Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Virtusa Corporation (NASDAQ:VRTU)

F3Q09 (Qtr End 12/31/08) Earnings Call Transcript

January 28, 2009 5:00 pm ET

Executives

Staci Mortenson – IR, Integrated Corporate Relations

Kris Canekeratne – Chairman and CEO

Tom Holler – EVP and COO

Ranjan Kalia – SVP, CFO, Treasurer and Secretary

Analysts

John Maietta – Needham & Company

David Cohen – JP Morgan

Bhavan Suri – William Blair

Moshe Katri – Cowen and Company

Vincent Colicchio – Noble Financials

Tim Brown – Roth Capital

Joseph Foresi – Janney Montgomery Scott

Operator

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Virtusa Corporation third quarter and fiscal year 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.

I would like to turn the call over to Ms. Staci Mortenson from Integrated Corporate Relations. Please go ahead.

Staci Mortenson

Thank you. Good evening, and welcome to Virtusa's third quarter 2009 earnings conference call, where we will be discussing our financial results for the quarter-ended December 31, 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, Senior Vice President and 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 prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of 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.

Other statements in this call also include certain non-GAAP financial information as defined by the SEC. We present constant currency revenue to provide a framework for assessing how our revenue performed, excluding the effect of foreign currency rate fluctuations.

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 and our press release.

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

Kris Canekeratne

Thank you, Staci. And thank you for joining us on our third fiscal quarter conference call. We had a strong third quarter in the face of a challenging economic environment. We were very pleased with Q3 revenue, which exceeded our prior guidance. Increased revenue, combined with solid progress and operational efficiencies and internal cost management, helped drive significant bottom-line expansion, which also exceeded prior guidance.

Our top line strength this quarter was driven by our compelling value proposition, which resonates particularly well as clients look for ways to further reduce costs by improving internal IT efficiencies. The current economic environment is precipitating clients to improve IT efficiencies within core business processes and this has become more important today than ever before. Our consultative platforming approach reduces IT costs and enables realization of business outcomes faster. This combined with the efficiencies of our industry-leading global delivery model enables us to further reduce costs for our clients. Simply stated, Virtusa’s global teams deliver much more value more cost-effectively to our clients.

Here are some of the highlights from the third quarter. We delivered strong revenue of $44.9 million, an increase of 6% year-over-year and 2% sequentially. On a constant currency basis, revenue grew 10% year-over-year and 5% sequentially. We expanded operating income to 12% or $5.4 million, resulting in earnings per diluted share of $0.27. The results exceeded the high end of our guided range for both the top line and bottom-line. Top line was driven by some additional year-end spending by our clients, which was not in our forecast and by ongoing solid execution across our client base. We significantly expanded margins, evidencing the progress we're making in our operational efficiencies, internal expense management, and our commitment to running a sustainably profitable business.

We repurchased $2.9 million worth of our shares through our share buyback program and ended the quarter with $96 million in cash and investments.

Despite the tough economic environment, we are pleased with the progress we're making with both our established and newer clients. We also remain focused on winning new accounts and commenced work with four new clients in the quarter. Our client wins were in BFSI and communications and technology and directly tied to our value proposition.

Elaborating on our value proposition, our engagement teams are focused on reducing IT costs and improving business outcomes for our clients. We do this by improving IT efficiencies within our clients’ core business processes, many of which have redundant and aging applications. We work with our clients to systematically evolve disparate applications to a single core platform that directly maps to a core enterprise process. This results in IT simplification, rationalization, and consolidation leading to immediate and sustainable cost savings and improved business outcomes. In addition, we deliver our services through a highly efficient global delivery model which has inherent and well-understood cost benefits.

In the December quarter, we continued to deliver our services with the best on-site offshore ratio in our industry. 84% of our effort was offshore and 16% was on-site. Also because of our unique value proposition delivered at a compelling global price point, our global realized billing rates remain stable. We are mindful that clients may try harder to negotiate on price, especially in tough economic times, but are confident that our value proposition provides our clients with significantly more value than just the inherent cost benefits of global delivery.

Our financial services industry group continued to lead our growth, growing 23% year-over-year and 6% sequentially. Strength in this industry group continues to come from our deep domain knowledge in conjunction with our solutions offering, the strength of our client management programs, and our outstanding track record of service excellence.

Communications and technology, excluding BT, grew 13% year-over-year and 16% sequentially. Strength in this practice area has been driven by newer clients we have won during the past 12 months and our ability to demonstrate the benefits of our value proposition.

Turning to BT, our revenue for the third quarter was $7.9 million, representing 18% of our revenue for the quarter. On a constant currency basis, BT revenue was unchanged sequentially, in line with our prior expectations. BT and Virtusa continue to have a strong strategic relationship. Our platforming approach remains strategically aligned with BT’s direction. We continue to have an outstanding track record of service excellence.

Although we had a strong third quarter, it is very important that we take into consideration the level of uncertainty in the marketplace, the timing of our clients, budgeting processes, and the impact on our fourth quarter revenue. From our perspective, clients are taking a cautious approach on setting budgets and the timing of releasing these budgets to commence new projects. But this should come as no surprise in these challenging times.

However, clients are looking for partners that can improve their internal IT efficiencies while delivering work at a global price point and we are having meaningful conversations along these lines. Our value proposition resonates well with new and established clients and therefore, we are modestly increasing our investment in business development and client acquisition. This will enhance our ability to win new business with enterprises that have the potential to become strategic accounts for us. We are confident that this will help us navigate in these challenging times and strengthen our foundation to increase market share as the economic environment improves.

Over the years, and as a US-based corporation, we have invested in building strong corporate governance processes. We have an exemplary Board, a strong global management team, and an outstanding finance function that is US-led. We are very well prepared and confident that this will serve us well in an expected environment of heightened corporate governance scrutiny.

Now let me turn the call over to Tom, who will provide more details on Q3 performance. Tom?

Tom Holler

Thanks, Kris. We are pleased with the strong results of our third fiscal quarter. After experiencing a decline in utilization earlier in the fiscal year, we took decisive actions to improve global utilization and further leverage operating efficiencies. These initiatives, driven by our global leadership team, resulted in restoring gross margin to over 40% and improving operating margin from breakeven in our June quarter to 12% in our December quarter. Our strong margin improvement demonstrates our business model’s earnings potential, driven by our optimal on-site offshore delivery mix, increased utilization, and strong discretionary spending controls.

As we have stated in the past, our long-term goal is to expand operating margin to the mid-teens. We believe we can attain these targets by maintaining strong gross margin or amortizing SG&A expenses over a larger revenue base. However, while we remain committed to our long-term goals, operating margin will be under pressure in the near term. This is predominantly due to expected lower sequential revenue and a slight increase in SG&A expenses as we balance profit expansion with investments focused on top line growth and building efficiencies and scale for the long-term. Ranjan will provide more color on guidance in a few minutes.

On the pricing front, our realized billing rates remain stable. Rates have been pressured by the strengthening of the US dollar relative to the British pound. However, this impact has been offset by higher billing rates at newer clients relative to the company's average. We have recently had some requests from clients for lower pricing, which to date, we have successfully addressed by demonstrating the value and productivity realized by partnering with Virtusa, and in a couple of instances, by offering discounts for higher volume levels. Overall, these requests have been limited and we believe we will be margin neutral as we leverage efficiencies associated with higher volumes. Of course, we are not immune to market pricing trends and competitive pricing situations, but will continue to steer pricing conversations towards our value proposition.

Looking at new clients, within the quarter, we commenced work with four new clients. Of these, one was in BFSI, and three were in our communications and technology industry group. Our track record of adding new clients provides us with a broader, more diversified base. In the third quarter, our non-top 10 clients grew 19% year-over-year. We finished the quarter with 54 active clients compared with 47 in the third quarter of last year. Sequentially, our active clients declined by three, as seven clients became inactive. These inactive clients were very small, contributing less than 1% of our first half revenue.

Attrition, calculated on a trailing 12 month basis, and excluding a one-time performance-based attrition of 9%, was 24%. The sequential increase in the attrition rate reflects a lower ending headcount, which has the effect of increasing the percentage, as our formula divides the past 12 month employee attrition by ending headcount. In fact, our quarterly attrition actually declined sequentially when looking just at one quarter attrition as a percentage of ending headcount. Calculating annual attrition based on just the third quarter, we find the attrition percentage to be 21%. This is still above our desired target of operating in the high teens and we remain focused on improving employee retention.

Our human resource efforts are focused on creating an environment for our team members, which instills a sense of confidence, trust, motivation, recognition, and growth. We continue to invest in and refine many initiatives to accomplish these objectives. Additionally we have implemented a predictive process that assists us in identifying attrition potential, thereby allowing us to proactively address individual situations. We remain committed to improving retention and are confident that we will continue to make positive progress in the quarters ahead.

Finally, we are pleased to announce the opening of our Hyderabad Campus this past November. This infrastructure will increase our operating leverage over time and will provide us with tax benefits of operating in a Special Economic Zone.

I will now turn the call over to Ranjan, who will provide additional detail regarding our third-quarter operating and financial results, as well as provide current guidance for the March quarter and full fiscal year 2009. Ranjan?

Ranjan Kalia

Thanks Tom, and good evening to everyone. Turning to our results for the quarter. Revenue for the third quarter came in at $44.9 million. This represents year-over-year growth of 6% and a sequential increase of 2%. Our revenue was negatively impacted in the quarter by the depreciation of British pound against the US dollar. On a constant currency basis, our revenue grew 10% year over year and 5% sequentially. Third quarter revenue was $900,000 above the high end of our previous guidance, primarily driven by year-end projects acceleration at select clients.

Our operating income for the quarter was $5.4 million. Operating income decreased by $500,000 year over year, operating margin decreased from 13.8% last year to 12% in our most recent quarter, a 180 basis points year-over-year decline. This includes, a 200 basis point negative impact due to the depreciation of the British pound against the US dollar, which was partially offset by 170 basis points from the depreciation of the Indian rupee against the US dollar; a 100 basis point negative impact from low utilization year over year and higher compensation costs; finally a 50 basis point negative impact due to the build [ph] up SG&A expenses, primarily related to the additional infrastructure in Asia.

Third quarter operating income increased by $4.7 million quarter over quarter, operating margins increased from 1.6% in the second quarter of this year to 12% in our most recent quarter, improving 10.4 percentage [ph] points sequentially. The drivers of the improvement include, a 680 basis point positive impact due to delivery efficiencies, such as high utilization, a lower percentage of work performed on-site, minimized use of subcontractors, and lower discretionary costs; a 200 basis point benefit from SG&A leverage; a 160 basis point benefit from one-time year end project accelerations; finally, foreign exchange had a neutral impact on operating margins quarter over quarter.

Other income increased by $900,000 year over year, driven by $1.3 million increase in foreign currency translation gains. We made a one-time reclassification of our UK to US inter-company payable from short term to long term to further capitalize our UK business. As a result, this reclassification reduces the volatility of the British inter-company balances on income statement going forward. Because the mark to market adjustment is now being reported in the other comprehensive income line item on the balance sheet. We had an income tax expense of approximately $1.1 million in our third quarter, which equates to an effective tax rate of 14.9%. Our year to date effective tax rate is now 2.8% compared to the benefit rate of 67%, discussed on our Q2 earnings call, primarily driven by higher taxable income in US and UK geographies compared to our prior guidance.

Net income for our December quarter was $6.3 million, compared to $5.3 million in the third quarter of last year. This is a 160 basis point improvement year over year. Diluted earnings per share were $0.27 in our third quarter of fiscal 2009, $0.15 above the high end of our prior guidance, primarily driven by higher revenue, and by operating efficiencies such as improved utilization, lower onsite delivery mix, management of discretionary spending, and by foreign transaction gains in other income, which were partially offset by higher tax expense compared to prior guidance.

Turning to the balance sheet. Ending cash was $96 million, inclusive of cash equivalents, short term and long-term investments. Our DSO, including unbilled receivables was 69 days; this was a 7-day improvement from our September quarter.

Cash flows provided by operating activities were $9.9 million in the third quarter. Capital expenditures were $1.9 million in the quarter, inclusive of $800,000 for the construction of our Hyderabad campus. We currently expect our campus spending for the fiscal year to be approximately $6 million. This is down slightly from our prior guidance predominately due to more favorable India rupee to US dollar exchange rates.

We continued our share repurchase program in the quarter and repurchased approximately 623,000 shares for approximately $2.9 million at an average price of $4.63 per share. Year to date, we have repurchased 1.1 million shares for approximately $6.3 million at an average price of $5.83 per share. Depreciation and amortization expense in the quarter was $1.2 million.

Now, let me turn to some additional quarterly metrics beginning with those related to our fiscal third quarter revenue. Revenue by geography was as follows. North America was 71% of revenue, growing 10% year over year. Europe was 27% of our revenue, declining 9% year over year. Excluding BT, our largest client, Europe grew 128% year over year. Other geographies contributed 2% of revenue.

Revenue growth across our industry groups was as follows. BFSI was once again our fastest growing industry group, growing 23% year over year, representing 44% of total revenue in the third quarter. Communications and Technology represented 32% of revenue and declined 15% year over year. Excluding BT, Communications and Technology grew 13% year over year. Media, information and other contributed the remaining 24% of revenue, growing 15% year over year.

Revenue across our services offerings was as follows. IT consulting and implementation services were 33% of revenue and grew 21% year over year. This growth was driven by the expansion of our new clients, which usually begin with IT consulting and implementation services and then transition to application outsourcing. Application outsourcing represented 61% of revenue and was flat year over year reflecting the decline of one large technology client who is moving work to its captive center as expected, coupled with lower spending at BT. Time and material contracts were 73% of revenue, a decrease of 1 percentage point from the prior quarter. Fixed price contracts represented 27% of revenue.

Our top client, BT, contributed 18% of revenue in the quarter. BT revenue declined sequentially due to the depreciation of the British pound against the US dollar. BT was flat quarter over quarter in constant currency. Our top ten clients for the quarter represented 72% of revenue. 84% of our revenue came from clients we have partnered with for more than one year.

Turning to our operating metrics, we ended the quarter with 4,048 global team members, of which 3,767 were IT professionals. The total number of global team members decreased by 249 or 6% compared to the prior quarter. Global utilization, excluding trainees was 73% in our third quarter versus 71% last quarter. We continued to operate in our targeted range of 70% to 75%.

We continue to deliver our services using industry-leading highly-efficient global delivery model. Our build effort mix was 84% offshore and 16% onsite.

Now, I will provide our current guidance for the March quarter and for full fiscal year 2009. As a reminder, all of our numbers are on a US GAAP basis. Revenue in the fourth quarter of fiscal 2009 is expected to be $40.5 million to $42.0 million. Diluted earnings per share in the fourth quarter of fiscal 2009 are expected to be $0.10 to $0.15. Earnings per share assume an average share count of approximately 23.4 million.

For the full fiscal year ending March 31, 2009, our revenue range is currently expected to be $172 million to $173.5 million. Fully diluted earnings per share for fiscal 2009 are expected to be in the range of $0.46 to $0.51. Full year EPS assumes an average share count of approximately 23.4 million.

Our current guidance is based on the following set of assumptions. In other income, we model interest income using an annual effective interest rate of 2.3% on our 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. Indian rupee foreign currency hedge contracts are in place for our fourth quarter, covering 85% of our forecasted expenses denominated in Indian rupees. The blended weighted average Indian rupee to US dollar conversion rate is consistent with our third quarter at 42. The fourth quarter realized Indian rupee conversion rate is sensitive to the changes in the British pound to US dollar conversion rate compared to the spot rate at December 31, 2008. Our fourth quarter guidance assumes a British pound to US dollar conversion rate of 1.475, which does consider the benefit of revenue and costs hedging contracts already in place.

We currently expect to have an effective tax rate for the full fiscal year of 2.8%. 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 fluctuations of foreign currencies against the US 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 fourth quarter guidance. Our new and existing clients are benefiting from our consultative platforming and solution-based approach and we expect this to continue. Our fourth quarter guidance implies a sequential decline in revenue, part of this decrease is driven by year end projects acceleration at select clients we experienced in the third quarter, which is not anticipated to occur in the fourth quarter. Also, the continued weakening of the British pound against the US dollar will impact our fourth quarter revenue. Finally, the seasonality typically associated with clients budgeting processes combined with a difficult economic environment is impacting revenue in the fourth quarter.

The third quarter demonstrated the earnings power of our model. However, in the near term, fourth quarter gross and operating margins are expected to decline from third quarter levels. Lower sequential margins are primarily due to lower projected revenues for the negative impact of the British pound depreciation against the US dollar and some incremental SG&A, which includes absorbing of full quarter impact of our Hyderabad campus and investments in go-to market initiatives. We will continue to remain focused on driving operational efficiencies by managing discretionary spending and optimizing resource utilization.

In summary, we are pleased with the operating improvements we have made in the quarter, and while the environment is challenging, we are strategically aligned with our clients’ initiatives and are meeting their business needs.

I will now turn the call over to the operator to begin Q&A. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from John Maietta with Needham & Company.

John Maietta – Needham & Company

Thanks very much. It sounds like you are saying maybe a little bit of pricing pressure, maybe a little bit of elongated decision-making cycles. But it doesn’t sound like you are saying anything in the way of your broad-based project cancellations or anything like that. Is that a fair statement, Tom or Kris?

Tom Holler

Yes, John. It’s Tom. That’s a fair statement. We haven’t seen any material cancellations of any existing engagements. Obviously, we have projects that come to completion and there were no recourse of business. We are seeing some timing delays due to the calendar year budget cycles.

John Maietta – Needham & Company

Got it. Okay. And then Tom, could you just maybe give one or two examples of where the investment is going to go in customer phasing and business development investment?

Kris Canekeratne

John, it’s Kris. Let me take that. So, clearly we’ve had fairly good success with our value proposition and we find that value proposition of consolidated platforming approach clearly resonates with clients, primarily because it delivers efficiencies at a global price point that certainly is very compelling to clients. So, we believe that by modestly increasing our investments in business development, which would include sales, which would include programs and which would include solutions and our ability to give some of the solutions through client services, will certainly enhance our ability to win additional clients that can create a better foundation moving forward. And as you will know in these difficult times, our ability to differentiate ourselves and to be able to win new clients puts us into a better position moving forward, especially as the economic environment improves in a post-recession environment.

John Maietta – Needham & Company

Got it. Okay, it makes sense. Thanks very much.

Operator

And we will move on to David Cohen with JP Morgan.

David Cohen – JP Morgan

Hi, thanks. I am sorry if I’ve missed this point. But, what was the extra revenue that came into the quarter from clients with additional year-end spending?

Ranjan Kalia

It was approximately $1 million, $900,000 to $1 million.

David Cohen – JP Morgan

Okay. Thank you. And then I just wanted to understand if you can help drill in a little deeper on the conversations you’ve been having with clients and prospects. You are hopeful in terms of some of the pricing, but are you getting a feeling that budget timing issues aside that clients and prospects are looking to do more outsourcing or – as the calendar year unfolds. If you could just talk a little bit more about the tone and the nature of the conversations you are having with clients, that would be great.

Kris Canekeratne

Sure, David. This is Kris. So, clearly what we are finding is a very, very challenging environment and clients are looking primarily at ways whereby they can improve their internal efficiencies and obviously do that through a global delivery model. So, when it comes to budgeting and when it comes to their plans for this year, it is a little premature for us to determine exactly what the final outcomes would be. But based on the tone of the conservation they are pretty confident that on a secular basis in the long term that more and more work would be done through a global delivery model. And I think what’s very exciting for us specifically is that clients are now certainly looking for deriving more efficiencies within their core processes and ways to essentially take a lot of redundancy within their application (inaudible) and net these very closely to core underlying enterprise cross-field [ph]. And that certainly has been resonating well with our clients.

David Cohen – JP Morgan

Should that mean that the pipeline has been picking up?

Kris Canekeratne

So, first and foremost I think as a result of our value proposition, which increases IT efficiencies and improves business outcomes, our pipeline is good and in line with our expectations of closing three to five new accounts per quarter. However, these are tough and challenging times and we are very pleased that we have compelling differentiation, very solid relationships, and outstanding track record of service excellence across our clients. We believe that this will augur well for us moving forward.

David Cohen – JP Morgan

And just a quick follow up on the pricing, if I can. Do you think that because of the value proposition and perhaps your pricing was already competitive, so that may explain (inaudible) how you are able to maintain the bill rate.

Tom Holler

Hi, David. Yes, I think that’s true. I think because we are focused on value, productivity, and business outcomes. So, that helps us support good price points and also the optimal delivery mix that we have on-site and offshore. If you take that into consideration, look at our bill rates on a blended basis, they are very compelling to our clients. So, combining all of that plus the new clients that we’ve added over the last several quarters, have come in at slightly higher bill rates, and they are starting to contribute more meaningfully to revenue.

David Cohen – JP Morgan

Thank you very much.

Operator

And we will move on to Bhavan Suri from William Blair.

Bhavan Suri – William Blair

Hey, guys good quarter.

Kris Canekeratne

Thank you, Bhavan.

Bhavan Suri – William Blair

Couple of quick questions. I know we were talking about (inaudible). Is this – and you talked about expanding its solutions. Are you thinking of specific geos and new verticals? How should we think about that, is this a new area or is it just in kind of BFSI, Communications and tech?

Kris Canekeratne

It’s pretty much in line within our current geos and current industries. And I think when it comes to our value proposition we’ve clearly seen resonance with this whole idea that we can improve the internal efficiencies of our clients by carefully orchestrating and mapping desperate, duplicative applications to a set of core and unified platform that then map directly to core underlying enterprise properties. Now as we do this, Bhavan, there are great opportunities for us to introduce solution. Solutions in the form of cross application and therein lies some good opportunities for us both in new clients as well as expanding existing relationships within our client base. Having said all of this, I wanted to be very careful, these are very challenging and very difficult times that we are in. And we are very focused on doing this in a modest way and making sure that we gain traction from the investments that we make.

Bhavan Suri – William Blair

Turning to another area. On the Satyam front, can you provide any color on any common customers, overlapping customers, and sort of are you guys looking to sort of grow that business, looking to sort of grow your share of any businesses there?

Kris Canekeratne

Let me first give you a little bit of context, then I’ll address this question. So, we are well aware obviously of the Satyam situation. As a matter of fact, our largest Advanced Technology Center and our new 3,000 personnel campus is in Hyderabad, which where they are headquartered too. We do not expect a negative impact to our industry and to us as a result of the Satyam situation. We expect that there could be some long term benefits to us and others in our industry, as clients decide to lower their concentration from Satyam and from others with whom they currently have a disproportional work concentration. There are a few clients where we overlap, and in those situations we have competed against Satyam and others in the past. And moving forward, we feel pretty confident that based on our value proposition that some of that work might move to others and to us as clients look to de-risk their work.

Bhavan Suri – William Blair

Great. And I am going to sneak in one more quick question. Any thoughts at this point about wages and sort of what those increment might look like in India that you are thinking about or that’s – how are you thinking about?

Tom Holler

Yes, this is Tom. Historically, we’ve stayed in line with industry wage increases. As you know April is – we typically give increases. Historically, it has been 12% to 15%. It is our intent to stay within industry. We do think that there will be less wage increases this year relative to historical periods. We have not concluded yet in terms of what levels it will be rolling out. But again, it will be in line with the industry best practices.

Bhavan Suri – William Blair

Great. Thanks, guy.

Kris Canekeratne

Thanks, Bhavan.

Operator

(Operator instructions) We’ll go next to Moshe Katri with Cowen and Company.

Moshe Katri – Cowen and Company

Hi, thanks. I just want to clarify something. Did we have a large currency gain during the quarter?

Ranjan Kalia

Moshe, like we said, we did have a currency gain from INR to US dollars, but then there was an offsetting depreciation because of the British pounds. So, they both offset under operating margin line. So, a neutral impact.

Moshe Katri – Cowen and Company

Okay, and I am asking that because, again, I am trying to kind of reconcile the EPS number for the quarter and the guidance for the March quarter and I am still not getting the meaningful degradation in earnings. So, are we embedding there project deferrals, are you embedding client loss? Maybe you can kind of give us the different factors that are bringing down the earnings number on a sequential basis as drastically as you are guiding to.

Ranjan Kalia

Sure. So, I guess, maybe your first question, it was really related to Q4. Yes, there will be about $1.5 million sequential negative impact due to the declining British pound to US dollar. And there is another $1 million worth of revenue impact that goes away because of acceleration of the clients’ project that we won’t really see it in Q4. And then lastly it’s fairly $1 million that we’ve allocated towards the macroeconomic demand that’s out there that will have an impact on our revenue. So, those three really impact on the revenue line item, taking that down to the – bottom line, if you really look at it we need to absorb almost to the midpoint (inaudible) $3.6 million revenue impact, but we are really preserving a piece of that because of the operational efficiency programs that we worked out in the first half. We are still going to see benefits of those into the second half. So, we think the margins on the gross margin line item will probably still hover around 40%.

Moshe Katri – Cowen and Company

Okay, understood. And then Kris can you kind of share what is your view on sales cycles and then ’09 budgets. And then how should we think about growth going out maybe two, three quarters going forward? I am talking about sequential growth.

Kris Canekeratne

All right. Let me start with ’09 budget. Clearly, Moshe, it’s pre-mature and early for us to comment on ’09 budget. In the past, a lot of the ’09 budgets got finalized later in the first calendar quarter. We believe that given the economic environment it will have an impact where budgets could be finalized potentially later. Once they are finalized, we feel that they will have very, very close range [ph] in terms of how they actually spend and dispense of these budgets. What we feel and based on some of the conservations we’ve had, is that long term more work will move towards a global delivery model. So, whether the budgets come in at about the same level, slightly down, slightly up, we don’t know. But what we are very confident about is that on a secular basis, more work will move to a global delivery model. As you will know, we are not in position today to provide you with guidance beyond our fourth quarter and the full fiscal year. We will do so when we have our earnings call at the end of our fourth quarter, at which point we expect that we would guide for the full fiscal year 2010. And I think your last question was about sales and about the pipeline. Because of our value proposition, which primarily is focused on increasing IT efficiencies and improving business outcomes for our clients, our pipeline is good and in line with our expectations of closing three to five new clients per quarter.

Moshe Katri – Cowen and Company

Okay, and that’s fair. Can you give us a feel on – I mean going back to I think you’ve touched a bit on BT. What should we budget or model for BT at an ongoing basis. I mean, do you think that BT continues to be sequentially flat down the road? And obviously we heard that BT is going through vendor consolidation and BT continues to have some issues here.

Kris Canekeratne

Yes, so let me spend a moment on BT. First and foremost our relationship with BT continues to be very strong and we remain a close strategic partner. Our focus and I think this really, really bodes well for us around the whole idea about software platform is squarely BT’s strategic direction. So, obviously I think that’s very synergistic between our value proposition and BT’s strategic direction. The economic environment continues to be challenging, and we expect that this will have an impact on BT on our Q4 revenue. We have included that into our guidance. And as you well know, Moshe, BT has contracted minimum spend of those with us, and we fully expect and are confident that BT will honor those commitments.

Moshe Katri – Cowen and Company

Can you remind us; is the majority of the BT contracted at fixed price states or TNM?

Tom Holler

The contracts that we have with BT, I don't know the exact metric, but it is probably 50-50.

Moshe Katri – Cowen and Company

Okay. And then under a scenario where BT is demanding some pretty aggressive pricing from customers, should we assume that your focus is going to be more on margins rather than on revenue growth down the road? I mean, at what point you will focus more on margins and not on revenue growth?

Tom Holler

You are referring to BT specifically, Moshe?

Moshe Katri – Cowen and Company

Yes.

Tom Holler

Yes? So clearly like with any client we look at gaining efficiencies over time. And British Telecom will be no different. As we get up the experience curve in certain areas that we're working on, we fund efficiencies and we look to leverage those efficiencies to preserve margin absolutely.

Moshe Katri – Cowen and Company

Okay, and last question, what about the free cash flow for the quarter and then what do you expect to exit the year in terms of free cash flow levels and cash levels? Thanks.

Ranjan Kalia

Moshe, free cash flow was about $8 million, and then, like I said it was $9.9 million from operations, and then another $1.9 million in CapEx, and net is $8.8 million.

Moshe Katri – Cowen and Company

Okay, how about what you are anticipating to exit the year with in terms of free cash flows and cash balance?

Ranjan Kalia

So we haven't guided on that specifically for our Q4 but both our cash from operations as well as free cash flow should be positive in Q4.

Moshe Katri – Cowen and Company

All right. Thank you.

Operator

Next we will hear from Vincent Colicchio with Noble Financials.

Vincent Colicchio – Noble Financials

Kris, can you address the financial condition of your existing client base? Are there any potential financial distress issues you need to worry about?

Kris Canekeratne

So Vince, clearly it is an extremely challenging environment and we have been very fortunate in that we have worked with many of our clients who have been, relative to their peers, very healthy and strong; and even in these difficult environments have shown that they have a meaningful business and strong balance sheets and great clients. So we have been very fortunate in that regard. Having said that, every once in a while we will find some smaller clients of ours that may have difficult – they might have some difficulties and a lot of that is already anticipated and included in our guidance.

Tom, would you like to add anything to that?

Tom Holler

Well, I think for the most part, our larger clients seem to have relatively stable business models, but we can’t predict the outcome of the economy going forward necessarily on their financial situations. We do know that British Telecom is cutting back on spend and so we are well aware of that and watching that very carefully.

Vincent Colicchio – Noble Financials

As far as your delivery mix, you have done a nice job moving more work offshore. Are we kind of tapped out in that regard or is there more of a slack there in the system?

Kris Canekeratne

It is a great question I think. So Vince, clearly we have traditionally had a very strong service mix. Over 80% of our services for several years now have been performed out of our advanced technology centers in India and in Sri Lanka. We have run anywhere between 16% and probably 18% in the recent past in terms of on-site, 82% to 84% off shore. We believe that that is a reasonable mix for us. It is strong; there are always opportunities to do even better than that. But we feel that from our model and the perspective that we have that the mix that we currently operate at is a good mix and it is certainly one that provides our clients pretty significant benefits.

Vincent Colicchio – Noble Financials

One last question and this is for Ranjan. I missed what you said in terms of tax rate guidance for 4Q; and also if you could help us with fiscal 2010, it would be great.

Ranjan Kalia

So it is effective tax rate of 2.8% for Q4. Next year, we are specifically not giving guidance, but from a modeling perspective, if that is what you are asking, I suggest (inaudible) as a tax provision.

Vincent Colicchio – Noble Financials

Thanks. Nice quarter, guys.

Operator

Tim Brown with Roth Capital has our next question.

Tim Brown – Roth Capital

Thanks. Nice quarter, guys. Just a couple of questions. I think Ranjan you might have gone over this, but can you go over the improvement in the gross margins again from Q2 to Q3 and was any of that foreign exchange or how much of it was foreign exchange?

Ranjan Kalia

Okay, sure. So if you look at it, I think specifically talking about gross margins, we went from 35.6 to 43.7. That was about 810 basis points. In fact, if you look at it, our cost of sales really decreased by almost about $3 million. About $900,000 of that $3 million is really FX-related and the other $2.1 million is business efficiencies that we hope will be sustainable going forward. So, from a long-term perspective, we do believe the 43.7 is going to be under pressure in Q4 because of revenue decline and because we are also modeling to use the on-site offsite ratio at historical rates, so I would suggest guiding it to using the 40% number.

Tim Brown – Roth Capital

Okay. The $900,000 related to foreign exchange, I mean that is at an effective rate of 42 rupees?

Ranjan Kalia

Yes, the effective rate is 42 but that includes some unhedged. So at the beginning of the quarter, we only hedged 85%, so that has an impact over the unhedged piece in it too.

Tim Brown – Roth Capital

So you got a little bit of a benefit there.

Ranjan Kalia

Yes.

Tim Brown – Roth Capital

Okay. And then just going out into just the year 2010 and I assume the effective rate there is going to be moving up. I mean, is that a fair assumption?

Ranjan Kalia

Yes, I would say that is a fair assumption and I would say think of it more so in the second half of the year versus the first half of the year.

Tim Brown – Roth Capital

Where you will really start to see the benefit?

Ranjan Kalia

Yes.

Tim Brown – Roth Capital

Okay. And then just two little things. In long term investments and as they went up $8 million, was there anything else there in the auction rate securities that has changed?

Ranjan Kalia

No, it is still – the ARS is still 7.7%. So there is no change in that.

Tim Brown – Roth Capital

Okay. And then finally, just on fiscal year 2010 I just wanted you to tell out your thoughts on capital expenditures now that – it looks like we're having slower growth this year and what is your thoughts on building out campuses in fiscal year 2010?

Kris Canekeratne

We are going to build out the campus as the growth needs come in. We have built the shell and the interior we are really trying to align it with the growth. So we are going to try to manage our cash flow on that.

Tim Brown – Roth Capital

Okay. Great, thanks.

Operator

Now we will hear from Joseph Foresi of Janney Montgomery Scott.

Joseph Foresi – Janney Montgomery Scott

Hi, guys. I think you talked about there being four new clients that sort of contributed to revenue here. I was wondering, is it accurate that they are new clients and maybe you could just give us some idea on what drives their decision to do work with you guys.

Kris Canekeratne

Sure. Well, this is Kris. I will start, and then I am sure Tom will add a little more to this. So, yes, we had four new clients in the quarter that contributed revenue. We announce a new client once a client commences work with us and we derive revenue from them. Many of our clients, we find are very focused on looking for ways to improve their internal IT efficiencies and let me spend a moment on that because it could mean a lot of things. Just moving the work offshore could mean improving IT efficiencies from a cost perspective. For many of the clients that we work with have already done a fair amount of moving applications stove pipes offshore and have derived the benefits of labor arbitrage and cost improvement.

What we find today, precipitated by the current economic environment is that clients are very focused on looking for ways to improve their internal IT efficiencies by stopping or shutting down redundant application stove pipes they are very often for an almost identical enterprise process. We find that there are multiple applications with a significant amount of overlap. We have a lot of expertise, well over a decade of expertise and experience. We go in, we very quickly analyze the spend that enterprise does make within a core enterprise process, which could be something like (inaudible) market, it could be lead to cash, et cetera; and then as we analyze that spend, we identify a lot of redundant and aging application stove pipes. Our focus then is to work with our clients to harvest out some of those applications that are best in class and then start consolidating and rationalizing those applications that we can map a core platform to a core enterprise process. And this is clearly a way in which our clients can derive significantly more value and benefit and pass the business outcomes, as opposed to just moving a bunch of redundant application stove pipes offshore.

Joseph Foresi – Janney Montgomery Scott

So is that a short-term engagement once you fix the applications or make them more efficient and the relationship terminates or is that a long-term one where they then allow you to maintain other applications?

Kris Canekeratne

What typically happens is once we get in and we start this work, it becomes a very significant long-term relationship, because as we move these applications and we evolve them to more of a platform, we end up continuing to maintain and support and enhance those platforms.

Joseph Foresi – Janney Montgomery Scott

I think you guys also talked about one client that was moving work to captive. I think most of the turns have been away from captives. Maybe you could just talk a little bit as to why that was taking place.

Tom Holler

You know, I can't speak directly on what is motivating the client. I think better left to the client. I would agree that what we see is the reverse trend or hybrids where clients or enterprises may want to have some balance. In this particular case, this is a long-standing multi-year relationship we have had, good relationship; and for their reasons, which I think is not fair to speculate on, they are migrating that work over this quarter and the next two quarters into their own captive.

Joseph Foresi – Janney Montgomery Scott

Is it possible they are looking to sell their captive?

Tom Holler

Again, I hate to speculate. I do not expect that but I would be speculating to comment on their motivation.

Joseph Foresi – Janney Montgomery Scott

All right. Fair enough. And then just on the BT relationship, I know you guys have minimum volume commitments. Are we close to that level or are we way ahead of that level, how should we think about that business going forward?

Tom Holler

Yes, currently, we are running great at above that run rate of the annualized quarterly spend.

Joseph Foresi – Janney Montgomery Scott

Sure. And then one last one for you guys. I know you talked about the movement into the new facilities. Is it accurate to say that the facilities are built but not yet filled?

Tom Holler

That is correct. Yes, we have the infrastructure in place, the shell and it can house 3,000 employees and we have just started moving in, in November. So there is a lot of headroom in that infrastructure going forward.

Joseph Foresi – Janney Montgomery Scott

I'm going to sneak one last one in. On the acquisition front, I know you guys got a lot of cash. Are you still looking around, anything in particular you are targeting?

Kris Canekeratne

Well, we certainly do consider and look at small tuck-in acquisitions that will fit our strategy and that is something that we will keep an eye out for.

Operator

And it appears that is all the time we have for questions today. Mr. Canekeratne, I will turn the conference back to you for closing marks.

Kris Canekeratne

Thank you. Thank you for joining us today. I would like to say a couple of things before we conclude. Clearly, we are very pleased with the progress we made during our third quarter, particularly in our operational improvement. The challenging economic environment will have an impact on our clients and their planning processes, which we have taken into consideration in our fourth quarter guidance. We are mindful of the challenges, but at the same time, we are well-positioned. We have a terrific value proposition, an outstanding group of clients, a solid and dedicated team of global professionals, a track record of exceptional service and an outstanding balance sheet. All of this will serve us well for the long term.

Finally, I want to take a moment to recognize and thank our global team members, who have worked diligently to create competitive advantage for our clients. Thank you.

Thank you all for joining our call today; and we look forward to working with you.

Operator

Again, that does conclude our conference. We do thank you for joining us.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Virtusa Corporation F3Q09 (Qtr End 12/31/08) Earnings Call Transcript
This Transcript
All Transcripts