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Syntel, Inc. (NASDAQ:SYNT)

Q1 2010 Earnings Call Transcript

April 22, 2010 10:00 am ET

Executives

David Mackey – SVP, Finance

Bharat Desai – Chairman & Co-founder

Prashant Ranade – CEO & President

Arvind Godbole – CFO & Chief Information Security Officer

Analysts

Reik Read – Robert Baird & Company

Brian Kinstlinger – Sidoti & Company

Bryan Keane – Credit Suisse

Bhavan Suri – William Blair

Tim Fox – Deutsche Bank

Srinivas Anantha – Oppenheimer

Cynthia Houlton – HFP Capital Markets

Puneet Jain – JP Morgan

Ed Caso – Wells Fargo Securities

Vincent Colicchio – Noble Financial

Justin Cable – Global Hunter Securities

Joe Foresi – Janney Montgomery

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Syntel first quarter 2010 earnings call. (Operator Instructions) As a reminder, this call is being recorded today, Thursday, April 22, 2010. 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 first quarter earnings release crossed Globe Newswire at 8.30 a.m. today. It is also available on our website at www.syntelinc.com. Before we began, I would like to remind you that some of the comments made on today's call and responses to questions may contain forward-looking statements. These statements are subject to the risks and uncertainties described in the company's earnings release and other filings with the SEC.

I 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. We also have Prashant Ranade, Syntel's Chief Executive Officer and President and Arvind Godbole, Syntel's Chief Financial Officer, on the call with us today.

As the economy stabilizes, the demand environment for offshore services has continued to improve. Our clients' focus is increasingly shifting from short-term cost reduction and business survival to long-term value and competitive differentiation. Syntel believes we are well positioned as a strategic technology partner to help our clients achieve their business objectives. Our ongoing investments in people, service offerings and infrastructure have created the right framework for success. Our corporate culture of innovation and operational excellence allows us to create custom solutions for our clients and help them succeed in their respective markets.

As the global services economy continues to evolve and mature, our flexibility and deep expertise will allow and enable Syntel to change with our clients' business needs and continue to provide higher value offshore-centric solutions.

At this time, I would like to turn the call over to Prashant Ranade, Syntel's Chief Executive Officer and President. Prashant?

Prashant Ranade

Thank you, Bharat, and good morning to everyone. Syntel's Q1 performance was indicative of the overall offshore services environment, highlighted by solid revenues and increasing margin pressure. Excluding approximately $6 million of short-term project revenue both in fourth quarter of 2009, Syntel's first quarter revenues grew 3.8% sequentially to $116 million. This represented a 20% increase against the Q1 of last year.

Maintenance revenues grew 6% sequentially and overall demand for development work and discretionary projects continued to strengthen. In fact, excluding the incremental Q4 project work, our development revenues grew 5% sequentially.

As Bharat noted in his earlier remarks, while the demand environment appears to be improving, the cost side of our business is becoming more challenging. Operating margins in the first quarter contracted to 23.3%. A portion of this decrease was related to aggressive hiring programs with Syntel adding over 1000 employees for the second consecutive quarter.

While some of these resources became available in March, our average utilization in the first quarter was significantly below previous levels. The company felt this hiring was necessary due to increased improving demand picture and the likelihood of increased acquisitions.

The Q1 margins were also pressured by on-site wage increases, which went into effect on January 1 and a 2% depreciation in Indian rupee. While some of the costs were impacted, our margins in the first quarter have not expected to continue. There will be additional cost pressures forthcoming as a result of currency appreciation, offshore wage increases, result costs and the possible outcomes from a large contract negotiation.

At this point, I would like to provide you with a brief update on the status of our negotiations. As of today, we have yet to finalize any changes to the existing JV agreement. Our conversations with the client remain productive and we believe we are continuing to make progress.

As was the case last quarter, our revised guidance assumes a range of discounts, which would impact both revenue and margins in 2010. However, guidance does not assume that the client will exercise its option to purchase the joint venture nor does it assume that the contract will continue with the same pricing, terms and conditions and without economic impact to Syntel.

Since my appointment as CEO and President, I have spent the majority of my time meeting our employees and clients across the globe. It has solidified my belief in the passion and talent inherent in our organization and also provided me the opportunity to see and hear first-hand the value we are delivering to our clients. It is clear to me, as Bharat has mentioned that the company is extremely well positioned for success. It is also clear that as an organization we must continue to leverage our business knowledge and create deeper relationships with our blue chip clients.

Capitalizing on this opportunity is my number one objective and I believe we are making strides towards this goal. We have been aggressively investing in the client partner role and expanding the number of participants in the program. Recently, we now have strategic account sales reporting directly to the client partners with the balance of the sales team focused on new accounts. Syntel also continues to roll out our new offerings across services, verticals and technologies.

As a means of augmenting this strategy, we have energized our strategic alliance program in the past few months, announcing partnerships with companies such as JasperSoft, Emirates [ph] and MEGA. As we move forward into the second quarter, we are excited by the prospects brought by an improving demand environment. The pipeline remains extremely healthy and the backlog of client projects is still growing.

With increasing regulatory and compliance-related changes sweeping multiple industries, the need for technology and process changes will only increase. Syntel will continue to focus on expanding our footprint within our blue chip customer base, which remains largely under-penetrated.

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

Arvind Godbole

Thanks, Prashant, and good morning. After my comments, we will open the call to questions.

Syntel's first quarter revenue came in at $116 million, up 20% from the prior year and down 1% sequentially. For the first quarter, Applications Outsourcing accounted for 75% of revenue. KPO was 16%, e-Business represented 6% and TeamSourcing was 3%.

From a vertical perspective, financial services contributed 56% with insurance at 18%, healthcare 15%, automotive 3% and all-over accounted for 8%.

Syntel's customer concentration reduced by approximately 2% in the first quarter. Our top three clients represented 49% of the revenue, stock price contributed 60% and top 10 came in at 75%. The fixed price component of our business was 46% of revenue for the quarter.

With respect to Syntel's margin performance, our gross margin contracted 2.4% in the first quarter. This represented a decrease versus 46.5% in the year ago period and 50.2% in quarter four of 2009.

By business segment gross margins for application outsourcing was 35.7%, KPO was 70.1%, e-Business was 45.1% and TeamSourcing 55.4%.

Sequentially our gross margins were negatively impacted by on-site rate increases, a 2% application in the Indian rupee and accelerated hiring, which reduced global utilization.

Moving down the income statement, our selling, general and administrative expenses rose 19.2% in the first quarter of 2010 compared to 19.4% in the prior year period and 17.0% in the fourth quarter.

On a dollar basis, this year was up $2.3 million sequentially, largely as a result of SG&A impact. This included a $1.9 million exchange impact related to balance calculations.

Net income for the first quarter was $25.1 million or $0.60 per diluted share compared to $27.3 million or $0.66 per share in the prior year period and $35.8 million or $0.86 per share in the previous quarter.

It is important to note that the first quarter of 2009 included approximately $0.10 for sales of favorability relating to an income tax result, which was no longer required.

The Company's balance sheet perspective in the first quarter of 2010 remains extremely healthy. Our total cash and short-term investments on March 31 were $213.2 million, an increase of $13.1 million from the third quarter.

As expected, DSO levels increased to 56 days from 42 days reported last quarter. Our capital spending in the first quarter was $3.8 million as we continued progress on the conception of our new campus at Chennai, India, which is set to become online late in the second quarter. The company still expects to spend between $40 million and $50 million in CapEx during 2010 with the construction on Pune Phase 2 beginning soon.

Since the end of the first quarter with a total headcount of 13,682, of which 3,804 were assigned to KPO. Our level headcount was 2,273 on-site and 10,532 offshore for a total of 12,805. Net our results to global accounts, we have 1115.

As a result of the aggressive hiring in advance of the revenues, our utilizing levels at the end of the quarter reduced to 92% on-site, 72% offshore and 76% building. The average utilized during the quarter was actually well below these levels as products were being improved late in the quarter.

Our delivery mix synergy stands at 22% on-site and 78% offshore. Voluntary activation during the quarter was 14.8%, up from 12.9% last quarter. Syntel added eight new customers during quarter one and one new (inaudible) license, which takes the total of number of reported partners to 201.

Looking forward, I would now like to provide you with our updated guidance for the year 2010. Based on our current visibility levels and the factors previously mentioned in prepared remarks, Syntel expects the revenue to be in the range of $445 million to $470 million and EPS in the range of $2.20 to $2.50 for the full-year 2010. This is based on an exchange rate assumption of 44.5 Rupees to the dollar for the last three quarters of the year. We will now open the call for a question-and-answer session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Reik Read of Robert Baird & Company. Please go ahead.

Reik Read – Robert Baird & Company

Hey, good morning. When I look at the midpoint of your revenue guidance, it is basically up $12 million, $13 million from where you were a quarter ago, it looks like most of that upside occurred in the first quarter, so it suggests that the second and the third-quarter revenues would actually be a little bit lower that is not a normal seasonal pattern. You are flat to up. So can you comment on what the thought process might be there in terms of what you may be seeing, just because it seems like most of your comments are incrementally more positive with respect to the demand picture?

Prashant Ranade

First of all, good question. As you know, we have had strong revenue performance in Q1 and we have rated ourselves for the growth based on strengthening demand environment. The guidance is consistent with the methodology that Syntel has used and based on the current visibility which is about 79%.

David Mackey

Yeah. I think the other things that are important to note, Reik, is that we do expect that at some point in this year, as we have been fairly upfront about, we do expect the impacts of our renegotiation on our joint venture to impact our top line and, as Prashant said, the guidance is visibility based. We certainly are optimistic that if the business environment remains stable for the balance of this year and that our clients' cost reduction initiatives continue to kick in that there is an opportunity to see discretionary spending in the back half of the year. But, at this point in time, the visibility to those types of projects is not there and as Prashant mentioned, we are sitting at 79% which is consistent with how we've previously guided.

Reik Read – Robert Baird & Company

Okay. And then could you guys just maybe talk a little bit more about the client partners and maybe give us a sense for how many more you have added versus last quarter and what that development pipeline looks like in terms of ability to field more of those folks coming into the mix this year?

Prashant Ranade

Reik, we have grown client partner programs from mid last year through March. We have had additions in Q4 as well as Q1. So we have had additions throughout the year over the last eight to nine months and we have plans to add more client partners moving forward.

David Mackey

I think also, Reik, the importance of the program has been drilled down to some of the Tier 2, Tier 3 level engagement managers, senior project managers, within the company and, as Prashant mentioned; we are trying to make this program a little bit more systemic across the organization. So not only is it the number of client partners that we've been able to create in the last couple of quarters but it is also the pipeline of internal candidates as well as our external search for these skill sets that continues to increase. So we are pretty comfortable that we are on the right track in terms of creating enhanced capability with the overall client partner program and trying to remove some of the potential bottlenecks for what we believe is a key gatekeeper to expansion of some of our smaller, more under-penetrated accounts.

Reik Read – Robert Baird & Company

Okay. Great. Guys, thank you very much.

Prashant Ranade

Thanks, Reik

Operator

Our next question comes from Brian Kinstlinger of Sidoti & Company. Please go ahead.

Brian Kinstlinger – Sidoti & Company

Thanks. Hi, I have a couple of questions. The first one, when I look at your BPO revenues, it seems they have come down sequentially. Has your top customer there slowed down in light of the negotiations or what else could be going on there that would slow the demand environment on KPO?

Prashant Ranade

The top customer in KPO business has not slowed down. It has been flat. It is true and I will acknowledge that our overall KPO business for all customers has not grown even though we have and we see tremendous opportunities based on synergies within IP and KPO business. This combination of business environment last year where customers did not make certain decisions and actually push the decisions out. But we do have a current pipeline, and we are focused on capitalizing on those opportunities. As you know, this segment has a longer cycle time because these are differentiated offerings.

Brian Kinstlinger – Sidoti & Company

Right. But I just want to make sure because that type customer makes up almost the entire segment. And so you did drop sequentially, I'm talking year over year. So what was the reason for the decline actually?

David Mackey

We had two issues, Brian. One was we did have a reprice with one of our smaller KPO clients. The other issue was, as you know, these are volume-based businesses. So to the extent that some of our clients' businesses are impacted in terms of transaction volumes, it does flow through to our revenue. So quarter over quarter, again, I'm sorry we do have a $700,000, $800,000 impact to revenue. A small portion of that, as I said, was related to pricing. The balance was related to some volume pullbacks with some of our smaller clients.

Brian Kinstlinger – Sidoti & Company

And then when I look at – you are talking about demand increasing but we have heard from a number of your competitors, and when we look at the application outsourcing performance, ex the $6 million from the fourth quarter, it is still among the lowest among your peers. So I'm wondering is that clients, certain clients are having troubles compared to the rest of the industry? I mean it seems like 5% seems to be the low sequential number and you miss that even with the $6 million adjustments.

David Mackey

I mean the applications outsourcing segment did grow 5% sequentially, excluding that $6 million. So in terms of a slowdown, I guess I missed the point in terms of the traction.

Brian Kinstlinger – Sidoti & Company

I'm sorry. My math, I thought it was only about 3.5%, okay. And the last question I had was on the Applications Outsourcing margin. When I look at the utilization, where you were at the end of 2008 that produced a much higher gross margin for this business. So it is unclear why the impact was 1000 basis points quarter to quarter.

Prashant Ranade

The margin impact quarter over quarter sequentially was made up of four components. The wages, clearly, as you have pointed out, utilization and productivity impact of currency as well as one-time impact and utilization and productivity impact was about 300 basis points out of the total that you mentioned.

David Mackey

When you look at the mix on the utilization as well, Brian, I think what you will see is that a lot of the hiring that was done in both Q4 and in Q1 was on-site centric. And you have seen that in terms of the modest shift in the delivery mix. So part of the issue is the overall utilization impact, the other part of the issue is the fact that it has been on-site centric, which carries a higher cost to the company.

Brian Kinstlinger – Sidoti & Company

And is your domestic utilization any different than it was at the end of last year?

David Mackey

It is. We are at about two percentage points lower than we were a year ago.

Brian Kinstlinger – Sidoti & Company

Okay. All right. Thank you.

Operator

Our next question comes from Bryan Keane of Credit Suisse. Please go ahead.

Bryan Keane – Credit Suisse

Hi. I was just hoping to get some color on the operating margin. I know the guidance was 23 to 25 before but we have had wage inflation impact, we've had some impact with the rupee. So can you quantify those impacts and what should we be looking for now for a total operating margin in 2010?

Prashant Ranade

As I mentioned earlier, there are four broad areas that have impacted operating margin, wages, utilization and productivity, currency impact as well as one-time effects on Q1. Going forward, clearly utilization and productivity is what we'll watch based on the demand realization and we do have headwinds related to wages as well as accretion and current negotiations with a large client. But we do believe that in moving forward the range of operating margin will remain the same as we improve the utilization and productivity performance.

David Mackey

And by saying, I think, Prashant is referring to overall our first-quarter margin should be indicative. Relative to our prior guidance, Bryan, we do expect now the operating margins for 2010 to be somewhere between 22% and 24%. So relative to prior guidance, about 100 basis point movement downward is a result of largely a change in the currency from our prior guidance and some expectations around some slightly higher wage inflation.

Bryan Keane – Credit Suisse

Okay. And what was the expectation originally for wage inflation and then I think you guys gave it to us on the call you are expecting it to be what, high single or I cannot recall exactly what it was? But what is now – what were the expectations, what are they now? Because I know wage inflation has been an issue in the industry.

Prashant Ranade

We have planned in the guidance low double-digit increments for our offshore employees and low single-digit increments for on-site employees. The offshore employees, the increments will be effective April 1 and for onshore employees, they have been effective January 1. And, as you have mentioned, over the last 15 months, the supply environment has changed considerably. About 12 or 15 months back, all of us were looking at reduction in headcounts, now, we are vetting ourselves for demand from this and ensuring that we are able to take advantage of the opportunity. And we feel we are prepared to do that.

Bryan Keane – Credit Suisse

And I guess two final questions for me. Attrition at 14.8%, do you expect that to go higher as demand has increased there and do you have any expectations for the year and then just an update on tax rate for 2010 and any update on '11.

Prashant Ranade

As far as accretion is concerned, we'll continue to monitor that. We do not provide forecasts of attrition. But at this point, we believe we are in the best position to manage the attrition.

Arvind Godbole

As far as the tax rate is concerned, for the current year, we expect it to be between 16% and 17% and for 2011 we expect it to be between 20% and 22%.

Bryan Keane – Credit Suisse

Okay. Thanks a lot.

Prashant Ranade

Thanks, Bryan.

Operator

Our next question comes from Bhavan Suri of William Blair. Please go ahead.

Bhavan Suri – William Blair

Hey, guys. Good morning. Just a couple of questions here, just one on State Street, you said that the guidance does not include or does not take into account that State Street might buy the JV. What are your thoughts around the possible potential that they might actually buy the JV or is that so far the picture that it is not worth considering here?

Prashant Ranade

We have had a successful partnership, our long-term goals remain aligned and we'll keep you informed as the discussions progress and discussions are progressing at the rate that both of us have anticipated.

Bhavan Suri – William Blair

Okay. Turning to margin for the quarter, it is down and you broke it out by the four points, Prashant. Could you give us just a little more color on the impact of each of those on margin in terms of what percentage of the margin decline that each accounted for?

Prashant Ranade

Yes. Roughly, if you look at utilization and productivity, as I mentioned, it will have an impact of 300 basis points. The one-time effects have an impact of 300 basis points and the other two areas in terms of currency, as well as wages, have about equal impact, remaining impact.

Bhavan Suri – William Blair

Got it.

Prashant Ranade

So if we look at these areas, utilization and productivity is something that we will closely watch, we'll manage but the focus remains on ensuring that we have – we position ourselves to take advantage of the growth environment and firming demand that we have seen over last few months.

Bhavan Suri – William Blair

Great. And then if I could squeeze this in here. Could you – if we look at the cost of services line, what percentage of that is for the on-site resources versus the offshore resources?

David Mackey

You are talking about the direct cost portion of our cost structure, Bhavan?

Bhavan Suri – William Blair

Yes, that would be helpful, Dave.

David Mackey

Roughly, a little bit over 50% of our direct costs are related to the on-site component and somewhere in the neighborhood of 30% to 40% are related to the offshore component.

Bhavan Suri – William Blair

Great.

David Mackey

So like most folks in this business, 90% plus of our direct costs are related to employee costs.

Bhavan Suri – William Blair

People-based costs, sure. And then as you look at that KPO business and you have added the client partners and trying to grow this business without clients, how many clients do you think you would have, say, by year end or maybe in by 2011? What is the target in terms of number of clients or potentially the number of new adds given that they will ramp over time. I'm just trying to think of how many more people you can at least sell the KPO business into in, say, the next 12 months.

David Mackey

The timing remains extremely difficult to predict. And like you said, I think what is even more difficult is once we do bring on a new client is anticipating how quickly they will move from the first process to the second process. And that being said, if you look at kind of where we were in the 2007/2008 timeframe and we discount what was obviously a unique environment in 2009, I think expectations of adding one to two clients a quarter is probably where we are. But it is certainly will be lumpy.

Bhavan Suri – William Blair

Okay. That's helpful. Thanks for taking my question.

David Mackey

Thanks, Bhavan.

Operator

Our next question comes from Tim Fox of Deutsche Bank. Please go ahead.

Tim Fox – Deutsche Bank

Hi, thanks. My first question was related to a comment you made about hiring being more on-site centric. What is driving that? Given the fact that more and more are trying to drive more of the work force off shore, what are the key drivers for more of an on-site-centric hiring trend?

David Mackey

I think when you look at project starts, Tim typically they do start on-site-centric and then migrate offshore. So to the extent that our top line has been growing and we are adding new projects and starting to add some new clients as well. We added eight this quarter. It makes some sense to believe that delivery mix will shift a little minute bit and that some of the adds will be on-site centric. And that is why you have seen the delivery mix move to 22% on-site, 78% offshore. But over time, you are correct. We would expect that as these clients and as these projects mature, that offshore will be increasingly leveraged and that delivery mix will begin to normalize.

Tim Fox – Deutsche Bank

Thanks. And the second question was around – you mentioned a restructuring in the KPO business. We heard from TPI yesterday that there has been – there was an enormous of restructuring, broadly speaking, in the IPO space. I'm just wondering do you anticipate any of your larger customers going through any restructuring in the quarters this year. And, if so, might there be any risk to the overall pricing and margins?

David Mackey

By restructuring, Tim, are you referring to the repricing that we just discussed?

Tim Fox – Deutsche Bank

Yes.

David Mackey

We did have a modest reprice. I would consider the situation we were dealing with there more of an anomaly than something that we have seen across our customer base. Obviously you are aware of the potential pricing impacts with our large JV clients. But in terms of the overall industry and in terms of our exposure to it at this point in time, we don't believe that we are going to be seeing pricing pressure as something that we will be dealing with in 2010.

Tim Fox – Deutsche Bank

Great. Thanks.

David Mackey

Thank you.

Operator

Our next question comes from Srinivas Anantha from Oppenheimer. Please go ahead.

Srinivas Anantha – Oppenheimer

Yeah. Thank you and good morning. Prashant, in your prepared remarks, you talked about the pretty healthy pipeline, the strong demand environment. Is there in any way that you can quantify what the percentage increase in your pipeline relative to where you were last year? If when you look at that pipeline, is that pretty consistent with a more normalized IT spending environment, or are you still seeing some pressures there?

Prashant Ranade

No. As I said in my remarks, the demand has definitely firmed up, and our hiring was indicative of the trend that we have seen internally. Obviously we do not provide a percentage increase guidance related to that. And we wanted to make sure, which we believe we are in a good position to do, which is to take advantage of that demand. And with the hiring that we have done, we are well positioned to do that.

David Mackey

One other thing to keep in mind is when you look at the overall pipeline and you look at where the industry had been in 2009, as we have talked about in the past, you are looking at a backlog of projects that clients have. So from a normalized perspective, to me the pipeline actually looks healthier than a normalized environment. And a lot of that is because a number of our clients have not done discretionary project work in the last 12 to 15 months. And, as a result, a lot of these projects, which are needed to bring their technology environments up to speed with changes in their business, remain sitting in the pipeline. So the pipeline has continued to grow from a project perspective, so it is very difficult to normalize what a pipeline looks like today.

Suffice it to say, the demand in environment is improving, and the fact that there are these discretionary projects sitting in the pipeline, I think it is more a question of timing than it is intent.

Srinivas Anantha – Oppenheimer

Got it. And secondly, just one question on guidance. When I'm looking at the midrange of their guidance now compared to what you guys gave on the last earnings call, you guys raised it by $3 million. The rupee depreciated by roughly around the same amount. Where is the most upside there coming from? Is it more in the application outsourcing, which I would imagine that is where a majority of the upside is coming from? And also, if you guys could care to comment on the overall pricing environment, especially with large deals.

Prashant Ranade

The first part of your question, clearly Applications Outsourcing being the largest percentage that is where the opportunity is. As far as your second question was related to pricing, right?

Srinivas Anantha – Oppenheimer

Yes.

Prashant Ranade

We expect pricing to be flat outside the comments we have provided about our large clients and JV partner.

David Mackey

Again, to the extent that customers are looking to take cost out of the structure, there remain a number of business levers for us to help clients achieve reductions in total cost of ownership, and that includes moving to more fixed price. It includes, as we talked about a little bit earlier, moving higher components of the work offshore. So if clients are facing increased pressure and are looking to reduce their total cost of ownership on some of these services, there are means to do that without getting into pricing or billing rates. So we do have that still in the toolkit at this point.

Srinivas Anantha – Oppenheimer

Thank you. Thanks for taking my questions.

David Mackey

Thanks, Sri.

Operator

Our next question comes from Cynthia Houlton of HFP Capital Markets. Please go ahead.

Cynthia Houlton – HFP Capital Markets

Hi. First question on revenue by geography; is it pretty consistent with what we have – I don't know if you gave that breakout.

David Mackey

We did not provide it in the prepared remarks, but the revenue in the first quarter was consistent. A little bit stronger in North America, a little bit weaker in Europe relative to the fourth quarter and to 2009.

Cynthia Houlton – HFP Capital Markets

Okay. And then on the hiring plant, I know obviously you have been increasing your hiring and also with an assumption of higher attrition. Any change in what your outlook is on hiring in terms of where we were maybe a quarter ago and at the end of the year? I mean just some thoughts on, as we exit 2010, what that might look like?

Prashant Ranade

As you know, last two quarters we have added over 1000 associates in each of the quarters and that is to prepare ourselves for the firming demand environment. We do not provide, Cynthia, as you know, the headcount forecast for year-end. But we will manage how demand comes in and the resources that we have and ensure the alignment to be able to take advantage of the demand and at the same time improve utilization and productivity moving forward.

David Mackey

Suffice it to say, given where we were in the first quarter with hiring and relative to the revenues that were generated from that employee base, we are ahead of the game in terms of hiring. We are prepared for attrition in the event that it spikes. We are also prepared for growth and certainly making sure that we're ready for the opportunities that the clients bring to us. If we do see increased demand in the back half of the year and we do see a resumption of spending on discretionary projects, it would be reasonable to expect that as we get towards the end of the year to see a resumption in hiring again.

Cynthia Houlton – HFP Capital Markets

Okay. And then just a last question on sales cycles, if we look at both businesses, the Applications Outsourcing and the KPO, and obviously demand improving, the overall environment improving, could you characterize what are the hurdles to getting deals closed? I mean is it just coming down to pricing? Is it the clients don't know what they want to do? Clients are not ready, that they want to do it incrementally? Maybe just a little bit more color on what is driving that final decision to buy or decision to wait in both of those businesses?

Prashant Ranade

They are separated by Applications Outsourcing and KPO. On Applications Outsourcing compared to last year, which I believe is a reflection of current business environment, the decision-making cycle has certainly speeded up. And based on the pipeline we see, we expect to remain it that way.

On the KPO side, clearly last year there were a lot of decisions that were deferred that is much longer cycle business. And the differentiated offerings that we provide to the market will take longer. I do expect the KPO decision-making process to become faster than last year, but the cycle will still remain longer compared to Applications Outsourcing business.

David Mackey

And to drill a little bit deeper into the Applications Outsourcing side and then to echo some of Prashant's comments, Cynthia, when you look at the decisions on things like cost reduction-based services, clearly that cycle has gone from what was complete paralysis in 2009 to a more normalized expedited cycle for those types of projects.

With respect to discretionary and development-related projects, I think ROI continues to be a key driver for our customers. When you look at their budgets for 2010, they are looking at relatively flat budgets. So reduction in costs this year is critical to be able to fund those types of initiatives. And I think part of that decision cycle right now is making sure that those cost reduction initiatives are in place before they move forward with ROI-based projects. So we are doing a lot of prioritization exercises with our customers. The pipeline is full of these initiatives and, as I said a little bit earlier, I think it is more a question of when than if.

Operator

Our next question comes from David Cohen of JP Morgan. Please go ahead.

Puneet Jain – JP Morgan

Hi. Good morning. This is Puneet sitting in for David. I will start with following up on Brian's question on margins. Do you have any targets for utilization rate and offshore mix within your IT services business, which is excluding KPO?

David Mackey

I think the delivery mix question, Puneet, is typically driven by the client. So a lot of that has to do with where their comfort levels are within projects and in the mix of projects that we have. Ideally we would be looking at between 25% and 30% of the work being performed overall on-site. We are obviously a little bit higher than that today when you look at the IT mix.

Relative to the utilization offshore, I think again excluding the KPO business because it does have a different set of dynamics, we typically target around the 70% utilization for offshore on the IT business in a normal growth environment. So obviously in 2009, when there was not a lot of growth and there was not a lot of demand, we were able to run that at a higher level. If we move into a hyper growth situation, you can certainly see scenarios where the offshore utilization falls below 70. We have historically talked about a range between 60% and 80% where at 60% utilization you are either growing extremely quickly or you have done a poor job of demand forecasting. At 80%, you are redlining on any opportunity to meet client demand. So hopefully that gives you a little sense on some of the ranges that we look at.

Puneet Jain – JP Morgan

Yes, it does. What is your current utilization, offshore utilization within your IT services business?

David Mackey

On the IT-specific business, our utilization at the end of the first quarter was sitting at 64%.

Puneet Jain – JP Morgan

So you still have some room to expand margins through increasing utilization?

David Mackey

Absolutely. And I think that is reflective of Prashant's comments around utilization and productivity. We have hired in advance of demand. We are ready for growth. We are prepared if we need to deal with attrition-related issues. But the bottom line is we do not want to miss the opportunity and we view this as an investment in the long-term health of our business.

Puneet Jain – JP Morgan

Okay. And next question on visibility. What is the current visibility on your second-half or full-year revenue? Can you also comment on trends you are seeing in clients' discretionary spending?

Prashant Ranade

Currently, we have a 79% visibility to the guidance which we have provided. And, as far as the discretionary spending, as both Dave and I commented earlier, we are seeing firming demand, clients making decisions faster which is again a reflection of current demand environment. And we believe we're in good position to take advantage of that based on the ready resources that we currently have.

Puneet Jain – JP Morgan

And the 79% visibility how does that compare with normal visibility you have at this point in time in the year?

Prashant Ranade

It has grown from Q4 to Q1 by about 15 to 16 points, and 79% is typically what we see during Q1 of the fiscal year.

David Mackey

Over the last three years, Puneet, our guidance at this point in time has ranged between 75% and 80% visibility.

Puneet Jain – JP Morgan

Okay. So you are entrenched now. This is good. And the last question, a housekeeping question on CapEx. With high CapEx coming up for the remainder of the year, how many seats will you add in the Pune and Chennai campuses for the remainder of the year? Will most of those seats be added in SEZ facilities?

David Mackey

Right now the plan is for 1700 finished seats to be coming online in the second quarter. They will be in our new Chennai SEZ. We will continue construction in Pune and Chennai, but we do not expect at this point in time to have additional capacity creation in 2010.

Puneet Jain – JP Morgan

Okay. Thank you.

Operator

Our next question comes from Ed Caso, Wells Fargo Securities. Please go ahead.

Ed Caso – Wells Fargo Securities

Hi, thanks for taking my question. Can you repeat what the tax rate guidance was for 2010, please?

Arvind Godbole

Yeah. For 2010, we are expecting the tax rate to be between 16 and 17%. And for 2011, we expect it to be between 20 and 22%.

David Mackey

And that's a full-year 2010 tax rate. So the expectation is really that we are going to run about 17% for the last three quarters of the year.

Ed Caso – Wells Fargo Securities

And can you help me with why the first quarter was lower?

David Mackey

When you look at the majority of the cost increases in the first quarter, they were onsite-centric. As a result, it drove down our U.S. taxes, drove down our U.S. profits. And as a result the blend of the two ended up lower.

Arvind Godbole

Also some of the units will grow out of the tax holiday in India. So that may impact the taxes.

Ed Caso – Wells Fargo Securities

When we listen to the advisors and some of the other players that talk about vendor consolidation from often 30 providers to a handful. Can you give us a sense in the last year or two has Syntel been hurt or helped by that trend, and is there any visibility? I know you always talk about I cannot remember which call, preferred clients or whatever. But you always seem to have clients, the number of actual clients less than that list. So I'm trying to understand where – what's happening with your actual client list given the trend of vendor consolidation?

Prashant Ranade

That is a good question. And I would like to share two things with you. Consolidation is generally a result of undifferentiated offerings. And in the segment that we play in and clients that we work with, especially in my last two months every client I have visited, they appreciate our differentiated offerings and the value we create for them. So to answer your question, we don't see any impact of consolidation on Syntel.

David Mackey

And relative to your question about what we had historically referred to as hunting licenses. The number we report, which is 101 here in the first quarter and has continued to grow I believe every single quarter with one exception, that number is a net number. So its reflective of not only what we have added in the quarter, but to your point, if for whatever reason we were added at one point to a preferred vendor list but never gained traction and were subsequently dropped, that is reflective in terms of those numbers.

So it is a good indication and kind of mirrors Prashant's comments to the fact that we continue to remain relevant to our existing customer base and increasingly becoming relevant with new clients.

Ed Caso – Wells Fargo Securities

Okay. How many actual clients then did you have in the quarter that you have booked revenue for?

David Mackey

In terms of clients that actually generated revenue in the first quarter, we had a total of 92.

Ed Caso – Wells Fargo Securities

Thank you.

Prashant Ranade

Also as we have stated in the past, our industry is highly fragmented. It’s a growing pie that sits at about $1.5 trillion today. So even companies that have $15 billion in revenue would have 1% of the overall revenue worldwide and there is just a couple of players that have anywhere above that. So as we engage with our clients and as we have continued to meet them, I think the thing that stands out most clearly is our customized solutions and our responsiveness and innovation in thinking ahead in solving their problems.

Ed Caso – Wells Fargo Securities

Thank you.

Operator

Our next question comes from Vincent Colicchio of Noble Financial. Please go ahead.

Vincent Colicchio – Noble Financial

I'm not sure who this question is for, but could you tell us which of your newer offerings – offer the most promise for the balance of the year?

David Mackey

In terms of what we expect on traction with some of the newer services?

Vincent Colicchio – Noble Financial

Exactly.

David Mackey

Clearly, our global testing service offering has continued to gain traction and it's something that is being extremely well received in the marketplace. Infrastructure management is gaining steam for Syntel. And when you look at some of the things that we're doing in business intelligence and if we see a resumption of discretionary spending, we think we are extremely well-positioned for some growth in business intelligence related activities in the back half of the year.

Vincent Colicchio – Noble Financial

And how large are those three service offerings in terms of contribution?

David Mackey

We do not report that. Clearly, the largest of the three today would be our global testing.

Vincent Colicchio – Noble Financial

Okay. And then on the KPO business, can you give a little more color in terms of what may have been behind the volume pullback with some of your smaller clients? And also what is the volume outlook for the largest client on the KPO side?

David Mackey

I think the changes to the volume in a few of our smaller KPO clients are more related to their specific businesses than anything that was industrywide. It was across three different verticals in terms of the clients that were impacted. So I don't know that we can paint that with a broad brush and give you an easy answer to that question. Relative to the volume outlook for our largest client, I think at a minimum we expect that business to be stable.

As we have talked about in the past, there are multiple ways that we believe that we can leverage our relationship to continue to grow that footprint and to help our client win in the marketplace and to attract volume to their business. And that's clearly the long-term objective of the joint ventures is to go to market and to be competitive and to create a differentiated service offering out there.

So whether that means adding new services to the joint venture or whether that means increased penetration with existing clients to the joint venture or whether that means helping our clients go out and acquire new customers. These are all tracks that we believe are out there to provide upside to the volumes that we are doing today.

Vincent Colicchio – Noble Financial

Can you give us an update on your prospects in the healthcare vertical market? I know that is one that offers a lot of promise in 2010.

Prashant Ranade

Yeah. We have had substantial pipeline and opportunity discussion, which is reflected by addition of resources in that vertical, as well as specific offerings related to regulatory changes. And we see opportunities in all three areas sales providers as well as device manufacturers. And we have had really balanced growth in all three areas as we have built our domain expertise, as well as just the strength in the healthcare vertical.

So I remain positive in terms of what we expect from our healthcare vertical. And during the last three months – two months, I'm sorry. The client meetings that I have had have reflected that.

David Mackey

And I think it's also important to note, when you look at our healthcare vertical and you look at the first quarter revenue that were generated out of that vertical. It represented a 23% increase versus the same quarter of prior year. So we are on a nice trajectory. We do have a very, very broad based healthcare client roster. And as Prashant had mentioned in some of his early prepared remarks, we do believe that that customer base is significantly under penetrated.

Vincent Colicchio – Noble Financial

Thanks, guys. It's all my questions.

David Mackey

Vincent.

Operator

Our next question comes from Justin Cable of Global Hunter Securities. Please go ahead.

Justin Cable – Global Hunter Securities

Yeah, thanks. Question about where you are seeing the demand specifically, what verticals, what type of processes, what type of technologies right now?

Prashant Ranade

We have based on our actual revenues and the information that we have shared; we have had good growth across all vertical. Banking and finance has also had growth from Q1 to Q1. Sequential growth in banking and finance was impacted because of one-time discretionary revenue. If you take that out, we have had a good growth rate across all verticals. And as we shared earlier in healthcare, we have had higher growth than the average growth rate.

David Mackey

From a technology standpoint, Justin, as I mentioned a little bit earlier, clearly when you look at our maintenance revenues 6% sequential growth, 26% year-over-year growth, it has been the predominant driver and it makes a lot of sense given the environment we were in 2009. And what the early environment looks like here for 2010.

As I said a little bit earlier, when we see the opportunity for discretionary projects relative to our pipeline right now, business intelligence, PLM and to certainly a lesser extent ERP packages, all present opportunities in 2010.

Prashant Ranade

And as we shared in our prepared remarks, in relation to BI, analytics and GRC are two additional areas where we are seeing a lot of interest. And we have readied ourselves to take advantage of that.

Justin Cable – Global Hunter Securities

Got it. And would you characterize current revenues as well as your pipeline right now, as sort of playing catch-up from the pent-up demand from last year's kind a stall in projects?

David Mackey

I think the overall size of the pipeline is clearly reflective of that stall. And as I mentioned, when you look at the things that our clients need to do to bring their technology environments in line with the changes to their business, this backlog of projects has done nothing but grow. So it's certainly is reflected in our pipeline and certainly an opportunity going forward.

Justin Cable – Global Hunter Securities

And did you say on the KPO client in terms of the impact from negotiations assumed in your guidance, did you say at what point in 2010 that starts to hit the top line? Do you assume it right away or do you assume Q3, Q4?

David Mackey

We have not provided a date. Obviously, we are in negotiations. We don't know when this will be resolved. And part of the reason that we do have a range of possible outcomes, one is that we don't know the magnitude of the impact; the second is that we don't know the timing. So no, there is no specific date included in our guidance and there is no specific percentage included in our guidance. But we think that the range that we have provided does cover the possible outcomes.

Justin Cable – Global Hunter Securities

Okay. And then last question. Have there been any major changes among your top 10 customers in terms of who they are or their ranking in the top 10?

David Mackey

No major changes in terms of the names. We do have – once you get obviously beyond our largest two clients, there is a pretty significant drop-off of what you see in the customer concentration. So there is some positional movement quarter-to-quarter within clients three through 10, we have had – depending again quarter-to-quarter some movements between clients 11 through 13 and clients 8 through 10, but nothing material.

Justin Cable – Global Hunter Securities

Thank you.

David Mackey

Thank you.

Operator

Our next question comes from Joe Foresi of Janney Montgomery. Please go ahead.

Joe Foresi – Janney Montgomery

Hi. This is Joe Foresi calling for Jeff; just a quick question regarding the JV renegotiation. With the re-price that you discussed earlier with the smaller KPO clients, would that have any impact on the negotiations at all?

David Mackey

It should not have any impact on the negotiations that we are currently having.

Joe Foresi – Janney Montgomery

Okay. Thanks. That's will have.

David Mackey

Thank you.

Operator

I'm showing no further questions.

Bharat Desai

Well, thank you, everybody for joining us today. Earlier this month Syntel celebrated our 30th anniversary. We have come a long way from our 1980 beginnings as a staff augmentation firm focused on the auto industry. As the landscape for global service continues to evolve, Syntel will continue to leverage our rich heritage as a flexible, innovative partner, delivering value to our clients and all key stakeholders. We look forward to talking to you next quarter. Good bye and thank you.

Operator

Ladies and gentlemen, that does conclude today's conference. You may all disconnect. And have a wonderful day.

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Source: Syntel, Inc. Q1 2010 Earnings Call Transcript
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