a 21% income tax benefit resulting in adjusted net income of $1.4 million or $0.09 compared to adjusted net income of $925,000 or $0.06 per share in the third quarter of 2007.

The third quarter 2008 financial results reflect the impact of share-based compensation of $550,000, which compares to $488,000 in last year's third quarter.

So now, I'll address restructuring charges. During the third quarter of 2008, the company reviewed its expected demand for North American centers for the balance of '08 and into 2009. As a result of this review, the company closed all or part of five North American centers. The restructuring charges for these centers totaled $2.3 million. This charge was comprised of $1.3 million of lease and other contractual obligations, $650,000 of severance charges and $350,000 of asset impairments.

Approximately $2 million of the restructuring charges will result in cash expenditures. And the closure of these centers result in reducing 535 workstations during the third quarter. At September 30th, we had 13,340 workstations in operation, which is a net reduction during the quarter of 453 workstations.

During the third quarter of 2008, we achieve strong collections of accounts receivable, which drove a sequential $11.6 million increase in cash and cash equivalents as of September 30th, net of outstanding debt. At September 30th, cash and cash equivalents totaled $31.7 million, and outstanding debt totaled $5 million resulting in a net cash of $26.7 million. The $5 million in debt was drawn on our $125 million bank line of credit.

We continue to believe that we have more than enough cash and borrowing capacity to fund our growth for the foreseeable future.

DSO decreased from 70 days at June 30th to 62 days as of September 30th, and approximately 79% of our September 30th cash balances are maintained in international locations and would incur additional taxes if repatriated to the United States.

In the third quarter of 2008, total property and equipment purchased totaled $5 million, 4.6% of revenue, which is below our historical average of 6% of revenue. These expenditures were largely attributed to facility and technology infrastructure to support the Philippines expansion.

Now I'll address guidance. The company is current evaluating closing or downsizing additional facilities, which is expected to result in special charges in the fourth quarter of this year. Should this occur, the total amount of additional special charges is expected to approximate $2 million.

All guidance discussed below is before any special charges.

Looking forward, we project that we will continue to see moderate call volume increases for the balance of 2008. We project that capital expenditures for the full year of 2008 will approximate 4.5% to 5% of revenue and the number of workstations to remain relatively flat through the fourth quarter.

We project combined US and Canadian capacity utilization to increase to the upper 60s in the fourth quarter and to increase the capacity utilization in the Philippines to the mid 90s during Q4. We continue to hedge six forward quarters for the Philippine peso, and we are currently approximately 85% hedged for the fourth quarter of '08 and approximately 70% hedged for calendar 2009.

The effective income tax rate for the fourth quarter of 2008 is expected to approximate 15%. We continue to anticipate that quarterly income tax rates will continue to fluctuate based on the geographic distribution of the company's profits in each respective quarter.

Based on these revised projections, revenue for the fourth quarter of '08 is projected to be down slightly versus the third quarter, and projected fourth quarter 2008 diluted earnings per share guidance is $0.04 to $0.08.

Cash flow from operations for the fourth quarter of '08 is forecasted to range from $6 million to $9 million. Fourth quarter free cash flow is projected at $2 million to $4 million, and net cash, again being defined as cash and cash equivalents less any debt, is projected to be in the $27 million to $29 million range at year-end.

And at this point, I would like to return the call to John for the 2009 outlook.

John Brennan

Thank you, Vince. While we are challenged with a difficult economic environment, we continue to see and pursue new business opportunities across the vertical markets we serve. The sales pipeline remains strong, and we've added experienced sales and marketing resources to seize the opportunities.

We've made significant progress in right sizing and right shoring our business and are now in a much better position to grow revenue and profitability. The offshore shift of our domestic business is beginning to level off, and I now anticipate future growth for both low-priced offshore solutions and call centers, as well as home-based agent onshore solutions.

We've maintained strong relationships with our financial services clients and attracted new ones by enhancing our service offerings to include a broader range of customer care, collections and BPO solutions. At the same time, we have significantly reduced our exposure to mortgage and credit card related programs.

We've successfully expanded our client base, both domestically and internationally within the telco/technology sectors creating a better balance to our vertical mix of business. In 2009, we expect revenue from telco/technology clients will account for 35% to 40% of our total revenue, and financial services clients will capture a little bit more in the 40% to 45% range. This compares to approximately 30% for telco/technology clients in 2008 and approximately 50% for financial services clients in 2008.

We've better leveraged our staff through some of the recent technology investments by improving labor productivity and workstation utilization. We have controlled cost, delayed CapEx spending, making it possible to generate significant free cash flow and maintain ample liquidity to fund the future growth of our business.

In closing, I would like to thank all of our employees for their contributions during a very challenging period and to let you know that we believe we are well positioned to compete in the current market. We believe the long-term trends for our industry are favorable and are cautiously optimistic that by continuing to implement our business strategies we'll be able to achieve modest revenue growth and improve profitability in the year ahead despite all of the economic uncertainty.

We'll now open the meeting to questions. Operator?

Question-and-Answer Session

Operator

Yes, thank you. Ladies and gentlemen, we will now be conducting a question and answer session. (Operator Instructions).

Our first question comes from the line of David Koning with Robert W. Baird. Please go ahead.

David Koning - Robert W. Baird

Hey, guys -- and it seems like you're making some nice progress here.

John Brennan

Thank you, David.

Vince Paccapaniccia

Good morning, David.

David Koning - Robert W. Baird

I guess, first of all, when we look into '09 -- the margins have started to get a little better this quarter, and that's certainly encouraging. As we look into '09, there's a bunch of moving parts sort of around the margin. One is that the FX rates and the Philippine peso is getting a little better. Another is I know there were a lot of ramp costs still in '08 as you were ramping the Philippines, and so that might start to go away and really get better in '09. And then utilization seems to be getting better, too.

So I'm just wondering, as we put all those parts together, how do you see margins sort of progress in '09 from kind of a flattish or so '08?

Vince Paccapaniccia

Well Dave, as you know, we haven't put out any 2009 guidance. But as we sit here, as we look at it, we see these same trends continuing. We are flying in the face a little bit of the current economic environment, but we believe, with what we're doing from a labor and productivity standpoint, the capacity and utilization improvements and some of those additional items that you've mentioned, our objective is to continue to improve operating margins sequentially as we move into 2009.

David Koning - Robert W. Baird

Will Q1 be the typical kind of downtick? I know Q4 is usually a good-margin quarter. Will that be the one sequential downtick that you'd probably expect and then kind of ramp from Q1 again?

Vince Paccapaniccia

Yes, simply because that's typically the period where we have somewhere in the $1 million to $2 million worth of cost burden in Q1, Dave.

John Brennan

Yes, I think like most people, we're not – probably not expect a big sequential bump in the fourth quarter that was typical because of the economic outlook right now, but we are growing productions volumes. And as you said, there's a lot of moving parts between the foreign exchange rates and the US dollar.

So looking into 2009, I would see the -- my anticipation is that the revenue --typical revenue flatness or down may not be a typical first quarter, but we do have added costs that come in there, as Vince mentioned, in the first quarter.

David Koning - Robert W. Baird

Okay, great. And then, second, as we look at the revenue line, when we look at FX, just where currencies are right now, by our calculation it looks like about a 3% or so headwind off from currency, meaning if you'd normally grow 5% next year, it'd probably end up being closer to 2%. Is that in the ballpark of your calculations, too?

And then, as we balance out the revenue headwind from Canada and Australia and a few of those other currencies, but then we look at the peso -- I'm just wondering how do we kind of think of the EBIT impact? Is one more beneficial than the other's headwind, or maybe how can we kind of think of that, too?

Vince Paccapaniccia

Okay. I'll start with the EBIT impact, Dave, and then if John wants to expand on revenue.

From the EBIT standpoint, I was looking at -- it was kind of funny, what's happened in Europe. If you look at the euro, the euro is actually up year-over-year and the sterling is down pretty significantly year-over-year. As you know, majority of our Europe revenue is generated in sterling since we're in the London market, UK market. So market was probably I would say a little bit north than that 3% -- maybe 3% to 4%, something like that.

From an EBIT standpoint, the Philippine peso, as you know, is trading in the 48%, 48.5% range. It's been pretty weak for the last, like, three months or so, two to three months. And as you know, we're about 85% hedged for our fourth quarter needs, and we're about 70% hedged for our calendar 2009. So it is certainly a positive when the Philippine peso weakens. However, much of that gain is offset by the hedge contracts that we have in place.

What we are doing in light of the pretty weak peso right now, we are continuing our hedge program, we're continuing to buy, and we're getting some very, very favorable rats currently. However, these will be benefiting primarily the second half of 2009 and the first half of 2010.

David Koning - Robert W. Baird

Okay, that's great. And then, just finally, call volumes declined sequentially pretty much through '07 and a little bit into early '08. But as the economy has weakened really in the last couple of quarters, your call volume has started to actually get better. I'm wondering, I guess, finally, if you can just make a comment on why the call volumes now are starting to get better when, during '07, they were coming down.

John Brennan

Well I think the major factor why they came down, probably between the second quarter of '07 and early part of '08, was the decline in our domestic telesales business primarily related to credit card programs and the mortgage programs. So we were, I'll call it -- our outbound telesales business was flowing faster than our inbound customer service and BPO volume.

So we’ve -- I’ve mentioned, in the third quarter of this year, on a year-over-year basis, we were down 30% in call volumes associated with telesales and market research programs but up 15% on the customer care and BPO. So we had two different moving parts. Because -- what's happened is that now, the volume of our business, about 75% to 80% of our total call volume is associated with customer care and BPO.

And if you look at us compared to, I'll call it, more of a traditional customer service company or a pure play --- like a Sykes customer service company, we're actually growing that segment of our business in double digits, 15% to 20% ranges on call volumes. Some of the pricing, because we've shifted some of that offshore, it didn't move as fast as the volumes.

On the other hand, the decline has gotten smaller and smaller, the portion of our business which is in the outbound sales side, so that 30% is of a much smaller number. So I believe we've hit the inflection point. The customer care/BPO business is very strong for us. We project it will continue strong, and we think we've kind of like bottomed out in the telesales/market research side. So we would expect to see, moving forward, continued growths in our total production volumes.

David Koning - Robert W. Baird

That's great to hear. Thanks so much.

John Brennan

Okay. Thanks a lot, David.

Operator

Thank you. Our next question is from the line of Josh Vogel with Sidoti & Company. Please go ahead.

Josh Vogel - Sidoti & Company

Good morning. Thank you.

John Brennan

Good morning, Josh.

Vince Paccapaniccia

Hi, Josh.

Josh Vogel - Sidoti & Company

Hi. I'm just trying to get a little bit of a better handle on your revenue guidance for Q4. The release discussed that it's going to be down sequentially, and I understand the unfavorable move and the dollar working against you. But you also mentioned that a larger portion of domestic work will be handled offshore. And we already knew that more and more work was moving offshore, but I'm curious whether this was already baked into your Q4 guidance on the last conference call or if you're actually planning to now have even more volume handled offshore today than you did three months ago.

Vince Paccapaniccia

I think there's really two major parts. The amount of work going offshore, we expect it to increase and it is moving at a faster pace, but it's also not dramatically faster than where we were before. We do think we're in the 65% to 70% range moving forward.

I think there's two major components of why we expect the revenue levels to be down a little bit sequentially, but probably $10 million to $12 million below our previous guidance, which was in the 115 to 120 range.

About half of that is going to be due to foreign exchange, and that's with the revenues we're generating out of Canada and Europe and South America and the rest of the world. We think that's going to be a $5 million to $6 million hit that we didn't expect in July of -- and I don't think anybody expected the dollar to strengthen as much as it has. So that's about a $5 million to $6 million part of the shortfall. And I'd say, basically, the other $3 million to $4 million of shortfall would come from -- we're seeing lower volumes on certain programs, particularly those associated with consumer products, due to economic conditions. Whether it's the purchasing of them or shipping of them or utilization of them, we're seeing lower call volumes associated both in live operator as well as in our IBR business over the past month.

So we think that will continue through the end of the year now.

John Brennan

And Josh, just to expand on that a little bit, the offshore we're talking about is really not a shift from a US current production facility to an offshore facility. It's really the split of new business wins.

Josh Vogel - Sidoti & Company

Okay. And the $5 million to $6 million you just said from FX and $3 million to $4 million from lower volume, so that almost $10 million -- is that $10 million down year-over-year or sequentially?

Vince Paccapaniccia

No, that's $10 million from our previous guidance. Sequentially, we think we'll be down a couple of million dollars.

Josh Vogel - Sidoti & Company

Oh, okay. Okay, now looking at the downsizing activities that are going to take place in Q4. You said that seats would be pretty much even -- the total net seats at the end of the quarter would be even to today. So are we going to see about the same amount of downsizing as you took in Q3, which is about 500 seats, and are these mostly in North America?

Vince Paccapaniccia

Yes, it's probably -- the range is probably 400 to 500 seats would be added as well as downsized. So they would offset, Josh, and those are primarily North America.

Josh Vogel - Sidoti & Company

Okay, great. And just lastly, the $25 million in new business that was added, can you just give us the split between what percent was from new clients and what was from existing clients?

John Brennan

About 80% of it was from existing clients. One of those existing clients, though, we have a very small amount of business with, and then we received a sizable contract, so we were probably doing less than $1 million a year with them, and I have a contract that, fully ramped up, is in the $8 million to $10 million range. So I'd almost consider that a new client in that term as opposed to an add-on.

Josh Vogel - Sidoti & Company

Okay.

John Brennan

So it's about 50/50 then.

Josh Vogel - Sidoti & Company

Okay, great. Thank you very much.

John Brennan

You're very welcome.

Operator

Thank you. Our next question is from the line of Bill Sutherland with Boenning & Scattergood. Please go ahead.

Bill Sutherland - Boenning & Scattergood

Thanks. Good morning.

John Brennan

Good morning, Bill.

Bill Sutherland - Boenning & Scattergood

I wanted to see what you guys see on the horizon looking at the new business pipe on healthcare.

John Brennan

Well we have -- I'd break it into three or four segments. The business with the health insurance carriers, we've seen a softening of that market all year long. And we've seen some of that work move back in-house. And so the remnants of work that we were doing there, post Medicare Part D, we noticed huge volumes of it a couple of years ago. So that business, in our market, has remained soft.

The second one is that we have been involved with patient assistance programs with pharmaceutical companies, individually, as well as consortiums of them. And that business has ramped down pre-election, and it's at significantly lower levels. It seems to be leveled off right now, but it's significantly lower than it was two years ago. Those are the two downsides.

On the upside, we're seeing an increasing pipeline of business with pharmaceutical clients, in both existing and new clients, for, I'll call them, patient support and product support for medical device companies, and we're seeing those opportunities both domestically, as well as globally, as a couple of our US customers are now looking at providing more, I'll call it, worldwide support, at least through Europe and parts of Asia. So we see significant opportunities there, a lot more activity going on in the pharmaceutical industry than in the past.

And lastly, as we mentioned in our previous call, in the second quarter, we landed our first contract really being involved in the provider section of the healthcare market with hospitals and getting involved with patient scheduling and insurance support programs and so forth. We are beginning to actively pursue additional opportunities there, but we're in the early stages. So I just think that there is opportunity there, but we're launching a sales and marketing effort, as we speak, to determine how big that's going to be.

Bill Sutherland - Boenning & Scattergood

These aren't the kinds of businesses that were formerly insourced and now being outsourced. This is kind of a like a new territory of opportunity.

John Brennan

Yeah, I think the -- if I look at the latter two, the opportunities are -- the customer support and patient support and device support opportunities with the pharmaceutical companies that we're working with are involved with operations that are currently insourced. Very few of these are outsourced. The one significant pharmaceutical program we’ve won, this past quarter, was a fairly large in-house operation of which they decided to outsource half of the seats to ICT.

The hospital-based ones, to my knowledge, I think are, overall, in-house today.

Bill Sutherland - Boenning & Scattergood

The progress in the US utilization looks good. What is the reasonable target as you get right sized and get a steady state on the business?

John Brennan

We're looking at -- our target for the US and Canada is to achieve – to reach 75% next year, the sooner the better. But our goal would be to get 75% utilization. We were in the low 60s earlier this year. We've moved up in the mid 66%. We think we'll improve on that in the fourth quarter.

And in the Philippines, it's a little bit different where we're measuring it on utilization of one full shift for six days a week, and we are getting multiple shifts because of our BPO activity, as well as an increasing number of clients -- we have a few -- but from Australia, as well as the UK, which operate in different time zones. So there we are looking at utilizations that can be potentially -- in our methodology, exceed 100%, but we're looking to be in mid 90s in the Philippines.

Bill Sutherland - Boenning & Scattergood

So these are the -- I mean, to ask kind of a simple-minded question. This is the real lynchpin in terms of the EBIT margin goals that you've had, right?

John Brennan

I think the utilization of the capacity and the technology and labor productivity are the two real lynchpins.

Bill Sutherland - Boenning & Scattergood

And so it's the -- what you're saying, John, is that you'll just be at another progress point next year as opposed to where you think you can kind of set an -- not an ultimate target, but when you think you've got most of that upside.

John Brennan

Yeah, I think, when you look at the players, maybe on the larger players that are coming out in the 8% to 10% operating margins, we think where our upside businesses are driving 6% to 8%, we think we'll have to be at -- every utilization -- high utilization rates to get there, and we will also -- we're continuing to focus on labor productivity, which is a combination of unbilled trading and attrition, which is a major issue in this industry.

Maybe an economic downturn will help our recruiting efforts.

Bill Sutherland - Boenning & Scattergood

I'm sure it will. I'm sure it will. Okay, thanks, guys.

John Brennan

You're very welcome.

Operator

Thank you. Our next question is from the line of Troy Mastin with William Blair & Company. Please go ahead.

Troy Mastin - William Blair & Company

My first question relates to the financial services industry and if the financial crisis resulted in positive impact on inbound call volume if consumers were concerned about balances or the state of their accounts or anything like that when you saw the spike in September.

John Brennan

It did, but it wasn't -- we didn't notice any significant increase. I think it's written up. So both Chase and Washington Mutual are clients that we handle inbound support for, and we did see, for several days there when the announcement of the acquisition -- there was certainly an up tick on calls on the Washington Mutual lines. But that leveled off after a while.

Troy Mastin - William Blair & Company

So nothing we should be focused on as it relates to sequential comparisons to the fourth quarter.

Vince Paccapaniccia

I don't think so. I think the -- we haven't seen -- you know, we typically don't handle all of the call volumes associated with a particular client. They have typically in-house operations as well as maybe other vendors. Some do, anyway. But we haven't seen any significant downtick in the financial services call volumes. Where we have seen, I'll call them, even some of the -- related to telecommunications devices and anything that has consumer spending associated with it, we've seeing -- in several instances, not every customer we have, but we've seen several instances of noticeable declines in call volumes.

Troy Mastin - William Blair & Company

Okay. And on the financial services vertical, have you tried to estimate the approximate exposure you have to financial services companies that have been involved in recent bankruptcies, potential bankruptcies, consolidations and so forth?

John Brennan

Well to the -- in looking at the companies that -- you know, if I looked at, as I mentioned, Washington Mutual being acquired by Chase, those -- all of those are what they -- basically, what we were supporting is customers of Washington Mutual branches, I assume those people are still going to be customers. And also combine Chase, I'm sure Chase hopes they will be. So we don't think that's going to have any impact on our business there. And the other major one, with Wells Fargo and Wachovia, we don't do any business today with Wachovia, but Wells Fargo has been a long-term client of ICT, and we're certainly already in discussions with some additional opportunities where we'll be meeting with Wells Fargo on.

So to date, it's been a positive, and I think our significant clients, as I mentioned in the presentation, people like Chase and Citi and Wells and Bank of America are -- I guess one other one I'd throw in there is HSBC. I think they're going to be the survivors, but who knows. But we think we're on the plus side of it to date. There're some exposures, but we think, in general, we're on the plus.

Troy Mastin - William Blair & Company

Okay. And then, my next question relates to the President Elect Obama and how this might impact your business. I'm not exactly sure what the policies may look like, but what's your perspective on what you've heard in terms of any implications for offshoring, maybe implications for the medical industry, financial services industry, if we see more regulation. And also, if unionization takes an up tick, do you see risk of some of your North American based call center is facing recession.

John Brennan

You got them all. How do you think Vince and I voted? So I think it’s just going to have to see how it plays out. I think the -- we've had, in the US in the past, unionization efforts over the last 20 years. I can recall two. And I think our exposure in the US -- I think it's going to -- I don't know to what extent they would be focused on call center operations. It's not a very good market to go after because the volume -- you don't contain your own destiny. It's based on what the client outsources to you through you. So you're not producing your own work in that sense.

So but there can be exposure to that, and I think all it would do is drive more jobs out of the US. We certainly have had -- we had one operation unionized in Canada and have several unions out that are active in the call center world in Canada. They have been for years. We don't have any unionized locations today in Canada, and so that's not an issue.

In terms of discouraging companies from doing work offshore -- so that's the other end of -- we have seen -- I'd say about half the wins that we have received probably in the past nine months have been US companies looking for US solutions and about the other half looking for offshore solutions. So there's been some movement back to the US, and sometimes they indicate for quality, and I think some of it is for political reasons. So we've got that dynamic going on.

And then, lastly, I know I've had other CEOs call me or talk to me about how real, through tax policy possibly, would the new administration reduce the tax benefits of offshore locations, whether it's Ireland or the Philippines or India or whatever. So we don't know the answer to that. I assume there's some ways they will try to do something of that mode, which would discourage some of the benefits of offshore. But I think that'll be a global fight, which is beyond ICT's ability to influence.

Troy Mastin - William Blair & Company

Which of those do you view as the most – highest probability risk to your business in one way or another, whether it be top line or margin related?

John Brennan

Well I think, without a doubt, that if there -- this is all hypothetical. I think, if there was more of the work was driven back on shore, without a doubt people, whether it's ICT or Sykes or Teletech or Converges, the ability to generate operating margins is more difficult in the US and Canada than it is offshore. The availability of labor is much tighter. The availability of alternative jobs and higher-paying jobs is much greater.

So I think political actions that would discourage the offshore phenomena that doesn't affect just call centers, but the IT industry and manufacturing and all those kinds of things, will have a potential negative effect on US companies. So I don't know, that's kind of -- if that's the direction it's going to move, I would think that would have a resetting of the operating margin potentials for this industry and a lot of other ones.

Troy Mastin - William Blair & Company

Okay, thank you.

John Brennan

You're very welcome.

Operator

Thank you. Our next question is from the line of Bob Evans with Craig-Hallum Capital. Please go ahead.

Bob Evans - Craig-Hallum Capital

Good morning, everyone.

John Brennan

Good morning, Bob.

Bob Evans - Craig-Hallum Capital

Most of my questions have been asked. CapEx for '09, can you give us a general sense? Is kind of that $20 million to $22 million range comparable to this year?

John Brennan

I'd say it'd be on quite the lower end of that range. I would say, again, we don't have guidance for next year, but early look, I'd say in the $15 million to $20 million range.

Bob Evans - Craig-Hallum Capital

Okay. How about seats, how would the early look in terms of seats for '09?

John Brennan

Again, that will be driven by the -- we mentioned a little bit earlier about the decrease and sequential increase in calling hours. So it would be pretty much tied to that. I don't think that would be all that different from 2008.

Bob Evans - Craig-Hallum Capital

Okay, all right. And other than that, I think my questions are answered, so thank you.

John Brennan

Thank you, Bob.

Operator

Thank you. Our next question is from the line of Shlomo Rosenbaum with Stifel Nicolaus. Please go ahead.

Shlomo Rosenbaum - Stifel Nicolaus

Hi, thanks for squeezing me in here. I want to ask a little bit -- like the gross margin was up, sequentially, pretty sharply. Was that the government grant that was in there or what else was moving around?

Vince Paccapaniccia

Yeah, that was a significant factor, Shlomo. The grant was recognized in labor. That's correct.

Shlomo Rosenbaum - Stifel Nicolaus

Okay. Is there anything else that's moving in? In other words, if you're expecting basically around 40% gross margins going forward, what's the big improvement from -- can you talk about some of the components?

Vince Paccapaniccia

Sure. I think the two largest ones -- the one in the gross margin -- there's one above the line and one below the line. But the one in the gross margin line is really labor productivity. We've had a concerted effort with the operations team and the three visions looking at labor productivity. It's grown very nicely through the first nine months of 2008, and we plan on -- we continually work at ways to continue to grow that. And this is -- the way we measure that is how many minutes on the phone people are generating revenue. So that continues to grow, and that's a nice driver to the gross margin line.

And from a reduction in SG&A expenses, largely, it has some impact on gross margin, but it's mostly down in the expense line. The cost savings there, in addition to the standard cost savings are the capacity utilization efforts. And what we're looking at there is what kind of programs we're putting in which locations, can we relocate customers to areas where we have sufficient capacity in an existing centers and moves along those lines to get the maximum amount of revenue and profit generated out of the existing centers.

John Brennan

Yes, I think there's two other pieces I'd like to make reference to. One is, Shlomo, that we now have more than half of our IT staff offshore located as opposed to in the US. That's also above the line where we charged off to the projects that they are working on. So our IT expenditure has been declining on a per hour --production hour basis.

And a second major one is we've moved a significant portion of our sales verification and our monitoring operations to offshore locations. And we expect to complete that movement in 2009, which would probably save us another $1 million $1.5 million annually.

Shlomo Rosenbaum - Stifel Nicolaus

Well last time, you guys had, like, 40% margins. I remember the EBIT margins were at sort of the 3%, 4%. And what's preventing you guys from getting there rather quickly?

John Brennan

We need more revenue on the top line. I think we've gotten the ship tightened up quite a bit here. The volumes are going up. I think we'll start seeing -- we don't expect a significant shift -- we'll be about 65% offshore this year, which is probably about 14 points more than it was last year. And maybe next year, it'll be 65% to 70%.

So that shift is kind of leveling off. So every additional production hour we get will be at a pretty much more of a constant or same average revenue per hour basis. So there's very little work in the US today that we would see moving offshore that's existing. We may see more from countries like Canada and the UK and Australia. We may see some of that work move offshore. But I think it's all going to be -- we have the ability to support more revenue growth from the internal SG&A, and I think that's going to get to the ultimate operating margins.

Vince Paccapaniccia

Yeah, I would say it's, yes, leveraging the G&A.

Shlomo Rosenbaum - Stifel Nicolaus

And just, Vince, this is a question for you. I mean, I've been talking to you for a long time about the capital intensity, and it really seems to be coming down now, which is really positive. And it seems to be a sharp decline. I'm wondering how are you guys doing it. Is it more selectivity of where you're going to put the money? Are you doing some of it with leasing as opposed to just paying for it straight up? Can you just talk about that a little bit?

Vince Paccapaniccia

Sure. We're doing some leasing, very little. I'd say it's probably maybe 5% or 10% of the CapEx spend. So it's not in the area -- I'm sorry, it's like 5% of the CapEx spend. So it's pretty low. It's primarily selectively making the investments.

Where we're investing it, we're looking at how to – to maintenance CapEx, definitely we're looking at -- I think a large part of this is capacity utilization. Instead of adding another center, can we get better utilization out of the existing ones? It's just continuing to look at things. And I'd say we're taking a harder view on a lot of items.

I think that probably the third component, Shlomo, is the way we're structured right now. We've been migrating to these data centers over the years. They are largely deployed right now. We've put a couple in some international locations now. And that does increase our flexibility, which also allows us to decrease our CapEx spend by having the flexibly of putting work in different centers and without having to incur CapEx specifically related to a center.

Shlomo Rosenbaum - Stifel Nicolaus

Okay. What about the DSOs? Is that a sustainable level?

Vince Paccapaniccia

Yes, we typically target 60. We, again, rarely get to 60. But 60, 61, 62 I think is the range we'll be in at the end of December. We're obviously going to continue to strive to get it down to 60. And that's our ongoing target is the 60 target.

Shlomo Rosenbaum - Stifel Nicolaus

Are all the issues with the WaMu acquisition laid to rest? In other words, have you met with Chase and JPMorgan and talked with them and they were like, "Yeah, we're going to" -- you know, saying that they're going to use you guys as the vendors, or is it just sort of it really hasn't been integrated yet, so there's still that big risk that they might decide to move stuff around, pull it in-house or do something like that?

Vince Paccapaniccia

We are working on with both sides at this point in time, and they are still in the integration process. It is flowing like normally at this point in time. And as John mentioned earlier, we work with both parties. So we think Washington Mutual work, continuing to service their customers, is going to continue after the integration.

From a cash flow and the normal business direction, that is happening I'd say on a business as usual basis.

John Brennan

All of our former Washington Mutual bills have been paid, and so that we're all current with that. We are working with the Chase management, both in the US as well as in the Philippines, and we are very close to them. Chase has an overall strategy of building captive as well as outsourced capacity, and they typically migrate some of the outsourced capacity into captive offshore sites, and then add additional new projects into their offshore vendors. So it's been a cycle that I've been working with Chase from the last five years. We don't see, as of today, any dramatic move by Chase to suddenly integrate the Washington Mutual work into their in-house locations, not that I'm aware of. And a lot of the work that we were doing for Washington Mutual, was in offshore locations, both in primarily in the Philippines but also in Latin America.

Shlomo Rosenbaum - Stifel Nicolaus

How big, as a percentage of revenue, is WaMu and in this relationship together right now?

John Brennan

WaMu was about $1 million a month. It's about 3% of revenues.

Shlomo Rosenbaum - Stifel Nicolaus

Okay.

John Brennan

And we nailed it down -- drilled down to this level of detail. And Chase was about $1.5 million a month or something like that.

Shlomo Rosenbaum - Stifel Nicolaus

Okay, very good. Thank you very much.

John Brennan

Okay, Shlomo.

Operator

Thanks, your next question is from the line of Howard Smith with First Analysis Securities. Please go ahead.

Howard Smith - First Analysis Securities

Yes, I know we're going long, so thank you for taking my question. My question concerns the pricing environment. In past economic downturns, some of the industry participants, when they had excess capacity started to price that out at more marginal cost-plus type rates and in specific geographies. I'm curious, it looks this time like participants are more willing to close centers and close the seats than try and keep them at their marginal rate.

Could you just address that? Are you seeing anything as you look at new business, where pricing is getting a little odd?

John Brennan

I would say, Howard, I haven't seen anything significant. I mean, I would say every pricing discussion is a tough one, and every time we try to renew a contract, in general, we're successful in raising prices because there probably the prices are three years old and costs have gone up. And you can have some tough negotiations there. I would say the majority of the time we are able to get price increases on renewals.

We haven't seen -- I think that's what's happened. I mean, I don't think this excess capacity in North America -- I mean, we had left more capacity in place in anticipation of somewhat more business back in January evolving over the course of this year. And while it's grown, and there's new business coming into the US and Canada size, we made the decisions that it just wasn't going to grow as fast as it was. And we’re also, I think us and all of our larger competitors are developing home-based agent models, which gives you more flexibility than you had with fixed facilities. And that is another contributing factor that you don't have to have this fixed infrastructure as much as you did five years ago.

In terms of offshore capacity, I think it's pretty limited. I mean, we're operating at over 90% utilization. We're adding a couple hundred seats at two provincial locations, and -- but we're adding them a couple hundred seats at a time. We're not getting ahead of ourselves. So I don't think there's a lot of excess offshore capacity at this point either.

Howard Smith - First Analysis Securities

Great. Thanks. No, I would've expected it in the US. And I appreciate your answer there.

John Brennan

Okay.

Operator

Thank you. We have a follow-up question from Shlomo Rosenbaum. Please go ahead.

Shlomo Rosenbaum - Stifel Nicolaus

Yeah, just one question on the currency side. What was the negative currency impact on the third quarter on the revenue line?

Vince Paccapaniccia

On a year-over-year basis, CapEx was almost neutral at the top line.

Shlomo Rosenbaum - Stifel Nicolaus

And I'm thinking more, like, you know, when you guys gave the guidance, and then all of sudden the US dollar starts to really appreciate. Do you have a meaningful appreciation? So maybe there was just $2 million that just fell out of the revenue line because of that.

John Brennan

Yeah, we estimate it was somewhere around $2 million, $2.5 million. Where we came in at 108.5 of revenue, and we think we would've been in the 110 to 111 in the third quarter based on what our expected currency projections were at the end of the second quarter. And it's having a much more significant impact on those projections that we made then on the fourth quarter because the real downturn was in September and --.

Vince Paccapaniccia

September-October.

John Brennan

But we think it's going to have, as we mentioned earlier, about a $5 million to $6 million impact on our last guidance for the fourth quarter.

Shlomo Rosenbaum - Stifel Nicolaus

And can you run us through what the significant currencies are and what percentage of revenue they are right now so we will sort of be able to track that?

John Brennan

Well the biggest one on an annualized basis is in Canada where we'll get about $90 million to $100 million.

Vince Paccapaniccia

It's about 100, yeah.

John Brennan

It's about 107 -- it's running at about a $25 million -- it was at a $25 million run rate. That's down about 10% to 15% on currency.

Shlomo Rosenbaum - Stifel Nicolaus

That $25 million was when? Was that the second quarter?

John Brennan

I would say that's about our average run rate. It's been growing. But I think it would've been $25 million in the fourth quarter prior to this currency hit. So that's going to take $2 million or $3 million out of Canadian revenue compared to what we thought it was going to be in July. It's all relative to when we're looking at it.

Mexico, we do about $4 million to $5 million a quarter. And that is having a -- that's down about 20%. And then, the UK and Australia, about another -- what do you think --?

Vince Paccapaniccia

Yeah, same range, $4 million to $5 million.

John Brennan

$4 million to $5 million a quarter in those countries combined, and that's -- well maybe $5 million to $6 million in those countries combined. And that's probably -- I don't know, it's swinging all over the place, but --.

Vince Paccapaniccia

Yeah, and ours is pretty much, there, tied to the sterling as opposed to the US dollar.

John Brennan

The sterling and the US dollar dropped about 30% for a while, and then now it's coming back up, so down around 20%.

So those are the numbers. So the sterling and the US dollar are probably a 20% hit. Canada is a 10% to 15% hit. And Mexico is about a 20% hit. Argentina, which is less than $1 million a month, is a -- we control the currency there, so there hasn't been much movement, maybe five percentage points in the Argentine dollar.

Shlomo Rosenbaum - Stifel Nicolaus

So if I just had to run it down on the revenue side, so you're looking at, roughly out of $110 million of quarterly revenue, $25 million of that from Canada, then it steps down pretty dramatically to $4 million to $5 million per quarter for Mexico, and then the UK and Australia, another $4 million to $6 million, Australia, another $1 million, is there anything else that stands out, or the rest of it is really US?

John Brennan

It's really US. So about $35 million to $40 million is our international revenue.

Shlomo Rosenbaum - Stifel Nicolaus

Okay, thank you very much.

Vince Paccapaniccia

You're welcome.

Operator

Thank you. (Operator Instructions). We have no more questions at this time. I'd like to turn the floor back over to management for any closing comments.

Vince Paccapaniccia

Okay. Well thank you very much, and thank you for all the questions. I just wanted to close by saying that I do believe we're on the right road. We've made meaningful progress, and we believe we'll continue to make additional progress in the fourth quarter. And while it's a difficult environment out there, we think we have repositioned the company for renewed revenue quality and profitability improvements. So I look forward to talking to you at the conclusion of the fourth quarter and provide you guidance with 2009.

Thank you very much. Have a good day.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: ICT Group Inc. Q3 2008 Earnings Call Transcript

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