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iSoftStone Holdings Limited (NYSE:ISS)

Q1 2013 Earnings Conference Call

May 17, 2013 8:00 am ET

Executives

Victor Kuo – Investor Relations, Christensen

Tianwen Liu – Chairman and Chief Executive Officer

Xiaosong Zhang – Chief Financial Officer

Analysts

Amit Singh – Jefferies LLC

Operator

Ladies and gentlemen, thank you for standing by and welcome to the iSoftStone Q1 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. (Operator Instructions) I must advise you that this conference is being recorded today, Friday 17 of May 2013.

I would now like to turn the time over to your first speaker for today, Mr. Victor Kuo. Thank you, sir. Please go ahead.

Victor Kuo

Thank you. Our team today includes TW Liu, Chairman and CEO and Jonathan Zhang, Chief Financial Officer. First, I will remind you about forward-looking information. Our conference call may include forward-looking statements made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Although, we believe that the expectations reflected in our forward-looking statements are reasonable as of today. Those statements are subject to risks and uncertainties that could cause the actual results to differ dramatically for those projected. There can be no assurance that those expectations will prove to be correct. Informations about the risks associated with investing in iSoftStone is included in our filings with the Securities and Exchange Commission, which we encourage you to review before making investment decision.

The Company does not assume any obligations to update any forward-looking statements as a result of new information, future events, changes in market conditions or otherwise except as required by law. The Company will also discuss non-GAAP measures, which are more completely explained and reconciled to the most comparable measures reported under Generally Accepted Accounting Principles in the Company’s earnings release and filings with the SEC. You are reminded that such non-GAAP measures should not be viewed in isolation or as an alternative to the equivalent GAAP measures and that non-GAAP measures are not uniformly defined by all companies including those in the IT industry.

The Company will cover the main points of the release then go to your questions. First, Mr. Liu, Chairman and CEO.

Tianwen Liu

Thank you, Victor. Hello everyone. Thank you for joining the call. We are pleased with the financial results achieved during the first quarter of 2013. Net revenue for the quarter was $96 million, up 11% from the same quarter last year. Both revenue and income are in line with our expectations.

In terms of geographic markets, we continued to experience a strong growth from the domestic market. During the quarter our Greater China business increased 28% year-over-year. Net revenue from the U.S., European and Japanese markets declined during the quarter.

As we outlined in our Annual Report, we expect the U.S. and the European markets will continue to develop at a slow pace in the near future, and the Japanese market will take a longer time to recover.

Both Consulting & Solutions business and BPO services experienced a robust growth, up 32% and 62% year-over-year respectively. The revenue increases in both the service lines were due to the new project wins. Our Consulting & Solutions business accounts for 55% of last quarter’s revenue and remains one of our fast growth and high margin business drivers. We believe this business has the potential to add up substantial value for both our clients and our shareholders.

Looking at the industry’s verticals, net revenues from technology and communication sectors were slightly down during the quarter, as a result of soft demand from some clients in the U.S. and weak market conditions in Europe and Japan. However, we take some comfort net revenue growth from JV with Huawei, has started to pick up quickly and should offset the industry's overall decline.

ETP sector, especially the public sector, achieved a tremendous year-over-year growth of 82%, primarily due to winning new projects. Net revenue from BFSI business also increased 19% mainly from newly added business in the domestic banking sector.

Q1 is the first quarter of operations for JV, joint venture with Huawei. The operation was established and we are making good progress with both partners delivering essentially as expected. We believe the JV should help improve iSoftStone’s revenue growth, profit margin and cash flow this year.

For the rest of the year, we will continue to improve our business operations. More specifically we will stay focused on expanding our key business drivers including a JV with Huawei, BFSI sector and the Smart business projects.

We will continue to work aggressively to improve margin and cash flow and we will continue to invest in emerging technologies such as big data, mobile, social networking, and cloud computing to help our clients accelerate their business transformations.

Although the markets continue to be challenging, our strategy remains focused on opportunities and that should create a long-term growth and value. We expect to create a satisfied client, higher employee performance, and greater value for our shareholders in 2013 and in the years ahead.

Next, we will have our CFO, Jonathan to comment on our financial results. Jonathan, please?

Xiaosong Zhang

Thank you, TW. Good morning and good evening, everyone. Thank you all for attending our conference call today. Our operating results for the first quarter 2013 were in line with our estimates provided early March on both top line and bottom line.

Our revenue for the quarter was $95.9 million, up by 11% from the same quarter last year. The overall year-on-year growth was mainly contributed by 31.5% growth from our solution based business, driven by new wins of public projects, supplemented by 61.8% growth from BPO business due to new customer wins, and offset by a slight decline 0.6% in IT services caused by reduction of demand from certain customers.

Once again, 98.8% of the overall business growth was organic. Comparing to a year ago, we are doing well in the domestic China market with 27.8% growth in the first quarter 2013.

At the meantime, our global business declined by 13.7% on a year-over-year basis due to challenges explained by TW earlier, mainly from business volume reduction from U.S. and the European customers, and also the political tension between Japan and China.

During the last quarter, we saw slowing down in declining pace in our global business and started to see certain stabilization trend on a sequential basis. However, we’ll remain cautious on any new development in the global market.

In terms of industry verticals benefited from strong demand from domestic banking and public clients, we experienced strong growth in the BFSI and ETP verticals during the quarter and anticipate these drivers will continue to contribute in our future growth.

As our joint venture with Huawei was in full operation during the later part of the quarter, we expect our communication business will ramp at a faster pace during the following quarters.

Non-GAAP gross profit margin was at 32.5% for the quarter, flat compared to the first quarter of 2012. With a higher cost structure, we carefully managed our cost base during the quarter as it was the season low during the Chinese New Year holiday through efforts in tightening cost control measures, our business mix adjustments and productivity and the efficiency improvements. We felt that there were no significant changes in the cost environment comparing to the fourth quarter of 2012 on the sequential basis.

Our non-GAAP operating expenses were at $24.1 million or 25.2% of revenue compared to 23.3% of revenue for the same quarter in 2012, an increase of 1.9% of revenue year-on-year due to higher G&A and R&D expenses. We had higher cost base as the salary increased for G&A personnel in 2012 was effective in July 2012.

The G&A expense for the first quarter of 2013 was at very comparable level compared to the fourth quarter of 2012. The higher R&D expenditures during the quarter reflected the Company’s efforts in developing capabilities in Smart City business, cloud computing, mobile applications, our business intelligence for banking and automobile industry specific solutions et cetera.

Our non-GAAP net profit margin was at 5.8% in the first quarter of 2013, 2.7% lower than that in the first quarter of 2012 mainly due to the above mentioned higher operating costs and higher interest expenses incurred on increased banking loans.

Next on cash flow, operating cash flow was a negative $17.3 million for the first quarter 2013, an improvement of $1.8 million compared to $19.1 million negative in the same quarter last year. The negative operating cash flow situation in first quarter was part of our business seasonality and has been very consistent pattern in our annual business cycle for the past many years. With the management’s focus on improving the Company’s cash flow, we are confident that the Company’s operating cash flow will be significantly improved in the rest of the 2013 compared to last year.

To meet the funding needs to support the Company’s business growth, we managed to draw down an additional net $4.8 million loan during the first quarter and the interest rate on the outstanding balances ranges from 6% to 6.6% annually. We also received RMB 25 million or approximately $4 million from Huawei as its capital contribution to the joint venture during the first quarter.

Next, I’d like to provide some color on the acquisition transaction we announced in the recent development section of our press release. First of all, the decision was made by management and our Board to support the Company’s business growth and to enhance the financial stability in both short-term and the long-term. Also the decision was made under our great confidence in our future business growth and cash flow improvement.

Upon completion of this transaction, we will effectively own the property, which is currently under lease by iSoftStone as its headquarter building for 10 years. We will start to enjoy modest P&L and cash flow benefits immediately in short-term from savings on lease payment versus paying the interest and the benefit was significantly expanded in the medium-term onward.

As we are in the People Business and the facility cost is a very significant component within our cost structure. By owning the property we eliminate the uncertainty of future increase in rental cost, which will enable the Company to maintain cost competitiveness and flexibility in the future.

When developing our forecast to test our ability to serve debt, we apply very conservative assumptions and perform stress tests under different extreme scenarios and believe that our future cash flow generated from the operations will be adequate and safe enough to cover the interest and the principal payments required in the coming years. And the financial condition will remain healthy and sound.

We plan to payoff the debt in 10 years. Based on the current economic environment in China and existing government policy to support our industry, we feel confident that the Company should be able to renew the mid to long-term debt upon maturity and maintain adequate short-term lines of credit in case of temporary funding needs.

With that, we are happy to take your questions. Operator, please.

Question-and-Answer Session

Operator

Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions) Your first question comes from Jason Kupferberg from Jefferies. Please ask the question.

Amit Singh – Jefferies LLC

Hi. This is Amit Singh for Jason. I just want to start talking about, start to talk on your non-GAAP margin expectations for the fiscal year and maybe next quarter. And while you’re speaking about it, if you can just update us on the operation of the JV, how it’s going and if anything has changed regarding the expectations for expenses related to the whole formation of the JV?

Xiaosong Zhang

Hi, this is Jonathan. I will take the first question and I will leave the JV related answer to TW. Based on the guidance that we provided for the second quarter, we anticipate for the non-GAAP gross margin at 34.2% and the non-GAAP operating margin would be at 9.7% and the net margin on the non-GAAP basis is at 7.2% based on 15% effective income tax rate, TW?

Tianwen Liu

Yeah, regarding the JV with Huawei, right, so far, everything is moving in the right direction. The official operations started early this year and we already have started to realize the margin due to this price increase promised by Huawei, based on agreement, and also, because of the JV, Huawei starting the consolidation of the vendors. So we’re enjoying the team. This is a new headcount with POs from our peers. That will help us boost our revenue. And also another thing is payment. Probably we are going to recognize, starting to recognize the first payment starting from next quarter, because this is only starting this quarter, the job, and they’re supposed to pay quarterly. So we believe we’re going to just enjoy the payment first cycle starting from this quarter. We say everything is in line with our expectation. So far we’re very happy regarding this JV.

Amit Singh – Jefferies LLC

All right. Thank you. And just going back to the top line, you mentioned that you’re seeing some delays or some weakness in the U.S. market. Is that specific to any particular client? And if it is, could you provide more detail on the vertical of that client?

Tianwen Liu

Our major customers are from two verticals; one is technology and communications. I see a couple of large clients. They are starting a new slope this year. So we see some soft demand from them and we are closely, to watch the direction of next quarter. Hopefully, those demands are going to come back. And also we experienced some slowness from financial sector too. So this is mainly from a U.S. customer. Japan, as we talked in last couple of quarters, Japan business is still very flat. And even though we are making progress in couple of larger accounts, technology accounts, but overall situation is still very flat.

Amit Singh – Jefferies LLC

All right. Thank you. And just finally, if you could talk about the thought process that you went through as you made the decision for this sale and purchase agreement? And you used some cash and there was some debt involved, and how did you balance that against the decisions for other M&A per se or maybe share buyback?

Xiaosong Zhang

Actually for acquiring the equity interest of the holding company of the property we have gone through a very detailed financial analysis forecast. As I mentioned earlier, also we performed a very strict stress test. And because, given the benefit is very clear, so management proposed to the Board instead of leasing the property would like to take the ownership of the building.

So then we went out, hired the independent valuer. Jones Lang did an independent valuation. Based on the valuation result we went out and negotiated the price which is, we believe, very attractive, significantly lower than the appraised value. And then we negotiated the sale and purchase agreement. And then we went back to the Board for approval. In the meantime, we went out to different local commercial banks to apply for mid-term loans. So far we have made very good progress. That will help us to finance the acquisition.

Amit Singh – Jefferies LLC

All right. Thank you very much.

Xiaosong Zhang

Thank you.

Operator

(Operator Instructions) There is no further question on the line at this time. I would now like to hand the time back to management. Please continue.

Tianwen Liu

Thank you for attending the call. Good-bye from Beijing.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.

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