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Syntel Inc. (NASDAQ:SYNT)

Q3 2009 Earnings Call

October 29, 2009 10:00 am ET

Executives

David Mackey - Senior Vice President of Finance

Bharat Desai - Chairman

Keshav Murugesh - CEO

Arvind Godbole - CFO

Analysts

Bryan Keane - Credit Suisse

Joseph Foresi - Janney Montgomery Scott

Joseph Vafi - Jefferies & Co

Brian Kinstlinger - Sidoti & Co

Bhavan Suri - William Blair & Co

Chris Whitman - Wells Fargo

David Cohen - JPMorgan

Justin Cable - Global Hunter Securities

Vincent Colicchio - Noble Financial

Tim Fox - Deutsche Bank

Operator

Ladies and gentlemen, welcome to the Syntel third quarter 2009 earnings 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; Thursday, October 29, 2009. I will now turn the call over to David Mackey, Syntel's Senior Vice President of Finance.

David Mackey

Thank you and good morning everyone. Syntel's third quarter earnings release across Business Wire at 8:29 am today. It’s also available on our website at www.syntelinc.com.

Before we begin, I would like to remind you that some of 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 will now turn the call over to Syntel's Chairman, Bharat Desai; Bharat?

Bharat Desai

Thank you, David. Good morning everybody and thank you for joining us today. As the overall economic environment continues to stabilize, the prospect of reacceleration in business momentum continues to improve. Mainstream cost reduction programs such as application maintenance are being implemented as planned and discussions of our newer service offerings such as KPO and discretionary IT projects are progressing. While we believe that additional certainty including 2010 budget finalization will be required before spending commitments are made, it’s clear that many of our clients realize that their technology and business processes have not kept pace with changes in their businesses.

We continue to feel that Syntel is well positioned to take advantage of the macroeconomic trends towards globalization of services.

Throughout the difficult economic environment, which has prevailed over the past year, Syntel has managed to sustain exceptional operational and financial performance. Our history as a nimble, flexible organization has allowed us to dynamically adjust our model to both changes in the operating environment and changes in our clients' business requirements. We have been able to do this without sacrificing the key investments necessary to drive long-term, sustainable business value for our clients and all other stakeholders.

To be successful going forward, we must continue to aggressively invest to provide our clients the vision and thought leadership they expect from a true business partner.

I will now turn the call over to 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

Our third quarter performance was highlighted by improving stability in the demand environment and unprecedented levels of profitability for Syntel. The Company was pleased with our healthy sequential revenue growth of 5%. While KPO and TeamSourcing revenues were relatively flat this quarter, application maintenance and application development grew $2.5 million and $2 million respectively.

From a development prospective, the e-Business segment was adversely impacted by $0.8 million due to the successful completion of a large banking project. However, demand for enhancements and small development projects around legacy systems which are reflected in our Applications Outsourcing segment include $2.8 million during this quarter. We do not believe that this represents a macro level return for discretionary spending; it was clearly a positive sign.

Additionally, we were very pleased with the vertical revenue performance as all of our key verticals posted sequential revenue gains this quarter. Given the revenue improvement and relative lag on cost impacts, Syntel was able to post record margins and EPS in the third quarter.

Our gross margin at 49%, operating margin at 31%, and EPS at $0.73 per share were the highest quarterly levels in the company's 29 year history. The majority of the improvement during the third quarter was driven by SGMA difference and a further increase in offshore utilization as revenue grew in advance of hiring. As we look forward to the fourth quarter, we do not anticipate that these margin levels will be sustainable.

Syntel expects both SG&A spending and hiring to pick-up in the fourth quarter, which should have an adverse effect on our margins. Additionally, margins will be pressured by the recent depreciation in the Indian rupee. Our guidance for the full year assumes a fourth quarter exchange rate of Rs.47 to the dollar which represents 3% depreciation from the fourth quarter levels.

On the client front, our blue chip customer base remains stable and our relationships with large clients continue to deepen. While this creates short-term customer concentration increases, we are aggressively investing in the resources necessary to replicate these successes at other high opportunity accounts. Conversations for both new and existing clients around our depreciated service offerings are progressing and the overall deal pipeline remains healthy.

As we have highlighted in our previous analyst calls and SEC filings, we are currently in negotiations with one of our largest clients regarding the extension and the terms and conditions under which the joint venture provides KPO services. While we continue to make progress with the discussions, no formal agreement has been reached at this time. As this joint venture currently represents 18% of Syntel's revenue, changes to the terms and conditions of the agreement could have a material impact on our business. The contract runs through 2012 with an option to purchase the joint venture beginning in February of 2010.

As we head towards the end of 2009, we are pleased with our overall operational and financial performance during a very difficult year. When we first provided guidance back in February we expected revenues in the range of $385 million to $425 million, EPS in the range of $1.66 to $2.08 per share.

Today, our revenue guidance stands at $405 million to $408 million and EPS is estimated in the $2.60 to $2.65 per share range. Visibility to the low end of this revenue guidance currently stands at 99%. We are optimistic that over the next few months, visibility to macro economic trends and our clients' budgets and business plans for 2010 will become clearer.

Given the current environment, while revenue growth may resume in 2010, it’s our expectation that margin pressure will also increase. We expect to continue our strategic investment plans in 2010, including European expansion, hiring of key personnel, targeted service offerings and enhanced infrastructure.

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

Arvind Godbole

Thanks Keshav, and good morning. As Keshav stated, Syntel is extremely pleased with our financial performance in the third quarter. Revenue for the third quarter (inaudible) at $104.7 million, was up 1% from $103.8 million in the prior year period and 5% sequentially from $101.1 million. At a high level, our revenue for third quarter increased due to improved maintenance revenues and legal fee development projects.

On a business segment basis, in the third quarter, applications outsourcing accounted for 74% of revenue; KPO was 18%; E-business represented 6% and TeamSourcing was 2%.

With respect to our verticals, Syntel is pleased to report that again this quarter our revenue growth was broad based, with each and every target vertical growing sequentially.

During the quarter, financial services contributed 56%, with insurance at 19%, healthcare 15%, automotive 3% and other was 7%.

Due to continued growth in few of our large relationships, customer concentration increased during the third quarter. Syntel's top three clients represented 50% of the revenue; top five contributed 62% and top ten came in at 76%. The (inaudible) point component of our business represented 45% of revenue for the quarter.

Our growth margin expanded to [49.3%] in the third quarter. This represented an increase of 500 basis points from 44.3% in the year ago period and over 100 basis points sequentially when compared to 48.2% in Q2 of this year. Our business segment, gross margins or applications outsourcing was 43.5%, KPO was 72.3%, E-business was 49.6% and TeamSourcing, 53.6%. Sequentially, our gross margins were favorably impacted by an increase in the offshore utilizations, improved productivity and to a later extent the 5% to 6% depreciation in the Indian rupee with even US dollar.

Moving down the income statement our selling, general and administrative expenses were 18.1% in the third quarter of 2009 compared to 19.1% in the prior year period and 20.8% in the second quarter.

Sequentially our SG&A was lower by $1.9 million in the [estimated] balance sheet calculation impact in the second quarter.

The other income line of our P&L also had a positive impact on the third quarter profitability as the company recorded $0.6 million in currency hedging gains and an additional [$0.7] million of interest on income tax refunds.

Net income for the third quarter was $30.3 million or $0.73 per diluted share compared to $22.1 million or $0.54 per share in the prior year’s period and $25.1 million or $0.61 per share in the previous quarter. The record earnings performance represented over 20% growth sequentially and over 36% versus the third quarter of 2008.

From a balance sheet perspective, the third quarter of 2009 also produced solid results. Our total cash and short-term investments on September 30, was $174.9 million, an increase of $16.2 million from the second quarter. DSO levels decreased to 52 days from 55 days reported last quarter.

Our capital spending in the third quarter increased to $8.6 million as we continued progress on the construction of our new campus at Chennai, India. We still anticipate capital expenditures for 2009 to be in the range of $20 million to $25 million.

Syntel ended the quarter with a total headcount of 11,487 of which 3,633 were in the KPO. Our billable head count was 1,748 on-site and 8,890 offshore for a total of 10,638.

Operationally, our matrix continues to be strong. Utilization levels at the end of the quarter were 92% on site, 78% offshore and 80% globally. Our delivery mix currently stands at 19% on-site and 81% offshore. Voluntary attrition during the quarter was 11.2%, up from 9.9% last quarter. Syntel added 8 new customers in Q3 and two new hunting licenses which take the total number of frequent partnerships to 98.

I would now like to close with the guidance. Based on our third quarter’s financial performance and current visibility levels, Syntel expects revenue to be in the range of $405 million to $408 million and EPS in the range of $2.60 to $2.65 for the full year 2009. This is based on an exchange rate assumption of Rs.47 to a dollar for the fourth quarter.

We will now open the call for a question-and-answer session. Operator?

Questions-and-Answers Session

Operator

(Operator Instructions) We will take our first question from Bryan Keane with Credit Suisse.

Bryan Keane - Credit Suisse

At an exchange rate of Rs.47 to the dollar, how do we think about long-term operating margins of the business? Obviously you guys are saying that these margins are sustainable. But I guess what is the sustainable level when you think about all the hiring and training that will probably be done here in the near future?

David Mackey

Bryan, this is Dave. I think as we look forward to where our operating margins could go, obviously currency is a pretty significant factor in terms of where those margins will be. As we have said in the past, right now with our cost structure at a little bit over 50% rupee denominated, we have got about a 40 basis point movement in our operating margins for every 1% that the currency fluctuates. So, in terms of where that can be next year, obviously we don't know and certainly are not in the business of prognosticating the exchange rate changes. But that gives you at least some sense in terms of the magnitude of the impact.

As you also mentioned, we are looking at a number of factors as we move through the fourth quarter and into 2010 that will have a negative effect on our margins and as we have been pretty consistent in saying over the last year we certainly expected a lot of these headwinds to come back on the cost side of our business when the demand environment started to improve.

So, things like wage increases, utilization levels, and as you mentioned before, the currency, these will all create headwinds. In terms of the magnitude, we will have to wait and see exactly what that means.

Bryan Keane - Credit Suisse

Okay, what are you guys thinking about wage increases? There has been buzz that wages are going up. Can you talk about that and then also pricing in the environment today?

Keshav Murugesh

Yes, I will talk about the wage side. Obviously at this stage we expect that we are not going to have a repeat of what we saw in 2009 and we will expect to see some kind of wage inflation. Having said that, our increment cycle for offshore kicks in effective at 1st of April so we do have some time to do some planning and see how the market actually shapes up before that. Additionally, I would like to point out that from a Syntel perspective, we have always handed out our compensations around a fixed plus variable kind of a component. So our employees are used to receiving a variable component based on the overall performance metrics of the company. The overall wage inflation will depend on a number of things including, how the market shapes up as well as the plans that we create an actual performance against those plans. But I think it is still early days to talk about specific numbers and we will wait to complete our planning exercise and also see how the environment shapes up.

David Mackey

To your question on the pricing front, I think over the last couple of quarters the pricing environment has definitely stabilized. As our customers start to look out a little bit further in terms of their business needs, I think most realize that the real value in terms of adjusting their cost structures comes from looking at how to do things more efficiently, look at leveraging the inherent benefits of off shore outsourcing. (inaudible) lot more bank for their buck that way than going back and re-negotiating rates. Our expectation certainly as we head into 2010 is that the pricing environment will remain stable and that clients will look for creative ways and creative alternatives to dynamically adjust their cost structures.

Bryan Keane - Credit Suisse

Okay, last question from me. Any thoughts on next year's IT budgets when you talk to clients, and then a second part to that question, have clients under-spent their budget and do you think there is any chances of budget flush for the rather fourth quarter?

Keshav Murugesh

Based on the kind of pronouncements we are seeing from Nascom, Gartner, and some of the other analysts, people are still talking about flat budgets going forward, but definitely some kind of growth in terms of the offshore services in 2010 and therefore we will obviously have to see how some of them shapes up before we actually pick specific growth numbers from an offshore perspective.

We are also seeing, much better quality of conversations with our clients. We are seeing that, as Bharat mentioned earlier, that clients are realizing that technology is now lagging business changes and they need to make some changes. We are still planning to wait for additional clarity in 2010 and we are waiting for our clients to finalize budgets but we are getting a little more positive feeling now in terms of how that spending could be.

In terms of budget flushes, we have never experienced that in the past and I don't think we are going to experience any of that this year as well.

Operator

We will take our next question from Joseph Foresi with Janney Montgomery Scott.

Joseph Foresi - Janney Montgomery Scott

My first question, and forgive me if I missed this; what is the performance of your top accounts? Did you give the percentage of revenue from the top client, top three, top five?

David Mackey

Yes, yes, we did, Joe and in terms of the contribution this quarter, our top three were 50%, top five were 62% and top ten were 76%. So, between a 1% and 2% increase from last quarter.

Joseph Foresi - Janney Montgomery Scott

Okay. If you could talk a little bit about, I know you are sort of in negotiations still with one of your large vendors that you talked about. Any particular commentary you can give about, maybe the length of those negotiations, the level of penetration you have with that particular account?

Keshav Murugesh

Obviously our relationship with this client continues to be very solid. As you are aware, the negotiation is essentially around an extension of our joint venture for provision of KPO services. This contract runs till 2012 and the client has the ability to purchase the joint venture in February of 2010. Having said that, there are many outcomes possible, I mean we are in October of 2009 now and the contract really runs out in 2012. So we really don't have to do this now but we are actually going out of our way to secure the long-term interest of the company by focusing on an extension.

The focus really is in terms of a win-win partnership, delivering long-term value and growing the business together, and in terms of details, obviously we don't have any specific details to discuss at this stage but, just like with any other client, discussions essentially would revolve around pricing including outcome based pricing, SLAs, productivity, wage inflation, volumes and various other factors. So, some of the factors what I mentioned here, there could be others as well and we will have to wait and see how this goes. Again I just want to caution you to the fact that at this stage we don't have any specific timelines for completion of this particular negotiation.

David Mackey

Just to add a little bit of color to Keshav's comments. We’ve disclosed in our last two 10-Qs that we were in negotiations with this client. Obviously these negotiations have been going on for quite some time. They are quite complex when you understand the level and depth of the relationship. But I think, part of the reasons we are having these discussions on both sides is because we both believe in the long-term benefit. You had asked about the penetration levels and I think if there was an opportunity for our client to improve their economics and there wasn't an opportunity for Syntel to improve their long-term economics then we wouldn't be having these discussions. So I think the objective as Keshav mentioned is for a long-term mutual benefit.

Joseph Foresi - Janney Montgomery Scott

In terms of next year, I wonder if you guys could talk a little bit, obviously, going from a down IT services spending environment to a flat one, certainly serves as a positive. I wonder if you could talk about individual catalysts, maybe some areas where you are planning on doing some of the re-investing that you see as growth drivers next year. Is that going to be linked to the top clients?

Keshav Murugesh

Yes, what I would say is that obviously our focus continues to be around investing in some key areas. We definitely have specific plans around each one of our key clients and as I mentioned earlier our focus really is to translate the kind of success that we have in our top ten accounts with the next ten and the following ten and so on. That is what the team is really focused on, coming up with key specific initiatives around each one of the clients that we service.

Separately, our focus again is on increasing our footprint across, Europe, adding more sales people on to our India sales team and focusing very strongly on key offerings like our infrastructure management services offering, our R&D offering, our testing offering where we are moving up the value chain with a new offering as such; our applications, maintenance outsourcing offering as well as enhanced levels of offerings on our healthcare portfolio.

I must say that, each one of our verticals has specialized offerings, targeted verticals as well as existing clients and potential new clients and with renewed fervor around our client-partner program we expect to see much more within our existing accounts as well as in our quest for new accounts.

Joseph Foresi - Janney Montgomery Scott

One last question here and if you can't do this, I know it’s a little bit early; but any way to quantify the reinvestment next year that you will be making?

David Mackey

I don't think there is a way to quantify it Joe because I think it would imply a known return within the year. So, we are going to invest in the things that we think are important to our business. What whether that yields additional revenues in the 2010 period or 2011-2012, it doesn't really matter, they are the right things to do for the business and the right things to do for our client and we are going to make the investments. In terms of how that will or won’t weigh on our margins next year, it would certainly depend on the revenue acceleration within the year.

Operator

We will hear next from Joseph Vafi with Jefferies & Company.

Joseph Vafi - Jefferies & Co

I thought maybe we could talk at little bit on revenue concentration here; seems like we are kind of getting a little more concentrated here. Maybe it would be interesting to talk a little bit about what is going on in the top accounts and way and if they are continuing to grow in this tough environment versus the non-top accounts and maybe I guess looks like less volumes there and why we have that differential and what that means in terms of opportunities for next year?

David Mackey

I think when you look at the behaviors of our clients in a very difficult year, it makes a lot of sense that our customers who were struggling with a lot of their own business challenges picked partners that they were extremely comfortable with to accelerate where they had existing relationships. So, if you look at, where the majority of our growth came from; it came from maintenance services with clients where we already had a significant footprint. I think, when things are difficult and the environment is uncertain clients return to ground zero in terms of comfort and that is what we saw. It makes a lot of sense that if you’ve got that level of comfort with one of your partners and you are going to do anything in a difficult environment, you want to be safe, you want to be secure and you are going to pick the partners that you trust. So, I think much easier in this kind of an environment to accelerate an existing relationship than to get something moving from a very small footprint to a significant footprint.

That goes for not only the services that we were talking about, maintenance and to some extent the KPO but also the fact that with discretionary spending almost completely frozen for a year, there weren't those project specific opportunities to get engaged and demonstrate differentiated value. So, I think the combination of those two would certainly contribute to some of the reasons that we saw client concentration increase again in 2009.

Joseph Vafi - Jefferies & Co

Okay. That does make sense. So, if we did see a little bit better budget activity next year, do you think that obviously that would benefit the large customers? You would see benefit in large customers as well, but do you think that it swings revenue concentration the other way and you get a little bit more in the underpenetrated accounts? Does that make sense?

David Mackey

It does. I think it certainly provides the opportunity for us to do that. As Keshav mentioned, we have been doing a number of client specific and vertical specific investments to try to put some of these differentiated services and value additions directly in front of our clients. The real question is going to be from a top two, top five type of client perspective. If those big customers continue to grow with us and we certainly believe that these relationships are still underpenetrated, it’s going to continue to create a challenge in terms of reducing that customer concentration. That being said, it’s not exactly a bad problem to have.

Joseph Vafi - Jefferies & Co

Right, right.

Keshav Murugesh

If I may just add on to that; as David mentioned, we continue to focus on each one of these clients. I really believe that each one of the top ten clients are still underpenetrated and we still have huge potential in terms of our KPO offering with even our top 20 clients even today. So, even as we continue to focus on the second ten clients and the third ten clients on that list, we still have huge potential of servicing our top ten from a KPO perspective. Remember, we are a firm that really offers an integrated ideal KPO offering and we are in serious discussions with a number of our top ten clients around KPO offerings. So, these are long-term kind of discussions, the sales cycle is long. Who knows, as we get successful with actually penetrating the KPO side, for some time we may actually hit a concentration continue to increase.

Joseph Vafi - Jefferies & Co

Then just finally, could you get a little bit of an update on the KPO pipeline? I know that the pipeline has been in place for awhile. Has there been any progress on that pipeline? Should we expect to see anything in the short-term there and you did have a big success with your top client there and the ability to replicate that?

Keshav Murugesh

I think the pipeline on the KPO side remains healthy, both on the capital markets side as well as the healthcare and the insurance side. Having said that; the sales cycles are really long and what we focus on are really custom processes, so we will have to go through the end of that sales cycle before we can actually announce new wins. Extremely confident about some of the discussions we are having and some of the client visits we are seeing as well as the experience we have had with some of the recent wins where our teams have been able to deliver outstandingly to the new clients and therefore we expect to see further rampup there and absolutely, there are lot of discussions happening around KPO and it’s our intent to continue to build more relationships like the one you alluded to.

Operator

We will hear next from Brian Kinstlinger with Sidoti & Company.

Brian Kinstlinger - Sidoti & Co

First of all, can you quantify your hiring plans in the fourth quarter and then also maybe looking at 2010, are there any initial thoughts as well?

Keshav Murugesh

Like I said, earlier, for 2009 fourth quarter, we expect to see some hiring coming in. During the third quarter, we did see a positive pickup in terms of our hiring, we expect to see that in the fourth quarter as well. To give you another signal again, we are continuing to build out our campuses both in Chennai and Pune. So, it’s early days as of now in terms of our planning process to talk about 2010. But when we will have numbers, we will update on guidance of our stage.

Brian Kinstlinger - Sidoti & Co

But for the fourth quarter can you quantify your plans and maybe utilization too, which you're talking about obviously taking a hit next quarter. You made some assumptions there.

Keshav Murugesh

We expect to see utilization come up a bit and we will be hiring like I said in the fourth quarter, preparing for 2010. We don't have exact numbers as of now but we definitely will be accelerating our hiring in the fourth quarter.

Brian Kinstlinger - Sidoti & Co

So, it seems that all the offshore companies have increased utilization obviously as demand has slowed. I'm curious where you think you are comfortable managing your business once hiring returns and fully ramps and so does demand maybe to where it’s going to be, I don't know whether it will be 30% again, but wherever that is, where are you as a company comfortable running your business from an offshore utilization standpoint?

David Mackey

Brian, I don't think much has changed at a the macro level in terms of how we view the utilization requirements offshore and being prepared to scale our business for growth. One of the things that has obviously changed over time for us is the mix of our services between KPO and IT which do present different types of hiring models because of the custom nature on the KPO side.

With respect to the IT utilization levels, I think we have been very consistent in saying that we are very comfortable at running our business at around a 70% utilization level offshore. If demand is slow we can certainly run higher than that. If we are in a growth mode or an accelerated growth mode, we may be running a little bit lower than that. But, in terms of a band, it’s hard to envision a scenario where our IT utilization levels get outside of the 60% to 80% range.

Brian Kinstlinger - Sidoti & Co

Where are you right now on the IT utilization?

David Mackey

The IT utilization at the end of the third quarter was 72%.

Brian Kinstlinger - Sidoti & Co

In terms of the offshore/on-site mix, I'm curious from an IT perspective where you are there and if there is still room to push more offshore?

David Mackey

We have been making some pretty significant progress, obviously folks who know the history of Syntel realize that this was one of our major challenges in accelerating revenue for a good four or five year period. The good news is, starting in 2009; we actually got to the 30-70 mark for the first time on IT delivery mix. As we exited the third quarter of 2009, our delivery mix for IT was 29% on-site, 71% offshore. So, is there room to continue to move that? I think there is some room. But a lot of the delivery mix issues from here on in are going to be driven by our clients. It’s one of the obvious long-term natural hedges to pricing and productivity. So, the more work that we can do under a fixed price basis, the more pressure that we get over time to reduce total cost of ownership per clients. This is clearly one of the levers that we will continue to try and push. The real question becomes, what tasks and what comfort levels the clients have letting certain parts of the business go offshore.

We believe that over time as clients increasingly become comfortable with the model, that envelope will continue to get pushed.

Brian Kinstlinger - Sidoti & Co

Okay, and several of your competitors gave wage increases in the middle of this year in this past quarter. Did you guys do that? I'm just curious basically.

Keshav Murugesh

No. We didn't have to do that.

Brian Kinstlinger - Sidoti & Co

Okay. What was turnover of the quarter?

Keshav Murugesh

It was 11.2%.

Brian Kinstlinger - Sidoti & Co

Then finally, there were two pieces I didn't quite get. The first one was the KPO gross margin, please.

David Mackey

The KPO gross margin was 72.3% this quarter.

Brian Kinstlinger - Sidoti & Co

72.3; currency hasn’t move that much, what was the difference there?

David Mackey

The currency did not move, as you rightly mentioned, although it’s a contributing factor. I think of the biggest things that we have seen and we have been talking about over the past couple of quarters is we had a large offshore-based KPO client that has continued to ramp down. That number is extremely low right now. It was a very low margin client, so part of the reason we have had improving margins on the KPO has really been addition by subtraction, if you will. We also did not add a significant number of new processes to KPO this quarter. So as a result transition costs and some of the associated training expenses that go with that were a little bit lower than usual. So, kind of the perfect storm if you will, on the KPO side. I don't think we believe those margins will stay at that level going forward. But we are certainly pretty happy with where they came in.

Brian Kinstlinger - Sidoti & Co

I guess I did hear it correct because I didn't believe it. I guess I'm curious, you said it’s not sustainable. Where outside of currency, what would cause it to come down?

David Mackey

Well, I think some of the associated expenses that we have talked about in terms of starting up new processes, ramping up new clients that will create some margin pressure until we get to an economy of scale on that revenue. Also we should be at a stabilized environment now in terms of new clients. So, we should see some margin pressure, all things being equal but I still would expect the margins for KPO here in the fourth quarter to run in the 60s. I don't think you are look at levels that are dramatically below where they have been historically.

Brian Kinstlinger - Sidoti & Co

So you are adding processes in the fourth quarter?

David Mackey

That would be the expectation.

Brian Kinstlinger - Sidoti & Co

Then the final number I missed, you talked about some gains in your other income and losses. Can you just go over the numbers one more time?

David Mackey

We had a gain on currency hedging in the fourth quarter that was about $600,000. Then we had a favorable impact from interest on a tax refund that contributed $700,000. So, a total of $1.3 million of favorable impact to the other income line this quarter.

Brian Kinstlinger - Sidoti & Co

Those are aftertax numbers?

David Mackey

Those are pretax numbers.

Operator

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

Bhavan Suri - William Blair & Co

Just a few questions; first turning to the recommend environment. It was nice to see sort of the pickup there. How is Europe tracking and how are some of the investments you made in Europe specifically in sales tracking?

Keshav Murugesh

Obviously our Europe story is relatively new. We have traditionally followed our global clients into that continent and have serviced them successfully over the past few years. But over the last year in particular we have actually brought in a number of new leaders there, a number of new sales people, more people on the ground focused on forming the existing relationships but at the same time also working closely with the vertical leaders in terms of identifying potential new clients for whom our offerings make sense. We are beginning to see some activity there. We are pretty confident about the fact that every one of these potential clients that we are targeting wants to have a global player who is nimble, flexible and right sized as Syntel is and we are pretty confident that over the next few quarters Europe will start contributing to the overall pie.

Bhavan Suri - William Blair & Co

Just turning to sort of the business today; it was nice to see sequential growth in the financial services healthcare space. What happened in retail then? Was there a customer loss, did a project end or what happened to that revenue stream?

David Mackey

In terms of the retail revenues for the quarter?

Bhavan Suri - William Blair & Co

Yes, you had broken out retail before at about 2% of revenue and then I'm not sure whether it was lumped in other this time, or if that client kind of end up going away?

David Mackey

It was lumped in other. Actually if you look at our retails as a percent of revenue this quarter, it was 2.8%. So, our retail revenues actually grew sequentially.

Bhavan Suri - William Blair & Co

Okay, that was just a little concern I had there. Have you been through the process this year, where customers have rationalized their vendors? How do you approach that and how have you fallen out on either side of that equation?

Keshav Murugesh

That is an interesting question. Obviously that is something that customers have spoken about, analysts keep talking about and obviously, we need to face day in and day out as we go through our business and I'm really delighted to say that based on all that is happening in the market in terms of consolidation and so on and so forth, Syntel has been able to actually hold its step extremely well in this environment, and in fact, if I may say so that most clients now like to have in their mix a player like Syntel that is nimble, flexible, right sized, attentive and extremely innovative and from that point of view we actually believe that we are very well positioned even in that kind of situation.

David Mackey

I think when you look at the consolidation and the rationalization that you are talking about Bhavan, a lot of talk about very, very large organizations moving from 40, 50, 60 vendors down to 10 to 20, and I think a lot of that marginalization came with local staff augmentation types of vendors. The clients that we have where we have been named one of four, one of five partners, we have not seen vendor consolidation and rationalization going from five preferred offshore vendors down to four or down to three. I think it was a lot of fringe vendors that were consolidated. It was more about ease of administration than lack of ability to service.

Bhavan Suri - William Blair & Co

Okay. One quick one if I could squeeze it in. Of the eight wins were there any in KPO this quarter?

David Mackey

Yes, there was. There was one new KPO client.

Bhavan Suri - William Blair & Co

Good quarter, guys. Thanks.

Operator

We will take our next question from David Cohen with JPMorgan.

David Cohen - JPMorgan

It seems that there has been a pickup of interest on the part of larger hardware and software vendors in the services space. What are you thinking in terms of industry consolidation here?

Keshav Murugesh

I think that, like I alluded to this earlier, obviously there is some amount of consolidation taking place. As that takes place we are actually seeing most of the so-called tier two players disappear and it makes our positioning even stronger. So, from our perspective, we just continue to focus very strongly on our markets, on our clients, and on our new offerings and just focus very strongly on building more surpluses for our stakeholders.

David Cohen - JPMorgan

As companies gain scale through M&A, that has not been an approach that Syntel has taken in the past. Is that something that you would look to do, to be more competitive or are you comfortable with solid organic growth?

David Mackey

A) I think we laid out, David, a pretty healthy path where we think we can grow organically and could actually grow organically without adding new clients. We have got great relationships that are pretty significantly underpenetrated. So the organic opportunity for Syntel remains extremely solid. The flip side, of that is that, as I think if you look at the M&A that has taken place in our industry it has not been about M&A for scale, it has been more about M&A for capability; clients looking to bolt on an offshore service offering; clients looking to consolidate so that they can add capabilities that they don't currently have. So, I have not seen at least in this industry where scale was a necessary ability for someone to participate in large-scale offshore service offerings. So, I guess the short answer is no, we don't believe that M&A for scale would be required for us to be competitive.

David Cohen - JPMorgan

Then just some house keeping; how should we think about the tax rate in Q4 and then as we look out into 2010?

Arvind Godbole

Overall for the year we expect the tax rate to be between 12% and 13%.

David Mackey

I think implied in that, David, we are looking at probably a fourth quarter tax rate that's going to be between 16% to 18% which is where our guidance has been and our actual operational tax rate has performed for the majority of the year. We were at 16.5% here in the third quarter. I think we should be looking at numbers similar to that as we head into 2010. Don't anticipate a material change in that tax rate unless there is some type of change in either US or Indian tax law.

David Cohen - JPMorgan

Then can you remind us of any seasonality there on the top line or on the cost side that we should be mindful of in Q4 and maybe as we think about Q1?

David Mackey

Nothing material in terms of seasonality in Q4. Obviously in Q1, we have historically had a bit of a revenue head wind from a couple of the behaviors from some of our larger clients but the seasonality on our cost structure really comes into play in the second quarter as Keshav mentioned earlier, when we typically provide our offshore wage increases.

Maybe a little bit of revenue head wind from Q4 to Q1, all things being equal, little bit of incremental cost in Q1 as a result of onsite wage increases. But the big seasonality in our business, if we return to a normalized environment in India will be based on wage increments in the second quarter.

Operator

We will hear next from Ed Caso with Wells Fargo.

Chris Whitman - Wells Fargo

This is Chris Whitman for Ed Caso. Following on an earlier question, are you currently in any vendor consolidation negotiations within your top ten client base?

David Mackey

Not to my knowledge, no.

Chris Whitman - Wells Fargo

Then could you talk about what you are seeing in the healthcare space? It looks like you had healthy sequential growth this quarter.

David Mackey

I think what we are seeing is a long-term opportunity for healthcare and Syntel is a US owned and operated firm with a number of very, very solid relationships across the payer and provider space, a company that is getting a decent amount of attention. So, we have seen some growth as Keshav mentioned earlier, the majority of that growth this quarter was organic, it came from our existing customer base but we are looking at a number of regulatory and compliance related changes in the industry over the next couple of years and having these deep relationships with a number of large organizations should only benefit us as the healthcare opportunity for IT and KPO continues to expand.

Chris Whitman - Wells Fargo

Lastly, the cash balance is the highest it has been in recent memory. Could you refresh us on your process of deciding on a special dividend?

Bharat Desai

This is Bharat. The Board will typically look at the balance sheet and then make a decision if it is the right use of that cash is to actually return it to shareholders.

Operator

We will take our next question from Justin Cable with Global Hunter Securities.

Justin Cable - Global Hunter Securities

Can you remind us what the total customer count was and whether the eight new customers, is that a net number or is that the gross number?

David Mackey

The eight new customers this quarter would be a gross number. In terms of the number of active clients that we had in the third quarter, we had 78 active clients.

Justin Cable - Global Hunter Securities

How does that compare sequentially year-over-year?

David Mackey

Sequentially it's consistent, year-over-year I think we are up 11.

Justin Cable - Global Hunter Securities

Going back to the re-negotiations or negotiations with your joint venture partner, your customer; can you remind us was this prompted by you guys or was this prompted by your customer when you began the negotiations?

Keshav Murugesh

Actually it was an initiative started by us. Like I said earlier, the contract really runs out in 2012. The client has the ability to buy the joint venture in early 2010 and basically in the longer interests of our stakeholders we decided that we would approach them. Also to some extent we have also seen that, the recent focus of all the news around sale of capitals actually vindicates the joint venture structure. So, we believe that this is the right time and we are focused on trying to getting this to closure as quickly as possible.

Justin Cable - Global Hunter Securities

In light of the upcoming currency headwind at least going forward for the foreseeable future here, are you trying to minimize some of that impact by either streamlining or more hedging or is that like your ramp-up plan will continue through 2010, but are there anyways that you can help mitigate some of the headwind?

David Mackey

I think there are some ways that we could do that and we're certainly looking at the possibility of changing our hedging strategy, but I think it has worked well for us. I think we take a conservative position. I think the reality, Justin, is that we've been consistent in saying that as opposed to taking a look at favorability generated by currency and then turning around and reinvesting, if you will, all of that favorability and creating a cost structure which we can't systemically sustain. What we do is let a lot of that favorability flow through to the bottomline. I think you've seen that in 28% and in this quarter 30% operating margins.

We don't expect these margins to be sustainable long-term, but as opposed to creating a situation where we invest for the stake of investments, for example, we've taken the other route and allowed that to flow through to the bottomline. As long as we're running a healthy business, as long as we're investing at the proper levels and doing the right things for our clients, we'll be fine with where the operating margins shake themselves out. Even if we were to do some aggressive or creative things on the hedging side which I don't think we really want to be doing, the reality is that that favorability would be showing up in our other income line and wouldn’t affecting those operating margins anyway.

Justin Cable - Global Hunter Securities

In terms of the use of cash, are you looking at any acquisitions and anything that would be imminent?

Keshav Murugesh

From our perspective, obviously, there is a lot of stuff happening within Syntel in terms of our investment, in terms of our business [brokers], in terms of our expansion programs and that real really keeps the management team very busy. Having said that, we are all the time on the lookout for anything that is interesting and if there is something that is useful, we will be opportunistic.

Operator

We will take our next question from Vincent Colicchio with Noble Financial.

Vincent Colicchio - Noble Financial

Just a couple, most of mine were answered. You mentioned that actually you've got a lot of opportunity in terms of the top 10 on the KPO side. How much of your top 10 clients are KPO clients today?

David Mackey

One.

Vincent Colicchio - Noble Financial

How many of the other nine, would you say, you're fairly far along with in terms of getting them comfortable with the idea? Any help appreciated there.

David Mackey

I would say that there are at least two additional clients in our top 10 where the discussions have been progressing nicely.

Vincent Colicchio - Noble Financial

Dave, I think you insinuated, I don't know if you said directly that KPO revenue should improve in 4Q. Am I right on that?

David Mackey

I don't think we talked about that. I think what we talked about is the transition costs associated with bringing on some additional processes in the fourth quarter. Obviously, there is a lot of pluses and minuses that go in including the business volumes for our customers. So we'll have to wait and see where that shakes out.

Vincent Colicchio - Noble Financial

Do you expect to add more KPO clients in the 4Q?

David Mackey

I think we would certainly hope to. The timing obviously of when exactly a client signs on the dotted line and what that means in terms of short-term revenue is pretty sketchy, but it certainly would be our objective to add a new KPO client here in the fourth quarter.

Vincent Colicchio - Noble Financial

One last question, Dave, do you any large clients, top 20 clients that are in financial distress we should be aware of?

David Mackey

Not to my knowledge, no.

Operator

We will take the final question from Tim Fox with Deutsche Bank.

Tim Fox - Deutsche Bank

Most of my questions have been asked, but just a quick follow-up on the couple of clients. I wonder if you could just help characterize a little bit around the potential growth there just in an improving economy. Is there a way to sort of quantify how much of the business may have been impacted this year just from the overall volume compression in the economy and some of the work you're doing for the clients.

Is that the right way to think about it with those two top clients? In an improving economy, should we see those revenues and volumes improve naturally outside of, of course, your renegotiations and the other things that are going on there?

David Mackey

Right, I think when you look at our largest two clients, Tim, the type of business and the nature of the work would give you two very, very different answers to that question. One client, the majority of the work that we do is maintenance. There is a component that's development or discretionary in nature. There is two things that we look at as we move forward with that client. One would be some optimism about the resumption of discretionary spending and project work that would serve as an accelerator.

The other thing is the fact that the client has continued to move more and more work offshore in terms of core maintenance. Even the baseline cost of production services, even through a difficult 2009 have continued to accelerate and that's a trend that's been going on for the past four or five years and it’s a client who will aggressively continue to push that envelope. So there is really two growth opportunities from that specific client.

The KPO client that we have in our top two, completely different set of issues, obviously, they are trying to add new processes which will allow them to leverage the inherent leverages from offshore in terms of capability and in terms of cost. They are trying to push incremental volume through those processes, which has been a challenge in the current environment.

There is also the opportunity with both of these clients to cross-sell services. So for the first to expand and open up KPO relationships and on the second one where we do have both a KPO and an IT relationship today to continue to expand our footprint within the IT side of their business. I think to circle back to Keshav's comments earlier, we believe that all of our top 10 clients including our two very large clients, are significantly underpenetrated and there is some pretty good opportunities for us to continue to grow the overall footprint with those customers.

Tim Fox - Deutsche Bank

My last question, trying to circle back little bit around utilization and margins. From an external perspective, what are the key things that we should be looking for that might be the catalyst per se for you to build out the bench? I mean the bench at this point is arguably the lowest that has been in a few years for obvious reasons. Is this going to be more attrition picking up or demand picking up or a combination of both? I'm just trying to get a sense of what is it that's gong to be really the trigger for that hiring to resume and possibly affecting utilization.

David Mackey

I think it’s a combination of factors, Tim. Clearly, if you look at our attrition rate here in the third quarter we did see a little bit of increase from the 9% to 10% we’ve run the first half of this year to 11%. That being said, we did expand our hiring plan during the third quarter because when you look at where our utilization, our utilization levels increased this quarter despite actually having a net hiring quarter for the first time this year. So it is combination of factors. Attrition is part of it.

The health of the pipeline and the revenue opportunities in front of us were part of it and the overall demand environment is part of it. The good news about the industry and some of the things that have changed recently is that the hiring model is now a lot more just in time than it's been historically. Now, I think some of that will become a little bit of a challenge as the environment improves, but the bottom line is, we've got a lot of flexibility in terms of how we hire and how quickly we can bring people on and make them productive.

So all things being equal, yes, net hiring should be a pretty good sign that things are moving in the right direction, but utilization levels in any given quarter can fluctuate especially depending on campus hiring cycles.

Operator

There are no questions at this time. You may make your concluding remarks at this time.

Keshav Murugesh

Thank you for joining us today. As we near the end of a very difficult year, we are encouraged about the prospects for the future. At a macro level, globalization of services and a stabilizing economy appear to be consistent teams. More specific opportunities for outsourcing will arise as a result of lags in technology spending, ongoing cost pressures and regulatory and compliance changes.

We believe that Syntel is extremely well-positioned to take advantage of these trends based on our blue chip relationships, differentiated services, and flexible customized approach to helping clients meet their changing business needs. We look forward to talking to you again next quarter. Goodbye and thank you.

Operator

This concludes Syntel's third quarter earnings call. A replay of today's call will be available until November 5th, 2009, by dialing 888-203-1112 and entering the passcode which is 5634944. Thank you.

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Source: Syntel Inc. Q3 2009 Earnings Call Transcript
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