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Syntel, Inc. (NASDAQ:SYNT)

Q2 2009 Earnings Call Transcript

July 29, 2009 10:00 am ET

Executives

David Mackey – SVP, Finance

Bharat Desai – Chairman and Co-founder

Keshav Murugesh – President and CEO

Arvind Godbole – CFO and Chief Information Security Officer

Analysts

Bryan Keane – Credit Suisse

Brian Kinstlinger – Sidoti & Company

Joseph Foresi – Janney Montgomery Scott

Joseph Vafi – Jefferies & Company

David Cohen – JPMorgan

Vincent Colicchio – Noble Financial Group

Bhavan Suri – William Blair & Company

Ed Caso – Wells Fargo Securities

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Syntel second quarter 2009 conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator instructions) As a reminder, this call is being recorded today Wednesday, July 29, 2009.

I will now turn the call over to David Mackey, Syntel's Senior Vice President of Finance. Please go ahead sir.

David Mackey

Thank you and good morning everyone. Syntel's second quarter earnings release crossed Business Wire at 8:30 AM today. It's also available on our website at www.syntelinc.com. Before we begin, I'd like to remind you that some of the comments made on today's call and responses to questions may contain forward-looking statements.

These statements are subject to the risks and uncertainties described in the Company's earnings release and other filings with the SEC.

I'll now turn the call over to Syntel's Chairman, Bharat Desai. Bharat?

Bharat Desai

Thanks, David. Good morning everybody and thank you for joining us today. While the second quarter of 2009, did not bring a reacceleration of business momentum, we were encouraged with the improved stability and increased activity levels as the quarter progressed.

Although our clients remained cautious in their decision making, they are beginning to discuss longer-term cost and efficiency initiatives, which are aligned with their strategic objectives. Maintenance and KPO services will continue to be the primary beneficiary of these discussions.

Discretionary project work remains sidelined, which has been impacting our global testing and e-business service offerings.

While we continued to help our clients manage through this difficult economic environment, one thing that has become clear is the resiliency of the offshore business model.

Despite demand softness over the past three quarters, the abundance of margin levers and natural supply and demand hatched hedges have allowed our business to produce superior operating margins, profits, and cash flow. This has been done without sacrificing our key investments in domain expertise, differentiated services, and world-class infrastructure.

Keshav and his team are focused on helping our clients position their business models for long-term success and in doing so helping Syntel create sustainable value for all its key stakeholders.

I will now turn the call over Keshav Murugesh Syntel’s Chief Executive Officer and then to Arvind Godbole, Syntel’s Chief Financial Officer to provide details on our operational and financial performance. Keshav?

Keshav Murugesh

Thanks, Bharat. Good morning everyone and welcome. Overall, we are pleased with our second quarter operational and financial performance. While the second quarter did bring some positive signs in the form of improved business stability, consistent pricing, and increased client interactions, we have yet to see strong evidence of an overall pick up in demand.

Cost reduction remains the central theme to these discussions. But increasingly both existing and new clients are willing to discuss incremental projects, which provide quick and certain returns. For the most part discretionary products remain sidelined and we would not expect a positive change in discretionary work before the end of 2009.

These pending trends were directly reflected in our second-quarter revenue performance. Syntel’s top line was adversely impacted by $2.2 million, due to the successful completion of e-Business projects early in the quarter. Offsetting this drop was an increase of $3.3 million in maintenance revenues and $1.5 million in new development projects and staffing assignments.

Syntel also received a $1.1 million revenue benefit from the appreciation in the Indian rupees during the second quarter. Within our KPO business the continued ramp down of an India-based client was offset by volume increases, with existing customers and the addition of one new client.

On a net basis, our revenues grew $3.7 million or 4% sequentially. The real positive coming out of the second quarter is that based on the improved economic stability and our current visibility levels, we believe the second-quarter revenue run rate will represent a minimum level for the remainder of 2009.

This of course is baring unforeseen changes in the overall economy and client specific behaviors. We have raised the low end of our guidance from $385 million to $395 million and our visibility to the low end of guidance now stands at 90%. From a margin standpoint, the second quarter was adversely impacted by a 4% appreciation in the rupees.

Including the negative impact of the FAS 52 balance sheet revaluation in SG&A, this had the effect of reducing our operating margins by 280 basis points and overall EPS by $0.04 a share. Despite this headwind Syntel was able to successfully maintain our operating margins by managing operating efficiency and delivering productivity.

Headcount reduced during the quarter based on the ramp down of our India-base KPO clients and we ended the quarter down 400 employees versus the first quarter. Given current utilization levels and revenue visibility, we believe our headcount numbers will remain stable in the near future.

Our key investment programs for 2009 remain intact with European expansion key domain hiring, targeted service offerings, and enhanced infrastructure all underway. Many of these investments are gaining both client and industry attention. In the past few quarters Center has been recognized with numerous media and industry awards.

Among others we were named one of the best managed global outsourcers by the Black Book of Outsourcing. Syntel was also ranked among the top outsourcing providers by Healthcare Informatics, American Banker Magazine, Global Services Magazine, and The International Association of Outsourcing Professionals.

I would now like to turn the call over to Arvind Godbole, Syntel’s Chief Financial Officer who will discuss our financial performance. Arvind?

Arvind Godbole

Thanks, Keshav and good morning. After my comments, we'll open the call to questions. While the environment continues to be challenging, we had overall very good result in this quarter.

As Keshav mentioned, our revenue for the second quarter, which came in at $100.1 million was up down, 3% from $103.4 million in the prior year, but increased 4% sequentially from $96.4 million. At a high level our revenue for the quarter improved due to improved maintenance revenues and appreciation in the Indian rupee.

On a business segment basis, in the second quarter Applications Outsourcing accounted for 72% of revenues, KPO was 19%, e-Business represented 7%, and Team Sourcing was 2%. On a vertical basis, Syntel is pleased to report that our growth in the second quarter was broad-based with each and every target vertical growing sequentially.

During the quarter, financial services contributed 55% with insurance at 19%, health care 15%, automotive 3%, and other was 8%. Due to modest growth in fewer of our larger relationships, customer concentration increased slightly during the quarter. Syntel’s top three clients represented 48% of revenue, top five contributed 61%, and top 10 came in at 75%.

The fixed-price component of our business also increased and represented 47% of revenue for the quarter. Our gross margin expanded 170 basis points sequentially and stood at 48.2% compared to 41.1% in the year ago period and 46.5% in quarter one of 2009.

By business segment, gross margin for Application Outsourcing was 43.4%, KPO was 64.7%, e-Business was 51.5%, and Team Sourcing 52%. Sequentially, our gross margins were negatively impacted by a 4% appreciation in the Indian rupee. This however was more than offset by our efforts to improve delivery productivity and utilization.

Moving down the income statement, our selling general and administrative expenses were 20.8% in the second quarter of 2009 compared to 19.1% in the prior year period and 19.4% in the first quarter.

Our SG&A levels were impacted by unfavorable currency moment during the quarter, which increased our operational rupee-based cost and also resulted in a foreign exchange transactional loss of $1.9 million. Partially offsetting the negative currency impacts on the operating margins were gains on hedging positions, which increased the other income by $0.2 million.

Net income for the second quarter was $25.1 million or $0.61 per diluted share compared to $17.4 million or $0.42 per share in the prior year period, and $27.3 million or $0.66 per share in the previous quarter. From a comparative perspective, it is important to remember that our first-quarter profits were increased by $4.3 million or $0.10 per share, due to the reversal of lower tax results, which are no longer required.

Our margin expansion is a testament to our strong financial and operational discipline. Now, we turn our attention to a few key balance sheet and operational items. Our total cash and short-term investments on June 30 were $158.6 million, an increase of $20.6 million from the first quarter.

DSO levels slightly increased to 55 days from 51 days reported last quarter. Our capital spending during the second quarter was $2.9 million. We ended the quarter with a total head count of 11,344 of which 3,813 were assigned to KPO. Our billable headcount was 1,659 on-site and 8,841 offshore for a total of 10,500.

Utilizing levels continued to be healthy at 93% on-site, 77% offshore, and 80% globally. Turning to our operational metrics, our delivery mix stayed unchanged from the previous quarter at 18% on-site, and 82% offshore. Voluntary attrition during the quarter was 9.9%. Syntel added three new customers in Q2 and two new hunting licenses, which takes the total number of prepared partnerships to 96.

I will now conclude our update today with guidance. Syntel now expects 2009 revenues to be in the range of $395 million to $415 million. We have also increased our EPS guidance and now expect EPS in the range of $2.40 to $2.50 for 2009, up from a range of $2.12 to $2.42 last quarter.

This is based on our second-quarter performance, current visibility level, and an exchange rate of rupees 48.7 to the dollar.

We would now like to open the call for a question-and-answer session. Operator?

Question-and-Answer Session

Operator

(Operator instructions) We will take our first question from Bryan Keane at Credit Suisse. Please go ahead.

Bryan Keane – Credit Suisse

Hi, good morning and congratulations on the results.

Bharat Desai

Thank you, Bryan.

Bryan Keane – Credit Suisse

If demand starts to pick back up, when do you guys anticipate you'll have to start picking up the headcount growth?

Bharat Desai

Well that is a great question Bryan and I think, first thing is obviously we are preparing on the basis that growth in demand will take place, you know somewhere towards the end of this year. So, I think what we are doing now is making sure that based on the signals we are receiving that we are getting our infrastructure ready, getting each of our offerings in place and in terms of our ability to accelerate hiring, you know we would be ready. So we already have our programs intact with the campuses and therefore our ability to bring in new people both on the – you know from a college perspective, as well as from a lateral perspective could happened very quickly, as soon as we see the kind of signals.

Bryan Keane – Credit Suisse

Okay. What happens to operating margins in that kind of an environment? The margins have been very solid here at 27%, even higher than that, but hovering around that 27% range, are we able to maintain margin on should we expect margins to fall if demand picks up?

Bharat Desai

I'll take that Bryan. I think as we have been saying in the past, you know we are in a bit of a unique situation now where the softness in the demand environment has actually created opportunities in both currency and the supply side of our business. And I think it is logical to expect that when demand does pickup for the industry as a whole, we would start to see some margin pressure in this industry. So, a lot of the things that have been going positive for us in terms of the depreciating rupee, in terms of downward pressure on wages, in terms of easy access to talent, I would expect some of those things to become a little bit more difficult, and as a result one of the byproducts of top line growth would be some margin pressure.

Bryan Keane – Credit Suisse

Okay and just final one from me. Just updates on pricing, I know we saw pricing hit kind of in the beginning of this year, but have you seen that lessen a little bit and what you think about pricing going forward?

Bharat Desai

Our pricing in the second quarter Bryan was flat relative to the first quarter. So, I think we by and large see the stabilization. Our expectation is that pricing will remain stable for the balance of the year, although we do have to watch for potential client specific impacts and changes in the overall economy, but in terms of visibility right now we expect the unit pricing to be relatively stable.

Bryan Keane – Credit Suisse

And do you think next year the beginning of the year, will see another – probably another ratcheting down in price or do you see potentially a stable pricing environment even as we go into next year's budget?

Bharat Desai

I think – I am sorry, go ahead Keshav.

Keshav Murugesh

I thought I will just take that. You know, I think, from our perspective we believe that most of the pricing related discussions are now completed and done with. Unless we see a significant change or deterioration in the overall economic environment I don't believe we are going to be having those kinds of discussions going forward. And having said that, I think from a Syntel perspective, I think what we focus on is on the value, as well as the total cost of operations that we enable our clients to achieve.

So, I think from, instead of looking at it as a factory kind of an approach our focus is really is around a customized solution to our clients where we help them build efficiencies, we help them reduce their overall cost of ownership and therefore from that perspective, I really don't believe that pricing is something that is going to get visited again and again, you know baring unforeseen circumstances.

Bryan Keane – Credit Suisse

Okay, congratulations again. Thanks.

Bharat Desai

Thank you.

Operator

We will take the next question from Brian Kinstlinger at Sidoti & Company. Please go ahead with your question.

Brian Kinstlinger – Sidoti & Company

Great. Thanks very much. My first question is generally how high are you willing to take utilization in the second half of the year, it sounded like you're not expecting to dramatically change your employee base or all that much, but it seems that revenue, is at the bottom you said, so how high could we see it going in the second half of the year.

Keshav Murugesh

I will take that. I think that at this stage, you know, the levers that we have our very controlled, very well being managed and I think I would expect to see stability from here. Having said that, like I said earlier, only if the business environment changes dramatically negatively, which at this stage, we don't expect to happen, we still believe we have levers available to us, but at this stage, we believe is going to be very stable for the rest of the year.

Brian Kinstlinger – Sidoti & Company

So, utilization should be stable for the rest of the year you're saying?

Keshav Murugesh

Yes.

Brian Kinstlinger – Sidoti & Company

Got it. I'm curious, with utilization actually increased 1% off shortly – sequentially and with the same on-site, and with the rupee hurting you, why would you get so much benefit on gross margin quarter-to-quarter?

Bharat Desai

I'll take that, Brian. I think when you look at utilization level for the second quarter, what we report for utilization is actually a period end-number. So, when you see the major move that we had in the first quarter in terms of improving our utilization level, the benefit of that really didn't affect our financials until the second quarter. So, while overall appears stable, what you really saw was the major move in utilization offshore from the end of the fourth quarter to the end of the first.

Brian Kinstlinger – Sidoti & Company

Okay that makes sense then. I'm curious also, of your top 10 customers as you look at in this year, how many are getting lower prices than they did in 2008?

Bharat Desai

On a unit price basis, Brian, I would probably say 25% to 30% had gotten unit price reductions. As Keshav mentioned earlier, I think the focus with most of our large customers is helping them manage total cost of operations. So, as we have talked about in the past there are multiple ways of for us to give clients that kind of a benefit. Unit pricing is only one element of that. You have seen our fixed price percentage has gone up.

That is one of the benefits that we have been able to provide our clients. We have also moved more work offshore as a percentage of total. If you look at IT profile at the end of the second quarter, IT delivery now hit the 30/70 mark for the first time. So, I think we have been successful in giving clients the type of assistance they need in this difficult time and doing it without having to go the unit price, which is something that I think is a positive for the Company.

Brian Kinstlinger – Sidoti & Company

And if I take a look at your top three customers, which are a bulk of your revenue, I guess I am curious if one of those decide to adjust prices would that impact your guidance or does that assume that one of them might lower prices on you?

Bharat Desai

I will take that. Again, like I said earlier, I think the discussions with some of the large clients have already been had and we have always dealt with it as a total cost of operations kind of a discussion. So, whatever, you know in whatever way we have to help these clients; we have already taken care of them. The good thing is, you know while some of these discussions are focused largely on the existing rate cards. What is most exciting from a Syntel perspective is the fact that we are constantly coming up with completely new offerings. Many of which don't necessarily feature on that existing rate card. So, I think on a blended basis I would say that overall we should be doing okay.

Brian Kinstlinger – Sidoti & Company

I think, Keshav, may be if you could update us on what is going on with Stage Street because I think when you made that filing about the joint venture, it seems, I think it is February of the top of my head in 2010 that they have the right to buy other joint venture, while many people don't think it is likely, what is going on in terms of discussions with Stage Street right now?

Keshav Murugesh

Yes, I will take that again. Again, this particular client is a very, very strong client and in terms of the relationships, the relationship continues to be extremely strong, number of meetings being held and you know constant discussions being held between both companies and we continue, Stage Street continues to focus very strongly on their business, while enabling us to focus very strongly on the operational sides of our business.

What is also great is the fact that we are also very enthused with the fact that again, this was one of the companies again, you now among our top few clients that very quickly was able to also return its stock money. We know for the fact that they are very aggressively out there in the marketplace. We believe that this is, this continues to remain a very strong client for us.

We believe that we continue to produce very good operating efficiencies for them and we believe that they will continue to focus on what they are good at while enabling and allowing us to focus on what we are good at. You know, we have already put out in the public domain, you know the rights of both partners as far as that arrangement is concerned. What they will ultimately do is anybody's guess, but we believe very strongly that the relationship is growing extremely well and we are actually focused on growth themes at this point.

Brian Kinstlinger – Sidoti & Company

And so, then just to be clear then, if one of your top three customers came in and did decide to lower prices, so it does not sound like it is something you're expecting to happen, that was not something that is in your guidance, is that right, am I reading that correctly?

Keshav Murugesh

Yes.

Brian Kinstlinger – Sidoti & Company

Okay, the last question I have is, after what is going on the automated industry, can you just give us a sense for – I mean I think (inaudible) was a client of yours, a big one at one time where is that right now?

Keshav Murugesh

I think when you look at our client base on the automotive side, Brian, you have seen the majority of the impact that we're going to see. We have had a pretty substantial reduction in our automotive revenues over the last few quarters. Automotive down to about 3% of revenues and overall our exposure to what I would consider the high risk clients at this point in time is very well.

Brian Kinstlinger – Sidoti & Company

Great. Thanks very much.

Keshav Murugesh

Thank you.

Operator

And we will take the next question from Joseph Foresi at Janney Montgomery Scott. Please go ahead with your question.

Joseph Foresi – Janney Montgomery Scott

Hi, guys. I wanted to ask first on just sort of this notion of the headcount, you obviously I think adjust the model correctly to what is going on, the economy by lowering headcount and raising utilization, at what point do you think we start to max out on those two areas and is it correct in assuming that in order to have sustainable growth going forward at some point you start to have to add people?

Bharat Desai

Joe, I think when you look at the comments of that Keshav made earlier about headcount stabilizing in this environment, I believe that really relates to the revenue guidance for the balance of this year. Overall, our utilization levels offshore right now are 77%, which seems to be high, but again I think, what is important is, you have to bifurcate the utilization offshore between KPO, which is a highly visible revenue stream and the IPO, which has a lot of moving parts to it. And our KPO utilization remains consistent at about 90%. Our IT utilization today offshore is only at 68%.

Where we have been pretty consistent as a company that we believe that that target rates should be between 60% and 80%, 80% red lining to growth, 60% probably some kind of a hyper growth scenario. So, we are very, very comfortable with where we are. We think we are prepared for growth, we think because the marketplace has changed in India to allow much more just-in-time hiring that if we did have a sudden spike in demand, we could account for that pretty easily, and then if we did have a sudden drop in demand we would have the ability to improve our utilization a little bit and exercise one of those levers.

So, I think Keshav’s comments little bit earlier were around our comfort level with where we are now. We have no immediate plans to pull that lever going forward, but it is one of the options that we do have in the event that we don't see top line materializing.

Joseph Foresi – Janney Montgomery Scott

And so I mean, directionally speaking over the next two quarters, without giving any kind of guidance should we expect headcount to be stable flat or down a little bit and the same question for utilization?

Bharat Desai

I think the answer to both of those questions is stable. Stable revenues, stable of headcount, stable utilization.

Joseph Foresi – Janney Montgomery Scott

Okay. And just moving over to sort of the, the question on some of your top clients, there was some growth in that particular group, maybe you could talk about what drove that growth and then particularly on Stage Street how penetrating do you think feel that count is?

Keshav Murugesh

I will take that. Actually on many of these accounts like I mentioned earlier, we actually believe that, whereas we are reasonably exposed to them from a concentration point of view. I sincerely believe that every one of them is under penetrated from a Syntel point of view.

So, whereas we're doing exceedingly well, with some areas within each one of those large clients, our focus really is, you know how do we get our needle in, even more significantly in some of the other areas there and that strategy has actually been working quite well with some of our clients, our focus really is on giving the same attention that we give parts of our business to other parts of the business within each of those clients, introducing a number of the new offerings that we have been announcing over the recent past and all of this really has been fueling growth for us within the client, within each of those clients.

And in fact I may say that many of these clients have actually had to reduce their overall IT budgets, but I'm also happy to say that within the reduced budget Syntel has actually been able to steal a larger wallet share because of being successful in executing this strategy.

Joseph Foresi – Janney Montgomery Scott

And then, just lastly, I think in the prepared remarks there were some talk of a $4.3 million cash reserve that was reversed and ended up adding about $0.10 to EPS, I wonder if we could just – is that accurate to have that accurate and can you just explain what that was?

Bharat Desai

That was Q1, Joe; that was the tax reserve in Q1.

Joseph Foresi – Janney Montgomery Scott

That was Q1, okay. And so this quarter we are only talking about the $1 million from the rupee appreciation on a revenue side?

Bharat Desai

The balance sheet revaluation this quarter was $1.9 million in SG&A and it went the opposite direction of the $1.6 million in the first quarter. So, in the first quarter, we actually had the benefit of $1.6 million because the rupee depreciated, in the second quarter on the balance sheet revaluation we had a $1.9 million negative move in SG&A.

Joseph Foresi – Janney Montgomery Scott

Got it.

Bharat Desai

A $3.5 million dollar swing quarter-to-quarter.

Joseph Foresi – Janney Montgomery Scott

Okay. And then on the top line, you have the rupee actually helping you buy about 1.1 million, correct?

Bharat Desai

That is correct.

Joseph Foresi – Janney Montgomery Scott

And what was the reason for that hitting the top line?

Bharat Desai

I think it is the same as why we saw a negative impact in the first quarter; it is a combination of rupee denominated billings and direct contract struck between US clients and our India-based entity.

Joseph Foresi – Janney Montgomery Scott

Okay, thanks. Appreciate it.

Operator

We will take our next question from Joseph Vafi of Jefferies & Company. Please go ahead.

Joseph Vafi – Jefferies & Company

Hi gentlemen, good morning and congrats on the sequentially up revenue here and in Q2. Maybe, if you could kind of just talk about your outlook on the top line for a minute, I know you said that you expect this to be your minimum run rate on the top line and we did see – as you said a couple of e-Business projects ended during the quarter, what is the outlook in terms of the e-Business line in terms of how you incorporate that into your outlook for the year?

Bharat Desai

I think, Joe, we have kind of taken a conservative approach to how we view the e-Business line; it is one of the areas that by the way we have defined that segment, it has always been a challenge to grow. And when you see large projects ramp down because they have been successfully completed and the follow-on activities that you would expect for some of the follow-on activities that in a normal environment might get approved have been some challenges.

So, obviously the e-Business has always been lumpy, I think it will continue to be lumpy. Our expectation is going forward through the rest of the year that it is going to be a challenge to grow that business. So, we're going to have more projects roll-off by definition there, you know typically 6 months to 9 months in duration. We do have some high visibility pipeline projects that we expect to come back in, but it is not going to be a major growth driver for us through the balance of 2009.

Joseph Vafi – Jefferies & Company

Do you think it is kind of without going into the kind of guidance for any, is it – do you think that the e-Business line, this run rate is the right run rate for the rest of the year of is it you are kind of looking at things with maybe some increased volumes in KPO/outsourcing and maybe continue kind of weakness and maybe a little bit down numbers here and e-Business until we get to a new budget next year?

Bharat Desai

My take, Joe, is that the e-Business and the development lines of our business, the expectation is relative stability for the balance of the year and that what we are looking on the KPO and the maintenance would be the upside.

Joseph Vafi – Jefferies & Company

Okay. All right and then I guess, just thinking about, if this is the minimum run great here on revenue, or I guess the question is that is on the outsourcing pieces of business and on KPO and if we exclude, if we look at constant currency sequentially, you know where were we seeing more volumes in the larger clients and KPO and in outsourcing or was it I guess or was it little more broad based and if it was I think it might have been in the large clients, where there anything particular to point out in terms of the type of work that is going on there?

Bharat Desai

It was so Joe. It was weighted towards our top clients and it was weighted towards the cost reduction activities. So, overall when you look at our KPO revenues in the first quarter, you know you're going to see that they were up slightly, we had one large India-based client as Keshav mentioned that was actually a drag on revenues for the quarter and we had our larger clients continue to grow and accelerate to offset that.

Obviously, when you look at the customer concentration you can see that the growth was weighted towards our Top 3, Top 5 customers, and as Keshav also mentioned maintenance revenues for us grow a little bit over $3 million sequentially from Q1 to Q2. So, it was cost-reduction-based services, it was in our larger clients and it is kind of the long-term stable types of revenues.

Joseph Vafi – Jefferies & Company

Okay. That is helpful and then just some commentary on the financial services vertical, it sounds like it was pretty strong anything to point out there in terms of, you know kind of particular and it is probably related again to your top customers, anything particular going on there in terms of opportunities or things that we should be concerned about?

Keshav Murugesh

I'll take that. I think what we have seen over the past few quarters, particularly with this group of clients have been their single-minded focus only on expense reduction, headcount reduction, you know a lot of internal matters and sometimes you know just the quest for survival.

The good signal that we are beginning to see with some of these clients now is, you know, getting more focused on bigger cost reduction initiatives finally. And so if it is at this time that in our discussions that on a number of our new offerings are actually getting accelerated.

We are also happy to see that many of these clients, you know some of these clients actually were also among the first bunch of clients to actually return the top money, selling out in a very positive signals and so essentially what we are seeing is some more confidence returns here. Beginning to discuss the number of our new offerings and if I may say so, most of these clients really have not commenced any KPO work with us.

So the potential for us is to actually go in with some of those other offerings, including KPO and I would like to say that we are having group discussions with almost every one of them around all these new offerings. So, again you can't say when, you know we can’t really predict timing of decisions, but I think the pipeline is looking good, the health of each one of our clients is looking strong and we are hoping to see better traction in the next few quarters.

Joseph Vafi – Jefferies & Company

That is helpful. Thanks a lot and congratulations.

Keshav Murugesh

Thank you.

Bharat Desai

Thank you.

Operator

We will take our next question from David Cohen at JPMorgan. Please go ahead with your question.

David Cohen – JPMorgan

Hi thanks. I was hoping if you could talk a little bit about the demand, it sounds like you are still somewhat cautious on the outlook, but you obviously sequentially things improved. So, specifically are you seeing that in the quarter budgets got finalized last quarter and the revenue was able to come in the projects we were able to start or was it really just through the quarter your large clients said let’s push more to Syntel, would you just talk about sort of some of the key factors that we are able to drive the sequential uptick? And then how dynamics may or may not play out as we roll forward to the next several quarters?

Bharat Desai

Sure. When you look at our revenue profile in the second quarter David, we obviously, as we just talked about had a pretty good acceleration from some of our larger customers and some of that relates to finalization of budgets, some of it relates to improved stability in their business environment and increased confidence and some of it relates to what I would consider to be a mild acceleration in some of the longer-term cost-reduction-based initiatives.

But in the case for example one of our larger clients, we had a pretty sizable sequential drop in revenues from Q4 to Q1 because the client moved some things into a complete paralysis mode and as they did go through the budget cycle, as they did go through and reevaluate some of the 2009 plans, those came back to us in the second quarter. So, there were a couple of things that I think provide us some short-term optimism and some short-term benefit and you saw that in the second quarter performance. There are some things that provide us some longer-term optimism as well, but the timing on those I think at this point in time is a little bit less certain.

David Cohen – JPMorgan

And then some (inaudible) outside, sort of its top clients, would you talk a little bit about the dynamics there, I mean are there – is there a possibility that there is going to be sort of a falling out and those clients might be able to start ramping revenues up with a lag effect to the larger clients?

Bharat Desai

You know, it is certainly a possibility, David. I think that one of the things that has really happened through this difficult environment is customers have really relied on their trusted partners to help get them through this issue. So you know it is one of the things where I think client concentration increasing is a logical reaction to what is going on in the marketplace.

You know, if you don't have an exhaustive footprint, if you're not the one, two provider or the existing client right now, I think some of those things are little bit more challenging that being said as the environment improves and as you continue to differentiate yourself with new offerings, I think there are some longer-term opportunities for us to accelerate with the Tier 2 clients, but expectation in this kind of an environment and this kind of an economy where familiarity and cost reduction are really what customers are looking for. The expectation would be that the majority of growth would come from existing relationships.

David Cohen – JPMorgan

Okay and then just a couple of housekeeping items, I don't know if he had mentioned your expectation for the tax rate for the full-year, but if it is where would you show that?

Arvind Godbole

We are expecting it to be around 13%.

David Cohen – JPMorgan

13%, okay. And then with the hedging, would you just remind us how far out your hedging programs run at the moment?

Arvind Godbole

Yes, we are continuing with the same strategy that we have been following all along and we always take a short-term view and not taking on longer-term view of one year or so. And we move along with the same strategy, there is no change in the strategy and we continue to do the hedging.

David Cohen – JPMorgan

Okay, so and would you remind us then how far out is short-term, I mean is it one quarter that you are hedged out?

Arvind Godbole

Yes, one quarter, logically, but to the extent of three months.

David Cohen – JPMorgan

Okay. Thanks very much.

Operator

And we will take the next question from Vincent Colicchio at Noble Financial. Please go ahead.

Vincent Colicchio – Noble Financial Group

Nice quarter, guys. If you minus the KPO business how many clients you have today and if there is an expectation that some of the other one, besides (inaudible) ramp in the near future?

Bharat Desai

Today, we have – as of the second quarter, we have 10 active KPO clients. I thin the expectation will be that we will continue to grow our existing relationship. As Keshav mentioned in his prepared remarks, we did add one new KPO client in the second quarter although its revenue contribution was extremely small.

We believe that not only do we have opportunity to continue to grow our large clients, but certainly some opportunity to grow some of the smaller ones that we have added in the last few quarters. The environment we are in today makes a little bit more difficult to do that because a lot of these services are not industry standards, but the opportunity is clearly there.

Keshav Murugesh

And as I said earlier I think the most exciting opportunity for us is, you know continues to be the fact that many of our large existing clients actually don't have any KPO exposure with us and we're actually having some very good discussions with many of them.

Vincent Colicchio – Noble Financial Group

And is the Indian-based client completely – are they completed in terms of business flows to Syntel?

Bharat Desai

Their contribution at this point Vince is negligible.

Vincent Colicchio – Noble Financial Group

Okay. And one last question, others were answered as – regarding Europe is there any progress to report there?

Keshav Murugesh

Yes, absolutely. I think we have made reasonable progress across the past one or two quarters in Europe and as you are aware our focus really is around leveraging our existing global clients in that geography, so we have started obviously with that, but what we have also done is really trying to bring the same attention that we have brought traditionally to our North American clients to clients in Europe as well and to really introduce some of those factors that have helped us to be successful in North America.

We have actually hired a number of sales leaders, both in the hunting side, as well as farming side, real senior people that we have brought in from industry, you know are on the ground, already there, we have actually fitted out and operationalized a brand-new office out of London and we're also, we've also brought in local German-speaking people into our office in Germany, as well as interacting with some of our German clients there.

In fact, I may also mention that the SAP head of, you know one of the large – you know one of our large competitors also is now – has now joined us to lead the safety side of the business there and our focus really is on the UK, the (inaudible), Germany, and on some strategic alliances, as well as on some of the platform base. So we expect to see good traction around Europe as some of these plans actually fortify and some of these actions fortify.

Vincent Colicchio – Noble Financial Group

Okay. Thanks guys.

Operator

We will take our next question from Bhavan Suri at William Blair & Company.

Bhavan Suri – William Blair & Company

Thanks for taking my question guys and good job on the quarter.

Bharat Desai

Thank you.

Keshav Murugesh

Thank you, Bhavan.

Bhavan Suri – William Blair & Company

Hey, couple of quick questions here. The first is, just what are you seeing in terms of vendor consolidation at customers, especially between Q1, Q2 players?

David Mackey

At this point, we are not seeing it. This point, we are not seeing it, Bhavan. Most of our clients were, we have good friends and we have been adding value and we continue to be a vendor, I think you haven’t seen a rational pricing behavior in the marketplace and you are not seeing competitors looking to undercut pricing to take existing portfolios away. I think of the efficiencies in the economies that customers were trying to generate by trying to combine vendors, I think they weren’t getting the economies that they were looking for and the business interruption that’s involved in doing that wasn’t worth the very low savings that they were looking for. So from my perspective, we have not seeing a lot of vendor consolidation and we have not been impacted by it.

Bhavan Suri – William Blair & Company

Interesting. And then turning to the new customers that you signed obviously through this quarter and the past quarters, is pricing there slightly better than your existing re-negotiations? How should we think about even through they are adding to material amount of revenue? How are you guys dealing with pricing from new customers or new engagements of customers?

David Mackey

As is always the case, Bhavan. I think the pricing that we provide to clients is a function of the type of services, the value that we are providing and the scope and scale of the overall relationship. And most relationships don’t start with sizeable types of headcounts. So you are not going to get best-in-class pricing from a brand new relationship. And I think most clients understand and expect. For newer customers, the value proposition to outsourcing is saving 40% or 50% from what they are spending internally. This is not about looking at a 2% or 3% reduction in a unit billing rate, it’s about how quickly you can go ahead and get those initiatives implemented. So I think the pricing discussions tend to be more with long term power users of offshore services as oppose to newer entries.

Bhavan Suri – William Blair & Company

And then, sort of sticking to that new customer that the non-top ten customers seeing, obviously the customer concentration increased. I guess I wonder the larger customers you have sort of the account managers and the partnership managers and everything else, but, is there a huge material difference in how you deal with say the next 20 customers and when this kind of growth in those start to get faster than the top customers? I am wondering if there is a relationship thing there or there is a way you work with those customers to drive an acceleration in that same next 20 pyramid [ph]?

Bharat Desai

Yes, I think you have made some very, very – I am sorry, go ahead Keshav.

Keshav Murugesh

You finish off.

Bharat Desai

I was going to say, I think we have made some very aggressive investments over the last year in terms of improving our relationship management layer with the specific intent of driving accelerated growth at some of our smaller clients. The reality of the situation is in an environment we are not much of anything is growing, it’s a challenge.

So we have invested in that layer, we have improved the relationship function within Syntel and we believe that we are pretty well positioned when demand and when spending starts to improve to take advantage of that. And Keshav mentioned that we have not only gone in and tried to improve what we have already been selling and already doing for those clients, but also to show them and demonstrate the value of a number of the newer services that we have rolled off, and we expect to see some good acceleration in tier 2 clients when the demand environment improves, but its going to be difficult over the next three to six months to do that given the current economic condition.

Keshav Murugesh

Right. And Bhavan, just to act to that, I think one of the areas where Syntel is spending quite a bit is around this entire customer facing layer where we are actually brining in a number of people to handle some of the clients that you just described, some of the clients were not necessarily the top ten or the top 15 or whatever, essentially to help replicate the model which has made us so successful with the top ten or the top 20.

Bhavan Suri – William Blair & Company

Right.

Keshav Murugesh

So that’s something which – in fact that’s something that backed into these numbers and we are very focused on continuing to bring in those kind of people so that we can push the model to the next 20 and the next 20. And you know I am just going back to a question that you asked, maybe two questions before this, quite often when I am sitting with this some of these large clients, I am beginning to hear much more comments like the earlier part that we should cut our exposure to you in terms of revenue to x percentage, but as we meet with your people, interact with some of the new offerings, see some of the investments you are making, we realize actually that you guys are nimble, flexible, right sized, but you also really behave like a tier 1 and therefore, we don’t see why we should curtail our spend with you and that’s one of the reasons why we continue to see the concentration going up. Even among the top ten because all of them realize that actually they are under penetrated from a Syntel point of view, this is lot more we can do with them and you are right, the challenge for us is, how do we bring the same attention to the next ten or the next ten, and I guess that’s what keeps us awake at night and that’s what we are continue to focus on.

Bhavan Suri – William Blair & Company

Good, good. One quick question, if I can sneak it in, and this is kind of a mix here which is the KPO margin improved a couple of hundred basis points. Utilization there can’t go up much more, you are at 90% something, what was the driver for the margin improvement within the KPO business?

Bharat Desai

I think this is a classic case, Bhavan, of addition by subtraction. The client that ramped down for us was a very low margin client relative to the rest of the portfolio.

Bhavan Suri – William Blair & Company

Got it. So where does KPO gross margin, where it kind of trends you if I take out some of the lower margin clients. I mean this is a 65%, 70% gross margin business?

Bharat Desai

I think long-term, we have always guided that we expect the KOP margins to be in the mid-50s. That the real reason with the KPO is hanging up here in the mid-60s now is more a function of the currency depreciation over the last year. Obviously, this segment is a 100% offshore. So it’s going to be more volatile with currency. But as long as the currency is stable at this level, then the expectation should be that we can continue to run the KPO margins between 60% and 65%.

Bhavan Suri – William Blair & Company

All right guys, thanks. Good quarter.

Bharat Desai

Thanks, Bhavan.

Keshav Murugesh

Thank you.

Operator

And we will take our next question from Ed Caso at Wells Fargo Securities.

Ed Caso – Wells Fargo Securities

Good morning and good evening. On the KPO business, in dollars terms, it’s been roughly flat in the last – for quite a few quarters now, how much of that business relates to the top KPO client?

Bharat Desai

I think, when you look at our overall portfolio, our largest KPO client is about 75% or 80% depending which quarter it is of the overall KPO revenues.

Ed Caso – Wells Fargo Securities

Okay. And we have been hearing that the tier 1 are increasingly attacking, approaching, going after smaller deals and historically Syntel has benefited from sort of doing smaller deals with bigger clients, I mean sort of inconsistent I think with what you guys said, I just want to make sure I heard it correctly that you are not seeing the major tier 1s and then the big BPO guys sort of attacking your space?

Keshav Murugesh

You know what, I will take that first. I just mentioned earlier, you know many of our top ten clients actually are referring to us as the good-to-have Tier 2 kind of player but also as one that behaves like a Tier 1 player. So we are actually seeing conflicting signals which actually are very positive from our perspective. In every deal that we compete with, we compete head-on with this so called Tier 1 players if you look at any of the clients that we service, the other vendors – I mean, it's always a multi-vendor kind of an environment that everyone of the others is really one of those Tier 1s and we have steadily stolen wallet share from each one of those, even in a shrinking kind of a budget environment.

And of course, we definitely have seen in the recent past, activity from some of the Tier 1s to try and focus on what they would traditionally call the smaller client, clients who can spend $10 million or less may be a year on them. But, from our experience, we have seen that based on how they have created their structures, they are actually finding it extremely difficult to service these clients, and we have actually benefited in one or two cases in terms of a new client actually going towards the Tier 1 can affirm, but in two or three months realizing that they're just not being serviced and then moving to a company like Syntel that gives them attention that is nimble, that is flexible and you know what behaves like a Tier 1.

Bharat Desai

Ed, if I may, this is Bharat – I would just like to add may be a little more context and color to that response. The overall ITO market is probably about $500 billion and a company that have $5 billion only has about 5% [ph] penetration of the overall market. I've always taken the view with my team that really, where we should focus is, "how do we add value to our customer”? And I think that’s proved to be a winning formula, so that’s really where we focus and its important to understand that it's a highly fragmented market and all the Tier 1s put together probably own under 5% [ph].

Ed Caso – Wells Fargo Securities

My next question is on – the any update on the Indian budget and the timing of a possible extension of the STPI tax holiday and what would be the implications relative to say your 30% tax rate guidance for this year as far as the tax rate for next year?

Keshav Murugesh

Yes, (inaudible). The budget is not yet enacted. It’s likely to be enacted. It has been passed by the lower (inaudible) yet, but the possible implication for Syntel and IT will be on two accounts. One is that STPI benefited when extended to March 31st, 2011 which will have a positive impact on the tax rate and the profitability for IT systems. Apart from that, they also have – the budget is also proposed to abolish the fringe benefit tax which was there for the last couple of years. And to that extent, our cost will be reduced.

Ed Caso – Wells Fargo Securities

And so what kind of tax is the STPI is formally extended and I assume its still in the legislation as proposed. What I mean I think in the past you have talked maybe about 20% tax rate, is that about right?

Keshav Murugesh

Right. But now, if it is extended through 2011, the tax rate for 2010 we will be expecting around between 17% and 19%, and for 2011 it will be between 20% and 22%.

Bharat Desai

And I think, Ed, it's also important to remember that the 13% tax rate that Arvind spoke about earlier for 2009 includes the impact of the tax reversal in the first quarter. Our guidance for the rest of this year has built in for the back half of the year at 17%, 18% effective tax rate. Our operational tax rate has been running right about 16%, 17% at the company. So in reality, the expectation is that our operational tax rate for 2010 will be the same as it was in 2009.

Ed Caso – Wells Fargo Securities

Right. Last question, when you look at the details, if I heard them correctly, you had the biggest improvement in gross margin in your outsourcing business. Was that just – that’s where you got the incremental growth or is that where you basically took people off bench? I mean, is that where the utilization pickup was?

Bharat Desai

Yes, the biggest utilization pickup offshore in the second quarter, Ed, and the benefit – the primary benefit of that would have been in our applications outsourcing space.

Ed Caso – Wells Fargo Securities

Terrific. Thank you.

Operator

And we will go next to Bryan Kingslinger with Sidoti with a follow-up.

Bryan Kingslinger – Sidoti & Company

Yes, two real quick ones. First of all, can you – I think you said it once – can you break down the other income? How much was interest and how much was the FX?

Arvind Godbole

Yes, other income basically had three components. One was the gain on the foreign forward contracts of $200,000 against a loss of $740,000 last quarter, and then we had gain arising out of the sale of investments in mutual funds, and we had interest which is on the deposits on banks.

Bryan Kingslinger – Sidoti & Company

How much was the gain on the mutual funds?

Arvind Godbole

Mutual fund gain, this quarter was around $500,000 against $340,000 last quarter.

Bryan Kingslinger – Sidoti & Company

And then usually in the fourth quarter, you also have big mutual fund gains, is that depended on the market movements and give us a sense for is that expected again?

Arvind Godbole

Right, I mean we can’t really predict when there will be a gain, but we have a strategy in place and based on that we continue to sell whenever we have a good margin.

Bryan Kingslinger – Sidoti & Company

Okay. And then the last question I have, when you look to 2011, I know it’s very far out there for taxes, Obama is talking about global tax initiatives – if that did ever pass, what was that mean for Syntel and the industry? I mean how high would taxes go for you guys?

Arvind Godbole

Right now, the proposals are quite sketchy and they're undergoing a lot of change, that's what we believe. So it is too premature to comment on the impact, but the general impression is that, we – for certain companies, the tax rate might go up between 8% to 9%.

Bryan Kingslinger – Sidoti & Company

I guess my question, but it wouldn’t go up ever to a normal tax paying company in United States in the high 30s.

Keshav Murugesh

Let me take that. As Arvind said, I think at this stage, it would not be right for us to comment on that. We still have to wait and see what specifically is being alluded to in those tax reforms. We will have to wait to see what passes there before we make those comments and at this stage, we have not done any specific work around 2011 tax rates based on an assumption of what those announcements are likely to be.

Bryan Kingslinger – Sidoti & Company

Okay. Thanks.

Operator

And we have no further questions in the queue. You may make your concluding remarks at this time.

Bharat Desai

Thank you for joining us today. We are encouraged by the stabilization in our business during the second quarter and are hopeful that the economy continues to move forward as the year progresses. While the timing for a pickup in demand is still uncertain, the macroeconomic trend towards globalization of services remains intact. We believe that our operating and financial structures are extremely sound, our investment philosophy is on track and the company is well positioned for the long term. We look forward to talking to you next quarter. Good bye and thank you.

Operator

This concludes Syntel’s second quarter earnings call. A replay of today’s call will be available until August 5, 2009 by dialing 888-203-1112 and entering the passcode which is 3402536. Thank you and have a nice day.

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Source: Syntel, Inc. Q2 2009 Earnings Call Transcript
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