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Executives

David Stein - Head of Investor Relations

Andrea J. Ayers - Chief Executive Officer, President, Director and Member of Executive Committee

Andre S. Valentine - Chief Financial Officer

Analysts

Ashwin Shirvaikar - Citigroup Inc, Research Division

Paul B. Thomas - Goldman Sachs Group Inc., Research Division

Timothy Wojs - Robert W. Baird & Co. Incorporated, Research Division

Convergys (CVG) Q2 2013 Earnings Call July 31, 2013 9:00 AM ET

Operator

Welcome to the Convergys Second Quarter 2013 Earnings Teleconference. [Operator Instructions] Today's conference is being recorded. If anyone has any objections, please disconnect at this time. I would now like to turn the call over to Mr. David Stein, Vice President of Investor Relations.

David Stein

Thank you, Stacy, and good morning. Welcome to the Convergys Second Quarter 2013 Earnings Call and Webcast Presentation. This call is the property of Convergys. Please note that slides accompanying today's prepared remarks are available on the Convergys Investor Relations website under Events and Webcasts.

Today's call contains forward-looking statements that address our expected future performance and that, by their nature, address matters that are uncertain. These uncertainties may cause our actual future results to be materially different than those expressed in our forward-looking statements. We do not undertake to update our forward-looking statements as a result of new information or future events or developments. Please refer to yesterday's earnings release and our most recent filings with the SEC for additional information regarding uncertainties that could adversely or positively affect our future financial results. This includes the risk factors provided in our Form 10-K for the year ended December 31, 2012.

Also, during the call, we'll discuss non-GAAP financial measures, including free cash flow, EBITDA, adjusted operating income and adjusted EPS. A reconciliation of these non-GAAP measures is available in the news release and on the convergys.com website under Investor Relations.

With me on the call today are Andrea Ayers, our President and Chief Executive Officer; and Andre Valentine, our Chief Financial Officer. Andrea will provide a summary of our operating performance, and Andre will cover our financial results and business outlook. Then, we'll open the call for your questions.

Now I'll turn the call over to Andrea.

Andrea J. Ayers

Good morning, and thank you for joining us today. We delivered steady improvement in revenue, EBITDA and EPS in the second quarter, as we execute our plan for sustained growth and margin expansion. Our revenue of $504 million in the second quarter represents an increase of 3% compared to revenue of $491 million last year. On an adjusted basis, EBITDA increased 6%. EBITDA margin was up 50 basis points, and EPS growth in the quarter exceeded 30%. We paid a $6 million dividend and repurchased $25 million of our stock during the quarter. $192 million remains authorized for repurchase.

On April 30, we acquired Datacom's Asia contact center operations for approximately $20 million. Contributions from this business and its team are in line with our expectations and the integration is going well. We continue to consider selective acquisitions when there is opportunity to leverage our current strengths and to add clients, capabilities or countries to our platform. We pursue M&A only if the opportunity meets our strict criteria regarding appropriate valuation and ease of integration. At the end of the quarter, we had $587 million of cash and short-term investments on the balance sheet.

Now let's review our operating progress in more detail. In terms of revenue, volume increases with several of our clients across the vertical markets we serve drove year-over-year and sequential growth. During the quarter, we grew with 14 of our top 20 clients. Call volumes remain strong across our service delivery region. Revenue was up in the Philippines, India and Latin America.

In the second quarter, we signed new live agent business worth $110 million of 2014 revenue with several existing clients and a select group of new logos. We expect $55 million of revenue from these wins in 2013. Investment in our winning business model is paying off, evidenced by our sales momentum in recent quarters. We are particularly encouraged by the breadth of our new business signings in terms of clients, verticals, geographies and service offerings. We had new business wins in each of our major verticals, across all of our geographies and for a wide array of call types, service offerings and our capabilities.

In addition to customer care, we won technical support, sales, collections, B2B and analytics programs in the quarter. Overall demand remains solid, but we continued to see volume fluctuations with some of our large clients. There is opportunity for sustained growth as trends in this industry continue to play to our strengths. We continue to see the same for industry trends: call complexity, full lifecycle of services, vendor consolidation and offshore delivery.

First is the trend toward increasing call complexity. Demand for our services remain strong even if consumers adopt alternate channels to address their simpler transactions. As these transactions are offloaded to non-voice channels, volume is shifting to more complicated calls, those that cannot be handled without an agent. This trend plays to our ability to invest in a Global Operating Model, using the right talent and tools to deliver consistent quality, responding accurately and on the first call as possible even for the most complex calls.

Second is client demand for the full lifecycle of services. Client service requirements span a wide range of customer support functions, including basic service inquiries, customer acquisition, technical support, billing and payments, cross-sell and upsell, retention and collections. As their customer support strategies change, clients must balance the need to improve the quality of the experience with the need to manage cost. Clients seek partners to cost effectively tailor their interactions based upon specific customer behaviors and support a seamless customer experience across channels. We invest in a breadth and depth of services, technology and analytics capabilities to allow us to rapidly address changing client needs.

Third is vendor consolidation. Large clients continue to rationalize the number of providers in their supplier base. We find many clients and prospects looking to consolidate with providers that are able to quickly ramp programs and handle most call types at scale with high quality from the regions that they prefer. This reinforces our commitment to invest in account management. Close client engagement allows us to understand their unique requirements and deliver the right mix of solutions when consolidating volumes from other vendors.

Finally, the offshore trend continues at a steady pace. Our investment in global capacity enables us to handle a broad range of contact types from multiple geographies with consistent quality. Investment in our unique combination of global quality delivery, comprehensive solutions and close client engagement allows us to address these trends. We are proud of the loyal and expanding number of clients who trust us with their most important asset, which is the contact with their customers. As clients choose to partner with us, we know that our winning business model is driving the predictable consistent performance they demand, which enables us to grow revenue and expand margins.

In addition to revenue growth in the second quarter, we also delivered solid margin expansion. On an adjusted basis, operating income was up 12% compared with last year, and operating margin improved 70 basis points. This reflects profit flow-through on the revenue growth in the quarter and our continued efforts to control costs.

Our ongoing cost control process seeks to enhance productivity and efficiency by continuously looking for ways to refine our operating model and reduce cost. After 12 months as a business with a singular focus, we're taking steps to become a leaner and more effective operation. Recall last year, we reduced a large portion of corporate G&A functions. Some of the functions retained in the business were structured to support a far more complicated company with multiple lines of business. We are taking steps in the third quarter to further simplify these areas and improve the efficiency of our operations. This action should result in continued margin expansion in 2014 as we drive toward our target EBITDA margin of greater than 13% by 2015.

Importantly, we are reaffirming our full year 2013 guidance for steady revenue growth and earnings expansion, inclusive of these activities. Andre will provide more detail on the impact of the restructuring action in a moment.

In summary, we are successfully executing our plan to drive sustained growth. We're signing more business and building stronger relationships with existing and new clients. We continue to invest in a winning business model and take steps to further improve operating efficiency. As a well-capitalized market leader, we remain committed to managing our capital to benefit both our clients and our shareholders. Our progress year to date gives us confidence we will achieve our full year targets. I want to thank the team for delivering another quarter of solid results. Finally, I'd like to thank our clients for their trust in Convergys as we partner to support their customers and to strengthen and grow their businesses.

Now Andre will provide more detail on our financial results and guidance.

Andre S. Valentine

Thank you, Andrea, and good morning. Let's begin with revenue. As expected, volume increases with existing and new programs in the second quarter drove steady growth, both year-over-year and on a sequential quarter basis. Revenue was $504 million, up $13 million compared with last year. As we anticipated, our sequential quarter revenue increased with our largest communications client in the quarter.

Year-over-year, we continue to see the negative impact of some program-specific changes with that client. We also absorbed the negative impact of a previously completed program with a financial services client. Based on our strong new business signings and our clients' forward volume forecast, we continue to expect revenue growth in the third and fourth quarters.

In terms of our footprint, our regional mix of contact center employees was unchanged at the end of the second quarter compared with the first quarter. By region, 43% of our employees were in the Philippines; 35% were in the United States, including our work-at-home agents; 15% in India, 4% in Latin America, 2% in Canada; and 1% in the United Kingdom.

In terms of profitability, on an adjusted basis, operating income was $39 million in the second quarter, up $4 million from the prior year. Operating margin was 7.7% in the quarter, a 70-basis-point improvement compared with last year. EBITDA increased $3 million to $61 million, and EBITDA margin improved 50 basis points to 12.2%.

GAAP results in the second quarter included an expected $8 million noncash pension settlement charge and a $1 million loss on real estate sales related to corporate simplification actions began in prior years. We completed the real estate sales in July and received cash proceeds of approximately $47 million.

The profit improvement in the second quarter was driven by positive volume impacts and our continued focus on controlling costs. This positive volume trend is driving increased investment in agent training and global facilities. As a result, we expect some margin pressure in the near term as we support several new program ramps. We expect our revenue growth to drive operating improvements later in the second half and for the full year.

Turning to net income. Adjusted EPS from continuing operations was $0.25 per share compared with $0.19 last year. Our effective tax rate was 23% in the quarter on an adjusted basis, and we continue to expect the full year rate of approximately 22%. In terms of cash flow, we generated strong free cash flow in the quarter of $35 million. Timing of capacity additions played a role in keeping our capital expenditures relatively low in the quarter. We continue to invest in global capacity to support future growth, and we expect full year CapEx to be near the low end of our historical range of 4% to 5% of revenue.

Moving to the balance sheet. We had cash and short-term investments of $587 million at the end of the second quarter. About 60% of the cash and short-term investments are held in the United States. We repurchased 1.5 million shares of our stock during the quarter for $25 million. Our capital structure principles remain balanced. We're committed to maintaining a strong balance sheet, investing in strategic growth, both organic and inorganic, and returning capital to investors.

Now I'll discuss our business outlook for the year. Given our solid performance in the first half and the expected pace of new program ramps in the second half, we are affirming our guidance for the full year. We continue to expect revenue to exceed $2.055 billion for the full year. Our earnings expectations on an adjusted basis remain full year EBITDA to exceed $248 million and EPS to exceed $1.05. We continue to expect free cash flow to approximate net income for the year.

As Andrea mentioned, we're in the planning stage of actions we expect to take later in the third quarter to further simplify the business and reduce costs. Included in our full year earnings guidance is an estimated $5 million restructuring charge related to these actions. Our guidance continues to exclude any additional costs that may result from the corporate simplification actions last year. Specifically, there will be additional costs this year related to noncash pension settlement charges. Also excluded from our guidance are any additional acquisitions or additional stock repurchase activity.

In conclusion, we are pleased with our results in the second quarter. We're focused on executing our operating plans to deliver profitable growth in 2013, and we have an attractive business with long-term prospects for revenue growth and earnings expectations -- earnings expansion.

At this time, operator, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Ashwin Shirvaikar of Citi.

Ashwin Shirvaikar - Citigroup Inc, Research Division

So my question is really with regards to forward guidance. If I look at normal seasonal patterns and what you've done year to date, I mean, in terms of EPS, it's quite possible you guys could be well north of $1.10, perhaps closer to $1.15 and especially because you're not including, I guess, the restructuring cost in there. So my question is half the year's gone by. Trends are looking good. You have both your cash on the balance sheet. Why the conservatism with the guidance?

Andre S. Valentine

Yes, Ashwin, this is Andre. One thing to clarify, our guidance of to exceed $1.05 in EPS and also our guidance to exceed $248 million in EBITDA includes the $5 million restructuring charge. And so I think of that as being roughly $0.03 of EPS.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Got it. Right. But even so I'm kind of talking more like the $1.10-$1.15 range where you could safely go above [ph]. Just based on normal seasonal trends the last couple of years and this year seems to be potentially better than the last couple from fundamental trend perspective, no?

Andre S. Valentine

Yes. So exceeding $1.05 would mean $1.06 or better, roughly $0.03 wrapped up in the charge, the restructuring charge we just talked about, and then we are seeing -- to get to our revenue guidance of pretty healthy revenue ramp in the second half, and that requires some investment, as I talked about in my comments, kind of ahead of the curve, so investing in agent training and some facility costs, frankly, before the revenue comes in or before, certainly, you reach peak utilization. So that's what's baked into our expectations. Obviously, we'll try to do better. But that's why we're confident with the guidance we're giving today.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Understood, understood. And in terms just deepening your existing client relationships, 14 of the top 20 you mentioned, is it possible to kind of give us an idea of what kind of overall wallet share you have? What's the potential there in terms of keeping on increasing?

Andrea J. Ayers

Yes. And so, Ashwin, the -- I'm very pleased with the investment we began making a couple of years ago in account management because I believe we're seeing that pay off in terms of those broader, deeper relationships, as well as the growth with our existing clients and the breadth of the service offerings that you heard me talk about that they're buying from us. We're in there with them now, understanding their needs, I think, better than we ever have, so I feel good about that investment choice. As I think about potential, if you just think large numbers, each of our clients outsources normally about 1/3 of what they spend in the type of work we do. We have wallet share with them that ranges in about 1/3 range. The trends that I'm seeing different that I'm very encouraged about though that I talked about a little bit is vendor consolidation. And so what we are seeing is a conscious choice by most of our existing clients to make some effort to rationalize the number of providers that they have, which means there is more opportunity to pick up wallet share from them when they're going through that process because what they tend to do is consolidate down with the larger players that can make the ongoing investment in breadth and depth of services, the geos they want to be in, infrastructure to drive the quality model that they require. And so I think we still have room to go, and it was one of the reasons a couple of years ago we identified that discrete account management investment as being very important to us. Did that help, Ashwin?

Ashwin Shirvaikar - Citigroup Inc, Research Division

No, yes, that certainly helped to frame it a lot better. Now in terms of -- one last question with regards to further simplification. Would this take the form of potential incremental divestitures? Or are you kind of just -- are you talking layers of SG&A, real estate, any idea, which direction you're headed in?

Andrea J. Ayers

Right, absolutely an idea. No additional divestitures. This really is us going in and continuously looking at what we do and how we do it and is there a better way and then specifically as it relates to some of those functions that used to support larger, more complicated business lines, looking at that and making them fit what we actually need in a singularly focused business. That's all it is.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Got it, okay. So more along the lines of like Six Sigma Lean type of thing.

Andrea J. Ayers

More along that line, exactly.

Operator

Our next question comes from Paul Thomas of Goldman Sachs.

Paul B. Thomas - Goldman Sachs Group Inc., Research Division

Could you talk a little bit about the new business wins, what the breakdown of the wins from new customers versus existing customers? And how does that compare with the last couple of quarters? And any differences there?

Andrea J. Ayers

Yes. One of the things that we feel very good about is there are some of both. So there are new customer signings in there. We've got a little communications addition to our new logos. We've got some in the other category. So we're feeling good about having some of both and then some existing growth with our existing clients that we talked about. One of the things we're liking that we've seen in the last several quarters is some real breadth and variety across our vertical markets, so we're seeing some wins in each, which feels pretty good. We're seeing wins in each of our geographies. And as I talked about before, nuanced under those verticals, we're seeing different types of work. All of those are just, to me, multiple ways we can diversify where our revenue stream comes from even within an existing client program. So I hope that gives you a little more color. But we're seeing more breadth there, more variety.

Paul B. Thomas - Goldman Sachs Group Inc., Research Division

That does. Maybe specifically on the financial services vertical, you talked about the contract ramp-down there and revenue being flat quarter-over-quarter. How are you thinking about that in the back half of the year?

Andrea J. Ayers

Sure. We are -- that also includes -- Andre talked about a contract ramping down. That's in there. It is also the place that our technology base revenues were mostly in that vertical as well, and so we've been talking about having some runoff from that as we go through this year. So that's what makes that up. How are we thinking about it? We have a new team in there focused on helping us make that grow. We're also thinking about it in terms of diversifying underneath that macro vertical with additional capabilities to allow us more access to grow with some of our existing clients by expanding our capability set in the vertical.

Paul B. Thomas - Goldman Sachs Group Inc., Research Division

Okay. Maybe just one last one for me, too. Can you talk a little more about uses of cash? How should we think about the growth potential for the dividend down the road or further increases in share buybacks?

Andre S. Valentine

Sure. Sure, Paul, I'll take that one. We were very glad to initiate our dividend roughly May of 2012 and to have raised it earlier this year. I think that's something we'll continue to look at. We know that yielding today, 1.25% is probably putting us in a bit of a no man's land, so we'll continue to look at the dividend as we project very strong free cash flow for the remainder of this year and next. That will put us in a position to continue to evaluate the dividend and whether an increase is merited there. Regarding share buyback, we've seen some of the write-ups already this morning that we were probably a little bit lighter than expectations there in Q2. We accept that. Probably best not to get into a dialogue regarding the exact timing of buyback activity. But we have an authorization of $192 million, and we are very committed to disciplined capital deployment, including investing in strategic growth, both organic and inorganic but also the role that share buyback and the dividend will play in returning cash to shareholders. So nothing really has changed there.

Operator

Our next question comes from Tim Wojs of Baird.

Timothy Wojs - Robert W. Baird & Co. Incorporated, Research Division

I had a couple of housekeeping questions and maybe just a longer-term one. I guess first on the restructuring. You guys are taking the charge of this year, but what type of annual benefit in terms of cost savings you guys expect from those restructuring charges?

Andre S. Valentine

Yes, Tim, so we're still kind of finalizing our plans, so I'll be a little rangy here probably or a little net-net too precise. But in general, I think a good rule of thumb is once fully implemented, and I think we'll have these things largely implemented by the end of this year, we would expect the savings to be roughly 2x the charge. So still finalizing plans, but kind of think about it in a range around that.

Timothy Wojs - Robert W. Baird & Co. Incorporated, Research Division

So as we think about next year, 2014, you should see the restructuring charges won't fall off and then see some cost savings around the incremental actions?

Andre S. Valentine

Yes. So we'll certainly see cost savings from that. Of course, every year, we also have cost headwinds, as you can imagine, agent wage increases, et cetera. This is just part of the business. And kind of our near-term plan is to keep progressing towards having a margin, an EBITDA margin of greater than 13% by 2015. And the actions we're taking with respect to this charge and just the way we're thinking about the business in general is all part and parcel of getting us to that level.

Timothy Wojs - Robert W. Baird & Co. Incorporated, Research Division

Okay, okay, that's helpful. And then just on the real estate sale, how should we think about just the incremental rent expense? I mean, is that material for you guys going forward? Or is there some opportunity to -- if we use those proceeds to buy back some stock and maybe offset the net income or the EPS impact from that?

Andre S. Valentine

Yes. So a couple of things on the real estate sales. First of all, I should point out that it's -- that's plural for a reason. So we sold 2 buildings, the largest portion being our corporate headquarters building here in Cincinnati. We also sold an office building that we owned in Dallas, Texas. And so I feel good about completing both of those transactions. The ongoing impact to operating income and EBITDA is, frankly, pretty immaterial, so I wouldn't be too worried about that. And so yes, sitting here today, we've got an additional $47 million of cash in our coffers that's not reflected in our June 30 balance sheet that will be part of our disciplined capital deployment strategy going forward.

Timothy Wojs - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then just on health care, we've done some checks, and it seems like the industry is a little bit more optimistic about the near-term volume benefits from the Affordable Care Act, as well as some of the opportunities with health care providers. And so how do you guys think about the impact to health care, both from a volume standpoint and then also from an employee cost standpoint?

Andre S. Valentine

Yes. So we are seeing an awful lot of activity in the health care vertical. I think we've talked pretty broadly about some segments of the other verticals that we feel good about, and certainly, health care and retail are 2 places where we're seeing some real success. The success in health care is certainly partially being driven by Affordable Care Act as our clients and potentially even the clients coming that aren't currently clients of ours think through how they will deal with the rush of calls that will be part of this year's open-enrollment period and ongoing. So yes, we see it certainly a positive impact from that perspective. On the cost side, it's a bit of a cost headwind, but I would not say it's a massive one. So it's in the range of things that you deal with in the call center industry every year, and you plan for it, and you work through it.

Andrea J. Ayers

It's also something we've been working on for a couple of years, and so I think that's helping us feel more comfortable with what the impact is going to be.

Operator

[Operator Instructions] At this time, I show no further questions.

David Stein

Thank you, Stacy, and thank you all for your participation on the call today, and have a good day.

Operator

This concludes today's presentation. Thank you for your participation. You may now disconnect.

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