Dean Ridlon – Director, IR
Alan Herrick – President and CEO
Joe Tibbetts – SVP and CFO
Rod Bourgeois – Bernstein
Julio Quinteros – Goldman Sachs
Sapient Corporation (SAPE) Q2 2009 Earnings Call Transcript August 6, 2009 4:30 PM ET
Good day, ladies and gentlemen, and welcome to the second quarter 2009 Sapient earnings conference call. My name is Geneta and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Dean Ridlon, Investor Relations Director. Please proceed, sir.
Thank you. And thank you all for joining us today. I’m Dean Ridlon, Sapient’s Director of Investor Relations. Our press release announcing this quarter’s results is currently available in the Investors section of our website, www.sapient.com.
Before we begin, I would like to remind everyone that some of the matters discussed during today’s call are considered to be forward-looking statements, as defined by the US Securities and Exchange Commission. These forward-looking statements are subject to known and unknown risks and uncertainties, which could cause actual results to differ from those expressed or implied by such statements.
We have described some of these known risks and uncertainties in today’s press release and in our annual and quarterly SEC filings, which we strongly urge you to read. The forward-looking statements included in this call represent the company’s views on August 6, 2009. Sapient disclaims any obligation to update these statements to reflect future events or circumstances.
During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. The most directly comparable financial measures calculated in accordance with GAAP and a reconciliation of those GAAP measures to those non-GAAP measures are contained in the press release announcing this quarter’s results.
I would now like to turn the call over to our CEO, Alan Herrick.
Great. Thanks, Dean. Thanks, everybody, for joining. We’ll go over our usual agenda; press release highlights, an overview of the second quarter, and then some comments on outlook of the market overall and guidance, and then hand it over to Joe to walk you through the financials.
Let me start with the press release highlights. $147.5 million in service revenues, down 11% versus Q2 ’08 and down 4% in constant currency, up 4% sequentially versus Q1 ‘09 and up 1% in constant currency. Non-GAAP income from operations was $14.2 million, which is a 9.6% operating margin for Q2, represents an 80 basis point decrease from 10.4% in Q2 ’08. GAAP income from operations $8.5 million, which represents a 30% decrease from $12.2 million in Q2 ’08 and also includes approximately $1 million in acquisition costs associated with the Nitro Group.
Non-GAAP diluted income per share was $0.10, down from $0.13 in Q2 ’08. And GAAP diluted income per share for the quarter was $0.06, down from $0.09 in Q2 ’08. Cash from operations was a positive $30.4 million for the second quarter.
Overall, I’m very pleased with our operating performance. Our team and our people across the world have done a great job here. Being able to put up growth on the top line in this environment is a great place to be. And at 9.6% non-GAAP operating margin, we continue to manage our profitability well through this environment.
Now let me give you a little more detail on our business units. Let me start with North America, represented 61% of service revenues in Q2 or $90.5 million. Revenues were down 10% year-over-year, but up 5% sequentially. In constant currency, North America was down 8% year-over-year and up 4% sequentially. And from North America’s perspective, we think this is very strong performance and great to see. As the economy first started to falter, we saw demand soften in the United States first. And to have 5% sequential growth is a very strong result for North America in this environment. And as we look ahead to Q3, we expect North America to be up again.
Europe represented 34% of revenue in Q2, or $49 million. Revenues were down 16% year-over-year and up 3% sequentially. In constant currency, Europe was flat year-over-year and down 4% sequentially. And we do expect Europe to be up as well in Q3. Government services represented 5% of revenue or $8 million. Revenues were up 17% year-over-year and down 3% sequentially. And we expect government services to also grow in Q3.
Now let me move on to our people. Total ending people count for Q2 was 6,009 people, up from 5,922 people in Q1. Q2 annualized voluntary turnover was 11.9% compared with 16.8% in Q2 ’08. Utilization was 81% compared to 76% in Q2 of ’08.
Let me move to some wins that we’d like to mention for the quarter. I’ll start in consulting with our Trading and Risk business. We had a nice win with a large integrated oil company to start a large program of work really helping them -- helping the oil company manage their risk in oil and gas trading markets and balance the operations of physical assets.
We also had several interactive wins in the quarter. VisitBritain selected us Online Agency of Record for VisitBritain, the UK’s official national tourism agency. We also had a win with Carter’s, the children's retailer, in establishing their direct-to-consumer business and we’re providing business consulting, marketing services, as well as web services.
We had a win that we announced in the press with Singapore Airlines. We helped deliver the global re-launch of Singapore Airlines Online to provide end-to-end digital commerce services, including strong online brand identity and enhance user experience. We also had a win with Energy Savings Trust, selected as the Digital Agency of Record to provide end-to-end strategic online and digital marketing services in a three-year relationship. And then finally, with Rhino Entertainment, we are working with Rhino to strengthen their direct-to-consumer business, ecommerce and online presence overall.
Also like to mention a couple notables around existing clients. We started -- actually we continue to do work with Sprint on a strategic program to redesign and re-platform Sprint.com. And we continue to do work for travelers with really helping travelers with their direct-to-consumer business or their personal insurance business. We are helping them across media as they establish their direct-to-consumer business. Website design, direct mail, television, mass media, local media, and online advertising, as well as paid search.
Also like to announce our first combined win with Nitro, with an existing Nitro client. The project will combine Nitro’s brand strategy and creative capabilities with Sapient’s deep digital expertise to develop a social media strategy and digital creative campaign, which will launch as a fully integrated online and offline campaign in Q1 2010.
Other things I’d like to acknowledge for the quarter, we came back from a very successful trip to the Cannes Advertising Festival, where we won nine awards in total between SapientNitro. And SapientNitro won The Best Job in the World, and Sapient won for Coca-Cola, the interactive vending machine. We won across several categories, cyber-marketing, direct marketing, public relations, media and designs. So, a great trip for us and great recognition of the tremendous work that the Nitro team and the Nitro Group did as well as Sapient and the work that we’ve done with Coca-Cola.
Let me now move to outlook and give you a feel for what we are seeing overall at, I guess, a little beyond the midpoint of the year. I’ll start with interactive. And as you can tell obviously by the wins, we are seeing good momentum overall in interactive with our clients in both digital marketing, digital commerce and digital content. And we are really keyed in and focused on helping customers with multi-channel marketing, multi-channel commerce to really drive brand experience, and of course, customer acquisition. And there are four trends we are seeing across the business right now.
The first is a wave of direct-to-consumer opportunities, which you probably noted in the wins that I read, but clients are either trying to move their business online or they are trying to increase the amount of business that they do online. And when I mention online, I’m really referring to the bigger thought process around online, whether that’s web, mobile, kiosk, digital merchandising, the entire idea of a digital relationship.
The second trend we are seeing is really around multi-channel strategy. As clients think about a more digital future, they are also engaging Sapient to help them to find their multi-channel strategy environment. And this is both multi-channel marketing and multi-channel commerce, online and offline. It also starts to become a discussion around their business model, their operating structure, how do companies and people embrace more digital future as a central operating principle as opposed to just adding the digital channel on top of their existing business.
We also continue to see the trend that I have mentioned before in agency consolidation. Clients continue consolidating their partners on the agency side to drive efficiency. We’ve got a real opportunity here given we are brand-led with unmatched multi-channel capability and scale to help our clients. Overall, the shift of traditional marketing to digital marketing continues as clients look to engage consumers and measure results. And as you might expect, these trends are all driving opportunities in our wheelhouse that we are excited about.
As I move to the consulting side of the business, seeing good momentum there as well. Let me start with TRM, financial services and energy in the first bucket. And what we are seeing is a continuation of what I have talked about in last couple quarters, which is there is a huge drive around compliance and regulation.
I’ve talked previously about the Fed letter on derivatives processing, but just generally about regulation and what you are seeing in the environment with Basel II and what the gaps might be around compliance and regulation in that framework. So you are seeing an overall movement of greater transparency in that industry, and that greater transparency causes changes in processes, changes in systems and technology and puts us in a good spot, take advantage of some of those opportunities.
We continue to see opportunities in commodities market, which, you know, has been a strength for us over the years. And we are also seeing the beginning of clients start to look at revenue growth opportunities. And this is new, something I haven’t mentioned previously. And it’s really in the area of customer relationship management, both from an acquisition perspective as well as a retention perspective. And that’s really a comment on financial services.
And then outside of that, if you look at the rest of our consulting business, we continue to see opportunities emerging in healthcare and government. We think the idea of open and transparent government is a place we can help, given our unique mix of interactive and consulting skills. These opportunities are early on. We think it’s a good fit for us long-term. And then, as you know, healthcare, government, education, about 14% of our revenues overall right now. And then I guess finally as a broad backdrop, clients universally continue to be focused on costs and effectiveness of their overall business, their G&A structures, their overall operating model in this environment.
So when you step back as we kind of get to -- as we kind of get, I guess, through the halfway point of the year, the best way I would describe it is clients are feeling incrementally better here from when we talked to you last quarter or certainly the quarter or two before that. And what that translates for us is we believe budgets are intact from here to year-end. We also see that decision-making appears to be evening out. Sales cycles look more normal to us here. And I think that’s a function of clients being in a position of confidence as it relates to the year kind of ending on track as they plan from here forward.
So for us, the pipeline continues to be strong. And that’s not new news. But what has changed for us here is our confidence in the decision-making and the budget release process. As we talked about going into Q2, we see good opportunity and good type [ph]. There is still a question about how quickly things get decided and how choppy that would be.
Now, as we go into Q3 and Q4, based on our experience in Q2 and our early on conversations in Q3, our confidence in decision-making is better here. Our confidence that the budgets that we do have are certainly not increasing, but are in fact being released as planned in the back half of the year. And of course, we’ve got to compete to those opportunities and win, and that has to happen, but incrementally improve confidence as we look through the back half of the year.
So with that, let me move to guidance overall. Revenues of $159 million to $163 million for the third quarter, that includes about $8 million to $9 million for Nitro. Non-GAAP operating margin of 10% or better in Q3. And also just a couple longer-term comments. As we look out, we continue to see the opportunity improve Sapient’s overall margin profile. We made excellent progress in 2008. In the first half of 2009, we continue to be committed to strong operating performance by the way we managed our business and by the way we managed our cost.
As I mentioned early in the year, we would trade some growth to manage our cost responsibly in this environment. Now, as we look ahead to Q3, we are ramping up hiring efforts to meet the growth opportunities that we see, and I’ve discussed couple minutes prior.
So with that, let me hand it over to Joe to walk you through the financials and I’ll come back with a couple of wrapping comments.
Great. Thanks, Alan. And good evening, everyone. Obviously, I’ll take you through the details of the second quarter results and share our outlook in a little more detail for Q3. Just as a reminder, I think everybody knows it, but since the acquisition of Nitro Group took place on July 1, our results for this quarter don’t include any Nitro results.
So on the revenue side, consolidated service revenues for Q2 were $147.5 million, up 4% sequentially. On a constant currency basis, revenues were up 1% from Q1 and were down 4% from Q2 of last year. Looking at revenue broken down by industry, we had another quarter of pretty consistent revenue mix among the industries, with financial services generating 34% of total revenue, down a little under 1% from 35%, which we had in Q1. Consumer and travel was 21% of total revenue in Q2. That was up actually 2% from 19% in Q2. Technology and communications generated 17% in both quarters, Q1 and Q2. Government, health and education was 14% this quarter compared to 15% last quarter. And energy services was 13% of total revenue, and that was consistent with Q1.
The recurring revenue statistic, which includes revenue commitments of one year or more in which the client has committed spending levels to us, includes also a retainer-based revenue and revenue where the client has chosen us as an exclusive provider of certain services. And that was 43% this quarter, which was up from 40% in Q1. The percentage of service revenues coming from our top five clients in the second quarter was 23%. That’s an increase from 22% in Q1. And our top ten clients were 36% of the revenue in the quarter. That’s consistent with the first quarter. 38% of our revenue in Q2 came from fixed price contracts and 62% from T&M contracts.
Looking at gross margin and operating margin, our second quarter gross margin, excluding non-GAAP items, was 32%, up from 31% in Q1, a decrease from 34% a year ago. Selling and marketing expenses were 4.6% of revenues, a decrease from 4.7% in Q1 and quite substantially down from 5.7% a year ago. General and administrative expenses were 18% of revenues -- again, all these numbers are non-GAAP -- a decrease of 18.4% in Q1 and 18.3% in the same quarter a year ago.
Stock-based compensation expense in the quarter was $3.7 million, a slight increase from $3.5 million in Q1 and down from $4.4 million a year ago. Restructuring and other related charges were $200,000 in the quarter compared to a charge of $2.1 million in Q1 and a benefit of $100,000 in Q2 of last year. And you will recall that the first quarter charge of $2.1 million included the $1.9 million cost of our Q1 restructuring action that we announced back on February 19th.
Acquisition costs and other related charges are now expensed as incurred under the new accounting rules, effective January 1. And as we previously mentioned, the expenses relating to the Nitro acquisition ended up being split between Q2 and Q3, as they were incurred. The amount in Q2 was approximately $1 million, and we expect the amount in Q3 to be about $1.3 million.
Q2 non-GAAP operating profit was $14.2 million, 9.6% of service revenues. This compares to $11.2 million in Q1, which was 7.9% of service revenues, and last year’s Q2 $17.3 million or 10.4% of service revenues. GAAP operating profit $8.5 million or 5.7% of revenue, up from $5.0 million or 3.5% of revenue in Q1, compared to last year’s Q2 reported operating profit of $12.2 million or 7.3% of service revenues.
Foreign currency had a net positive impact on the quarter at the operating profit line of approximately $700,000. The three pieces of this were a net translation gain of $1 million as compared sequentially to Q1 of ’09, and this gain was driven primarily by a depreciation of all major non-US currencies in which we have operating profits; a small net transaction gain of $7,000 included in G&A that compared to a net transaction loss of $200,000 in Q1 and a gain of $1.3 million a year ago; and a net hedging loss of approximately $320,000 that’s also included in our G&A expense line, that compared to a net hedging loss of $150,000 in Q1 and a loss of $530,000 in Q2 of last year.
Moving on, interest and other income netted $800,000 for us in Q2 compared to $1 million in the prior quarter and $1.6 million a year ago. The income tax provision for this quarter was $1.7 million. The effective tax rate for the quarter was 18.1%. The effective rate for the second quarter reflects an adjustment downward due to the lower expected annual rate slightly down from the previous quarter, as you know, and that included a year-to-date catch-up effect.
Our Q2 non-GAAP net income, as Alan said, was $13.1 million versus $10.3 million in Q1 and $16.7 million a year ago. Non-GAAP diluted earnings per share were $0.10 per share in Q2 versus $0.08 in Q1 and $0.13 a year ago. GAAP net income was $7.6 million in Q2 compared to $4.5 million last quarter and $11.6 million a year ago. And GAAP diluted earnings per share were $0.06 per share in Q2 versus $0.03 in Q1 and $0.09 a year ago. Weighted average common shares for the second quarter were 127.1 million shares and 130.8 million shares on a basic and diluted basis respectively.
Switching over to the balance sheet, cash and marketable securities at quarter-end were $194.9 million, an increase of $35.4 million in the quarter. Cash provided from operating activities was $30.4 million in Q2, and cash provided from operations in Q2 a year ago was $22 million.
Accounts receivable net of allowances increased to $94.6 million at the end of Q2 compared to $81.8 million at the end of Q1. Unbilled revenues at quarter-end were $47.7 million, down from $58.6 million at the end of Q1. Deferred revenues totaled $13 million in Q2 compared to $11.2 million in Q1.
Days sales outstanding, DSO, was 75 days. That was an improvement from 78 days last quarter. In this economic environment, collections timing is impacted. And while we had excellent collections and cash flow in the quarter, we didn’t quite get DSO to where we would like it to be. We remain committed to return DSO to the 60 to 65-day range, and we expect further improvement in Q3 toward that goal.
Our people count at the end of the quarter, as Alan mentioned, was 6,009. And the breakdown on that is 5,077 in delivery and 3,234 in India-based delivery people. Just to note, we filed our Q2 quarterly report on Form 10-Q about an hour ago or very few minutes ago.
On the outlook basis, turning to that, as Alan mentioned, we expect the third quarter service revenues will be in the range of $159 million to $163 million, including $8 million to $9 million revenue from Nitro. And non-GAAP operating margin in Q3 is expected to be at 10% or better.
Few other data points we want to share with you, I thought I should briefly recap the expected accounting or July 1 acquisition of the Nitro Group. Some of these numbers have been further refined from the estimates we gave on our call at the time of the acquisition. They are still estimates, but they are pretty close now. They haven’t moved all that much, but we just want to make sure people are familiar with them.
We estimate that the purchase price for accounting purposes will be about $46 million, remembering that there is about $8 million of employment-related equity and the deal consideration, which will be recognized as compensation expense over the vesting period.
We are currently working with the independent valuation firm to determine the allocation of the purchase price, but based on our current estimates, we expect an allocation of about $1 million to net acquired assets and liabilities, $8 million to the assumed debt, $15 million to an identified intangible assets such as customer relationships, trademarks and non-competition agreements. That amount will be subject to amortization over various lives up to as long as eight years. And the remainder of $38 million will be recorded as goodwill.
Moving on, stock-based compensation expense is expected to be between $3.8 million and $4.2 million per quarter in Q3 and Q4 of 2009, next two quarter in other words. The increase from our previous guidance is a result of the additional stock-based compensation resulting from the Nitro Group acquisition.
The effective income tax rate is expected to stay in the range of 18% to 22% in the third quarter and for the full year 2009. Deferred tax asset valuation allowance related to our US net operating losses is still in place. And while nothing is guaranteed, I would not expect it to be reversed until at least the end of this year.
Capital expenditures for Q3 of 2009 are expected to be in the range of $5 million to $6 million, primarily related to office space and computer hardware and software. And lastly, looking at weighted average shares, the basic share count should increase approximately 1.5 million in Q3 as a combined result of shares we expect to issue in connection with the Nitro Group acquisition as well as the DCG acquisition, as well as our usual RSU vesting and stock option exercises.
Weighted average basic shares for the whole year of 2009 is expected to be in the neighborhood of 127.9 million. On a diluted share count, the shares will increase about 4 million shares in Q3; obviously, the same 1.5 million that I just mentioned plus another 2.5 million relating to the Nitro acquisition.
And with that, I’ll pass the call back to Alan.
All right. Thanks, Joe. Just a couple quick wrapping thoughts. Again, we are very pleased with delivered growth in Q2 and we are in a position to guide up for Q3. We continue to have a very strong competitive position, and we are seeing opportunities in our wheelhouse, which for us validates what we have been thinking all along, which our strategy is working and even working in this environment.
And at the highest level, the Internet, mobile, social media and other technologies continue to ship how we shop, how we consume content and how we socialize. Technology is changing how we live our lives, and Sapient is uniquely positioned to help companies adapt to that changing landscape. And I guess on a final note, I guess we’ve demonstrated we remain committed to strong operating performance and we see the opportunity to continue to improve our margins not just as go forward, but we will talk obviously more about that as we enter 2010.
So with that, let me wrap there. And then operator, if you could opening it up for questions?
Thank you. (Operator instructions) Your first question comes from the line of Rod Bourgeois with Bernstein. Please proceed.
Rod Bourgeois – Bernstein
Hi there. Yes, Rod Bourgeois here. So in currency, you can just see the sequential revenue growth positive. I think that was a key goal for the quarter. I’m very interested in your commentary about Q3 that both Europe and the US can pose I guess positive sequential growth in Q3. Europe always faces a tough quarter in Q3 because of all the holidays that happen in Europe and the vacations and so on. Are you able to see positive sequential revenue growth in Europe despite the negative seasonality that you have in the quarter? And if so, what’s behind that?
Yes. And I think yes, we do believe we are in a position to execute the positive revenue growth in Europe. And I think part of it is obviously we see really strong strength in our funnel, and of course, we got to execute win [ph] and close those deals. And I think part of you obviously gets some seasonal hits to your point, but increasingly we’ve got some retainer-based revenue and those kinds of things that don’t add and flow [ph] with the same degree of seasonality in Q3. So I’ve kind of net our pipeline very strong, getting more stability from some retainer-based deals that offset your seasonality a little bit. And I think when we look back in history, we’ve been able to do that before in Europe and we think they are poised in good position for Q3.
Rod Bourgeois – Bernstein
Okay, great. And then on that note, I think you used to give a long-term view on the margin outlook. And I don’t want to press too hard on this at this point. But you’re getting revenue visibility coming back, which was a key milestone needed to be able to start talking about longer-term margin plans again. It may still be premature, but what are you thinking about the long-term margin plan? I’m assuming you’re feeling better about the margin outlook longer-term given the stability in revenues. But can you give us any update on how you are thinking about that?
Yes, sure, Rod, this is Joe. Yes. Just to give you a little more color on that, I mean, I think the way you characterize it is right. I think we felt that it’s not -- we're not totally out of the clouds in terms of being able to give long-term positioning on that. But as we look at the trends, we feel a lot better about where we are today and what we see ahead. I think we still see room for improvement on sort of both levers, which is to say the gross margin line and the operating expense, particularly G&A. So I think those two can both contribute to us, continue to expand profitability, and certainly with revenue growth ahead of us that we see that enabled that even more. So I think we are getting to the point where we are starting to feel good about where things can go as we go forward.
Rod Bourgeois – Bernstein
When we announced the Nitro acquisition, you indicated that it was kind of neutral to your longer-term margin outlook. Having a little more time to look at that business and start some of the integration planning, are you viewing Nitro as helpful to your longer-term margins, neutral, or a bit of a headwind at this point?
I think in terms of plugging two pieces together, I think on their own, I think it’s pretty neutral to our margin percentage and our profitability outlook. I think the aspects of bringing the two businesses together other than two separate pieces and start working together, our hope is that that will actually help us as we go forward and actually expand margin a little bit. On the revenue side, I think we felt like -- the acquisition, I think, will come together very well from the standpoint of bringing into our books. The first quarter, of course, is the first time they will ever have -- they have ever had to deal with reporting under US GAAP. And so we are watching that carefully, but we want to make sure that our guidance to you considered the transitional effects of getting into the US GAAP world for them. So that’s kind of how we see them coming into our books in Q3 and beyond.
Rod Bourgeois – Bernstein
Great. Thank you, guys.
All right. Thanks, Rod.
(Operator instructions) Your next question comes from the line of Julio Quinteros with Goldman Sachs. Please proceed.
Julio Quinteros – Goldman Sachs
Hey, guys. Sorry, I just toggled over to this call. One quick question, I just wanted to make sure the impact of DCG and the other acquisition that you guys made here, what were the numbers that you guys had kept from a contribution perspective in the current quarter? Nitro and DCG.
Right. Nitro doesn’t have any impact on the current quarter because the acquisition took place literally the first day of Q3. And then DCG, we stopped actually talking about them (inaudible). They are fully integrated into our systems at this point and fully integrated as a business into us. So we don’t break out DCG separately and haven’t for a couple of quarters now.
Julio Quinteros – Goldman Sachs
Okay. I’ll just leave it there and I’ll follow up later on. Thank you.
Okay. Great, Julio.
At this time, there are no further questions. I would now like to turn the call back over to Alan Herrick for any closing remarks.
All right. Excellent. Well, that’s the first. So we must have done a good job on the overview. But again, really pleased to be in a position where we are able to post growth in Q2, happy with the outlook, and longer term we think we are sitting in a great spot here. We think we’ve got obviously a transformative world in front of us as it relates to consumer behavior and how people live their lives. And our integrating offering, we think, is a tremendous value proposition. And we continue to do a great job on the consulting side in the TRM business. So with that, we will end the call there and we will look forward to talking to you on the Q3 call. Thanks.
Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.
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