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Syntel, Inc. (NASDAQ:SYNT)

Q2 2010 Earnings Call

July 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

Brian Keane – Credit Suisse

Joseph Foresi – Janney Montgomery Scott

Joseph Vafi – Jefferies & Company

Brian Kinstlinger – Sidoti & Company

Bhavan Suri – William Blair

Vincent Colicchio – Noble Financial

Puneet Jain – JP Morgan

Srinivas Anantha – Oppenheimer

Reik Read – Robert Baird

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Syntel’s Second First Quarter 2010 Earnings Call. (Operator Instructions) As a reminder, this call is being recorded today, Thursday, July 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 Second Quarter Earnings Release across the Globe Newswire at 8:30 a.m. today. It’s also available on our website at www.syntellink.com.

Before we begin, I’d like to remind you that some of the comments made on today’s call and responses to questions may contain forward-looking statements. These statements are subject to the risk and uncertainties described in the company’s Earnings Release, and other filings with the SEC.

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

Bharat Desai

Thank you, David. Good morning, everybody. 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.

Through the downturn, Syntel continued to proactively manage both the short-term and long-term health of our business. We continued our aggressive investment programs, including new service offerings, hiring, and training of key resources, and the ongoing build out of our world-class infrastructure in India.

Additionally, in 2009, we challenged our employees to use the difficult environment as an opportunity to strengthen business relationships and position the company for long-term success.

With the relative stability in the domestic economy, we believe we are beginning to see the benefits of these program. This is evidenced by the ongoing growth in cost-production based initiatives and services, and the acceleration in new development projects.

We are extremely pleased with our Second Quarter Financial and Operational performance, and remain focused on continued execution.

I would now like to turn the call over to Prashant Ranade, Syntel’s Chief Executive Officer and President, to provide further details. Prashant.

Prashant Ranade

Thank you, Bharat. And welcome everyone. During the second quarter, Syntel continued to build on our business momentum. Revenues of $130.6 million represented a 13% sequential increase and a 31% increase was in the Second Quarter of 2009. Not only are we extremely pleased with the overall revenue progress achieved during the quarter, but we are equally excited about the broad-based nature of the improvement across service offerings, verticals, and clients.

Arvind will provide additional color on some of these key metrics in his prepared remarks.

As anticipated, margin pressure increased during the quarter as Syntel rolled out our 2010 offshore wage increases effective April 1st.

Additionally, other margins in the second quarter were negatively impacted by the recognition of our large – I’m sorry, renegotiation of our large KPO Joint Venture, which was finalized effective June 1st.

As disclosed in our 8K, our client waived their right to purchase Syntel’s interest in the joint venture through February of 2012. And the joint venture provided economic compensations to the client.

From a currency perspective, while average Indian rupee appreciated by 0.2% during the quarter. The exchange rate actually depreciated significantly in the month of June.

This resulted in minimal impact on our rupee-denominated cost structure, but resulted in a variable balance sheet adjustment. The adjustment in Q2 reduced our SG&A expenses by $1.7 million, which was in sharp contrast to the $1.9 million incremental expense reported in the first quarter.

Operating margins in the second quarter also expanded due to accelerated revenue growth, which allowed Syntel to leverage our SG&A costs.

During the second quarter, Syntel added over 1,200 employees on net basis representing a 9% sequential increase.

Improvements in utilization were put on hold as we continued to proactively hire in response to strengthening demand trends, a healthy pipeline, and driving accretion rates.

As a result, average utilization in the second quarter was largely unchanged from first quarter levels.

In support of healthy demand, and accelerated hiring, we are aggressively building out our infrastructure in India ahead of the curve.

Syntel inaugurated Phase 1 of our new campus in Chennai during the second quarter with 1,700 finished seats and available capacity of an additional 3,400 employees.

We are also moving forward with construction of Phase 3 of our Pune campus and are looking at additional opportunities for further infrastructure expansion this year.

Last quarter, we spoke about the need to leverage our business knowledge and create deeper relationships with our blue-chip clients. We believe that our second quarter revenue performance is evidence that we are on the right track.

While our largest clients continue to grow with Syntel, our remaining customers are currently growing at a faster rate. With the backdrop of a stable business environment and aggressive investment programs focused on delivering value, we are optimistic that the second half of 2012 will continue to provide opportunities for expanding existing relationships and forging new ones.

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. Good morning. After my comments, we’ll open the call to questions.

Syntel’s second quarter came in at $130.6 million, up 31% from the prior year period and 13% sequentially.

For the second quarter, Applications Outsourcings accounted for 76% of revenue. KPO was 14%, e-Business represented 7%, and TeamSourcing was 3%.

From a vertical perspective, Financial Services contributed 56%, with insurance at 18%, healthcare 15%, automotive 3% and All-Other accounted for 8%.

Syntel’s customer concentration reduced by approximately 1% in the second quarter. Our top-three clients represented 48% of revenue. Top 5 contributed 59%, and Top 10 came in at 74%. The fixed price component of our business remained at 46% of revenue for the quarter.

With respect to Syntel’s margin performance, our gross margin was 39.5% in the second quarter. This represented a decrease versus 48.2% reported in the year ago period, and 42.4% in Q1.

By business segment, gross margins for Applications Outsourcing was 34.1%, KPO was 62.2%, e-Business was 43.3%, and TeamSourcing was 59.6%.

Sequentially, our gross margins were negatively impacted by off-shore rate increases and lower pricing related to our JV contract renegotiation.

Moving down the income statement, our selling, general and administrative expenses rose 14.6% in the second quarter of 2010, compared to 20.8% in the prior year period, and 19.2% in the first quarter.

On a dollar basis, SG&A was down $3.1 million sequentially, largely as a result of currency variations.

As Prashant mentioned, quarter over quarter exchange impact related to balance sheet translation was $3.6 million [ph].

Other income during the quarter was down by $3 million, as Syntel recorded the loss on the hedging.

Our tax rate came in at 17.9% as compared to 14.2% posted in Q1. The increase was largely attributable to the geographic distribution of doctors during the quarter.

Net income for the second quarter was $28.3 million, or $0.68 per diluted share compared to $35.1 million or $0.61 per diluted share in the prior year period, and $25.1 million, or $0.60 per diluted share in the previous quarter.

The company’s balance sheet at the end of the second quarter of 2010 remained extremely healthy. Our total cash and short-term investments on June 30, 2010 were $221.5 million, and the company had an additional $21.5 million in non-current term deposits with banks.

The DSO levels were to 56 days during the second quarter. Our capital spending in Q2 was $5.1 million as we completed the new Chennai campus in India.

The company still expects to spend between $40 million and $50 million in CapEx during 2010 with the construction on Pune Phase 2 underway.

Syntel ended the second quarter with the total headcount of 14,926 of which 4,366 were assigned to KPO. Our level headcount was 2,479 on site, and 11,543 offshore for a total of 14,024. Net additions to global headcount, we have 1,244.

Our utilizing levels at the end of the quarter were 94% on site, 73% offshore, and 77% globally. [Inaudible]. The averaged utilized during the quarter was slightly below the first-quarter levels.

Our delivery mix currently stands at 22% onsite and 78% offshore. Voluntary Attrition during the quarter was 15.6%, up from 14.8% last quarter. Syntel added six new customers in Q2, and two new [inaudible] licenses, which takes the total number of reported partners to 103.

Looking forward, I would now like to provide you with our updated guidance for 2010. Based on our current visibility levels, Syntel expects the revenue to be in the range of $410 to $522 million. And EPS in the range of $2.50 to $2.60 for the full year 2010.

The company currently has 91% visibility at the low end of the revenue range and guidance based on an exchange rate assumption of looking for the 6.5 to the dollar for the second half of the year.

I will now turn the call for the question-and-answer session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brian Keane from Credit Suisse

Brian Keane – Credit Suisse

Hi. Good afternoon, and congratulations on a really terrific quarter.

David Mackey

Thanks Brian.

Brian Keane – Credit Suisse

I guess my first question is just the significant increase in the revenue guidance. I guess kind of what caused that? I guess some of that is probably maybe Stage Street knowing the outcome there, and then how much of that is just a surprise in the demand environment?

David Mackey

You know, I think Brian, relative to the pricing on the contract negotiation, we had provided a range of outcomes and I don’t think there was anything surprising in terms of what happened there. I think the real upside that we’ve seen to the revenue guidance from where we were a quarter ago comes from just the realization on some of the new development initiatives that we had been hoping would pull through throughout the rest of the year. The visibility on these projects tends to be relatively low, and given the environment that we’ve been in for the last 18 to 24 months, we certainly wanted to take a cautious approach.

And what we did see in terms of the acceleration in the quarter, while the cost-reduction based initiatives continued to move ahead full steam, we did see additional traction on the development side of our business in the quarter, and certainly helped us drive top-line growth.

Brian Keane – Credit Suisse

Okay. And should we see an acceleration sequentially in top-line, or do we have a step down function because maybe some of this business with short-term discretionary that we won’t see heading into the third quarter?

Arvind Godbole

As you know, Brian, our guidance is consistent with what we have done in the past based on 91% visibility, the low end of guidance. So we have stayed consistent with our process based on 91% visibility.

David Mackey

I think the other thing that you can certainly infer for the guidance, Brian, is when you look at the low end, at a worse-case scenario what we’re looking at is relatively stable revenues for the balance of the year.

Brian Keane – Credit Suisse

Right. Right. Okay. And then just trying to understand the reversal and the charge due to the exchange rate variations, I know you had to – you took a charge last quarter and this quarter it was a benefit. I’m just not sure I understood quite why that happened.

Arvind Godbole

The charge is basically because of the development of the assets. That is why last quarter we had seen [inaudible] in the rupee and the dollar. Whereas this quarter the distribution is a significant distribution for these types of assets, 3.4 – 4.0%. And that is why a loss of $1.9 million, we have made a gain of $1.6 million.

Brian Keane – Credit Suisse

Okay. And then just finally, now that at least this Stage Street, we have some visibility on that at least until February, 2012. What’s the next steps? Are you still in talks with Stage Street, or do you start those up starting next year? Thanks

Bharat Desai

Thanks, Brian. Our relationship with State Street remain strong. We are jointly committed to the value that we both get from a joint venture, and it was in that spirit that we finished renegotiation. We continue to look at additional opportunities jointly with our client to grow that business and that will be the path we stay on. So our relationship is healthy and we continue to build on it.

Brian Keane – Credit Suisse

Okay, great. Thanks a lot.

Operator

Our next questions comes from the line of Joseph Foresi from Janney Montgomery Scott.

Joseph Foresi – Janney Montgomery Scott

Hi guys. Nice work on the numbers. I guess my first question is Application and e-Discovery and TeamSourcing all did well this quarter. I wonder if you could talk about – I know e-Discovery and TeamSourcing tends to be a little bit lumpy. Was that a one time based on this quarter? Maybe you could talk about what’s been going on in the Application business as well.

David Mackey

Yeah, I think, Joe, relative to the types of services that we provide in those business segments, e-Business has historically been a lumpy segment for us. By definition, the types of projects that we do in the e-Business segment tends to be high-dollar, high-value, shorter-duration projects. When the demand environment is poor and discretionary spending is relatively weak, that’s the segment of our business that tends to get hit the worst.

As I mentioned a little bit earlier, we did see some good growth in development this quarter. As a matter of fact, our development portfolio overall grew about 12% sequentially. e-Business was one of the primary beneficiaries of that pickup, and when you look at the revenue acceleration, we had about a $1 ½ million growth in that business during the quarters.

So kind of the combination of continued success on the cost-reduction based services, which drives a lot of the Applications outsourcing, and also a pickup on the development side, which provides a portion of the Applications Outsourcing and a majority of the e-Business segment.

Joseph Foresi – Janney Montgomery Scott

And that development business, was that driven by your present client base, the large clients, or can you just give us a little bit more color on that?

David Mackey

I think as Prashant mentioned, we were kind of happy with the progress that we made, not only with our largest clients, but also some of the progress that we made with our second and third-tier customers this quarter. As is always the case with our business, the majority of the revenue growth is going to come from existing customers and that’s across the board. But what we were extremely please with this quarter is that there was a disproportion in the amount of net growth that came from some of our smaller clients, you know Tier 2, Tier 3 customers for both cost-reduction based services and for development services.

So again, very, very broad based in terms of the growth that we saw this quarter across services, across verticals and across clients.

Joseph Foresi – Janney Montgomery Scott

Okay, so just to be clear, there’s no one-time project in there that would roll off going forward?

David Mackey

Nothing material, that’s correct.

Joseph Foresi – Janney Montgomery Scott

Okay. And then just maybe you could talk about Stage Street. What were the volumes like in that business in this quarter?

David Mackey

The volumes across our KPO business were relatively stable. If you look at the revenue overall for KPO, it was consistent with Q1 levels. So we did have a bit of a stepdown function as a result of the JV contract renegotiation but we did have a pickup in volumes for both our KPO and our non-KPO – I’m sorry, both our JV and our non-JV clients.

Joseph Foresi – Janney Montgomery Scott

Okay. And you wouldn’t happen to have that volume growth number would you?

David Mackey

We’re not going to provide that as a percentage or as a dollar value this quarter.

Joseph Foresi – Janney Montgomery Scott

Okay. And one last one, just on the demand environment in general, have you seen a continuation of the trends that began at the beginning of the year, or have you seen any customers get maybe a little bit more conservative on the discretionary side? Thanks guys.

Arvind Godbole

I think customer have remained [inaudible] to cost reduction and opportunities to improve total cost of ownership. The decision making cycles have certainly become shorter on Applications Outsourcing area. On KPO area, as you know, the cycle times continue to be longer, but the pipeline is healthier than it was two quarters back. That is the basis of our guidance and our projections.

Joseph Foresi – Janney Montgomery Scott

Okay. Thank you.

Operator

Our next question comes from Joseph Vafi from Jefferies & Company

Joseph Vafi – Jefferies & Company

Hey guys. Good morning and congrats on the 30% annualized growth. That’s great.

Maybe we could talk a little bit about gross margins. You know, obviously Q2, we do have some pressure – we had some pressure from hikes and from the pricing on State Street. I was wondering, you know, as we move into Q3, it sounds like, you know, you’re continuing with your hiring. How should we look at Q3 gross margin relative to some of those – relative to Q2 and the puts and takes on the pressure side there?

Arvind Godbole

What we expect in the full-year 2010, the gross margin will be within 40 to 41% [inaudible].

David Mackey

I think directionally, Joe, we obviously did not have a full quarter’s worth of impact in the second quarter from the contract renegotiations, so that is something that’s going to continue into the third quarter. And as Prashant mentioned in his prepared remarks, when you look at the utilization for the company given the demand environment we’re looking at, and the opportunity in front of us, we certainly don’t want to get caught without resources. So we do plan to continue to hire and to continue to make those investments.

The focus right now is clearly on taking advantage of the opportunity, both short term and long term, and continuing to invest, to build out the infrastructure to higher ahead of the curve and to make the necessary investments in services to drive that.

That being said, as Arvind mentioned with a full year gross margin expectation of 40 to 41%, what we’re looking at in the back half of the year is relatively stable levels on the gross margin for both Q3 and Q4.

Joseph Vafi – Jefferies & Company

Okay. That’s helpful. And secondly, I’m pretty sure I understand that the guidance [inaudible] to dollars here is intact. You know, basically almost basically what you have in hand more less. But I just want to try to get a little more color on that versus the hiring trend. Is the company really hiring ahead of the curve, or do you see some business out there that’s maybe not kind of hard backlog at this point, that you’re pretty excited about and that’s what driving hiring versus truly ahead of the curve hiring?

Arvind Godbole

As we have shared with you, the demand is across clients, across verticals and across services. So the demand is supported by our decision to do hiring ahead of the curve, investment in infrastructure and building up our services. And we are confident about the pipeline that we have with 91% visibility, and we are committing to ensuring that we realize that growth and take advantage for the fullness in the demand was just two quarters back.

David Mackey

I think the other thing, Joe, from a utilization standpoint that’s important to note is that when you look at our guidance last quarter, one of the things I think we would have included in our expectations was an ability to improve utilization throughout the year in the event that the demand really didn’t materialize. So clearly, the hiring was ahead of the curve and it was ahead of the guidance that we had provided last quarter.

We expect to continue to hire through this year and part of that is, as you mentioned, for things that are high visibility in the pipeline at this point and time, but a portion of that hiring will be more around the campus and the entry level. And that’s about preparation for longer-term growth and making sure that we’re ready to fuel that growth.

So it is a combination of both a healthy demand environment today, and also making sure we’re prepared to service our clients going into 2011.

Joseph Vafi – Jefferies & Company

Okay. And then just one final one. It sounded like you had some ramps on some new customers this quarter and you kind of called them Tier 2 customers. Would you consider these Tier 2 customers in terms of their spend with you currently, or Tier 2 customers in terms of their kind of overall size the businesses themselves? I’m just trying to get an idea if some of these new ramps have the potential to say break into the top ten or maybe the top five over time?

Prashant Ranade

What we are pleased with as far as Q2 is our top-five customers certainly grew, but our next set of customers grew at a higher rate. And that’s what provides us opportunity to have higher-wallet share based on our presence, understanding of the domain, our service offering as well as our strong client relationships.

David Mackey

Yeah. I think Joe, you know what Prashant has accurately reflected, the way we view this when you look at the acceleration for us, I wouldn’t say it was acceleration with new customers. It was better acceleration with existing clients, but clients that are outside of the top three, top five, which have been contributing the majority to our growth in the past. So a lot of the investments that we’ve made in terms of, as Bharat mentioned in this prepared remarks, getting closer to our clients through the downturn, making sure that we’ve got the right services, looking at aggressive opportunities to cross sell these services. I think we’re starting to see some of the traction in that. And also, the investments in programs like the Client Partner Programs that we have made over the past – to help us to gain mindshare with the clients, drive value, and expand the relationship.

So those are all headed in the right direction.

Joseph Vafi – Jefferies & Company

All right. Thanks a lot, guys.

David Mackey

Thanks, Joe.

Operator

Our next question comes from Brian Kinstlinger from Sidoti & Company

Brian Kinstlinger – Sidoti & Company

Thanks for taking my question. The first question I had, the KPO sizes into the – before we started the recession, you guys were talking about a lot of new customers, similar to what you were doing with your top customer there. And some of that was delayed given the uncertainty in financial services. And then can you sort of talk about how you’ve gone back to those customers now and where those negotiations are, how soon might we see some results there?

Arvind Godbole

Good question, Brian. Our strategy of keeping IP and KPO all together and with that combination approaching customers to show the value is certainly appreciated and valued by our clients.

So we are in dialog with those customers who had put some of their decisions on hold. We see interest in making those decisions. And one thing I can share with you was during Q2, one of our current clients in the healthcare segment, we have actually started a pilot in the financial revenue area in the healthcare segment.

So our expectation is the decision-making cycle will be shorter and clients will make the decision. So based on that, we have defined those discussions and we see the value in IT, KPO, or technology and processes, and approaching with those expertise jointly and showing the value to the customers.

Brian Kinstlinger – Sidoti & Company

But on the financial services side, the bigger bang that you, I mean, if I understood correctly, two years ago you were in contact with – and we’re talking about Stage Street here, so some of Stage Street’s competitors about offering this great value that you’re offering Stage Street. Are those discussions back on as well?

David Mackey

No, I think, Brian, when you look at the types of relationships that we’re pursuing in both financial services, healthcare and insurance, we’re looking to leverage our ability to customize these solutions for clients.

So clearly, there are components of our knowledge in terms of how to globalize services that are leveragable. And we’re aggressively looking for ways to leverage that knowledge. But in terms of the types of clients that we’re pursuing and in terms of the opportunities that are in the pipeline today, you know, there hasn’t been a fundamental change. We’re looking for select ways to leverage our relationships and our knowledge to be able to move forward.

Brian Kinstlinger – Sidoti & Company

When I look at the Applications Outsourcing business, the gross margin I think is at the lowest point maybe in two or three years at about 34%. It seems a little bit low right now, can you talk about why you that is? We’re sitting there and directionally when you said that we expect flat margins for the rest of the year why would it not start to recover a little bit?

David Mackey

I think, Brian, this is one of the areas predominately where you are going to see a lot of the investments that are being made into our business. It’s clearly a situation where when you look at the utilization for this service and this segment, it’s below where we would normally run in a standard operating model.

Now, that clearly explains a part of it relative to where we’ve been in previous quarters in previous years. Obviously if you wanted to compare these margins to the Applications Outsourcing gross margins of a year ago you’re looking at pretty significant headwind in terms currency. There are definitely some factors to explain why the gross margins are lower than where they have been historically, but I think at the end of the day one of the fundamental reasons is that we are aggressively investing in terms of how to grow this business.

Brian Kinstlinger – Sidoti & Company

Growth starts to slow a little bit and new hire just a little bit slower and less value on training, does that mean your margins start to recover?

David Mackey

I think when we see that the growth rates are in a stable mode and we don’t need to be hiring ahead of the curve there is a longer term opportunity to improve the utilization level in this business, absolutely.

Brian Kinstlinger – Sidoti & Company

Okay. Two more questions. The first one is on SG&A. You seem to be one of the few companies where SG&A doesn’t move so much with revenue. It didn’t move much here on a huge swing, if you back out both of those one-time gains in charges. Talk about looking forward as you grow your business, how SG&A is really going to move along with revenue, please.

Arvind Godbole

We are expecting SG&A to be between 17 and 18% for the full year. And apart from the currency we are expecting to spend more on our properties, the Chennai campus. Other than that, also we are going to invest in a couple of other [inaudible]. That is why we are expecting it to go up. And the reason we expect it to remain low, between 17 and 18% is because of the [inaudible].

Brian Kinstlinger – Sidoti & Company

My only follow up to that is, first of all how much is Chennai going to add on an annual basis? And the second one on that is: If I take a look at revenue out performing, historically you have, for example, if you out perform by $20 million, will that, in step, bring up SG&A very much or not very much?

David Mackey

I think Brian there’s a two-part answer to that. When you look at our SG&A levels they tend to run in a step function. SG&A overall in our business is a lot more variable than I think people recognize. Taking aside the volatility that is created by some of the balance sheet revaluation from a quarter-to-quarter perspective. When you look at some of the biggest drivers to our SG&A expenses as a percentage of revenue; infrastructure and feet cost are a significantly up there. Sales and marketing is up there, and as a part of the sales and marketing the commission expense.

Timing aside, when you look at those costs by and large they are going to move fairly close to one to one with the overall revenue performance. In any given quarter when revenue accelerates ahead you do see the leverage we saw in this quarter. But longer term, our expectation is that SG&A is going to stay in that 17, 18, -19% range. As Arvind mentioned, that’s what we expect to run for this year. The reality is when you look at the SG&A expectations for the back half of the year implied in that guidance we do expect SG&A to go up significantly.

We do need to continue to build out our infrastructure. When you look at hiring that we have done over the last three quarters, if we don’t do that we are not going to have enough seats. We do need to make those investments, they’re not necessarily ahead of the curve but they do tend to move in a step function. It does create quarter-to-quarter volatility, but on an annualized basis it does tend to be relatively stable.

Brian Kinstlinger – Sidoti & Company

Great, thank you.

Operator

Our next question comes from Bhavan Suri from William Blair and Company.

Bhavan Suri – William Blair

Morning guys. And thank for taking my question. Just a couple questions here. First on the pipeline, you’ve obviously executed well and converted some of the deals that have been in the pipe for awhile, and that was nice to see. But can you provide a little color of how the pipeline continues to grow and the strength and potential coverage ratio on the pipeline.

Arvind Godbole

Our pipeline is certainly healthy and we are pleased with that. As I mentioned earlier, our low-end revenue guidance is based on 91% visibility which support it and we are seeing the season cycles to be a lot shorter than they were last year at this time. So a combination of three things; a firming demand environment, shorter decision cycles, our visibility to low-end revenue guidance, as well as healthier pipeline this time versus two quarters back.

David Mackey

I think at a macro level, Bhavan, when you look at the backlog of work that was created through the downturn, I mean, we’ve just begun to kind of eat through some of that backlog, if you will. And the development projects that are getting done are still relatively small in size and scope. They are short in duration, and they tend to have very recognizable return on investments for our clients. And we are certainly optimistic that as the business environment continues to stabilize and hopefully strengthens and improves over time, the horizon for clients to look out and to get those returns will increase. The amount of ROI that’s required will start to come down a little bit. That pipeline and that backlog continues to be there and continues to build. We also have a number of initiative that are starting to queue up now related to regulatory and compliance-related changes that are coming that will also help fuel the pipeline going forward. So very very happy with the overall size and strength of the pipeline, and don’t see it diminishing in size if you will as a result of the progress that we have made on the top line.

Bhavan Suri – William Blair

Great. And then if you look at the pipeline, what sort of percentage could you say, or sort of color you might provide, is made up of discretionary projects that are more – or have less ROI than pure cost-reduction type of initiatives? Has that changed at all?

David Mackey

I don’t think it’s changed materially. I think the majority of the pipeline still remains around cost-reduction based initiative, the development pipeline remains healthy, but the mix overall has not changed.

Bhavan Suri – William Blair

Okay. And then turning to pricing outside of the KPO business, do you see any pricing pressure or ability to gain pricing in the IT business or the e-Business segment at all?

Arvind Godbole

Actually you see pricing environment firming up clearly with our large KPO joined venture partner, we did conclude the negotiation through 2012. But with increased wages environment, with attrition rates trending higher in proportion to demand, we see pricing firming up at this point. We don’t see a lot of opportunities for increases but will continue to monitor that.

David Mackey

And I think the long and the short, Bhavan, is that the pricing environment right now is stable. There’s not a significant amount of downward pressure given the increases on the cost side of this business. The flip side is our clients are clients are still under a lot of pressure as well, so the ability to generate increased pricing is also difficult at this point. The focus is still on reducing total cost of ownership for our customers, and we do still have a number of levers to be able to help our clients to accomplish that.

Bhavan Suri – William Blair

Okay, then one quick one just on hiring. Attrition kicked up a little bit and obviously the entire environment in India has improved. Any challenges in hiring resources, either at a lateral level or the college level?

Arvind Godbole

Actually, attrition level increased a little bit, which is normal, which is generally the timing issue related to attrition levels going up post April 1 increments. We are certainly managing that. Attrition level as you know are higher, but in terms of our pipeline both of college hiring and laterals where required, we remain committed to managing our business to serve the demand and ensuring that we meet the commitments made for our customers.

Bharat Desai

And if I can chime in; this is Bharat. The depth and breadth of the talent pool, especially coming from colleges, continues to be very strong and therefore provides long-term sustainability to the business model.

Bhavan Suri – William Blair

Great. That’s it for me guys. Thanks, nice quarter.

Operator

Our next question comes from Vincent Colicchio – Noble Financial.

Vincent Colicchio – Noble Financial

Great quarter guys. I’m not sure who this one is for, but can you tell us which one of your newer-service offering saw the most traction in the quarter, and should we expect a follow through on that?

David Mackey

I don’t think we saw anything unusual in terms of the service offerings. Clearly, as we’ve talked about the last couple of quarters, one of the areas where we had seen some good growth recently, and it certainly continued again in the second quarter, was the business intelligence and data warehousing area.

But as Prashant mentioned in his opening remarks, the growth was extremely broad based and our maintenance and cost reduction-based services still grew the fastest at 17% sequentially, development grew 12. It was a combination of not just the new services but again the existing services and the stable services with our existing clients.

Vincent Colicchio – Noble Financial

And a question on the KPO business. What is your – did you add any clients to the quarter and what targets should we think about going forward?

Prashant Ranade

As I said earlier, we have a pilot underway that we commissioned during Q2 with one of our top healthcare clients, and we are certainly pleased with that. We were in discussions with that client for some time. And we do have a pipeline and ongoing discussions with clients in other verticals. And technology, domain knowledge, and processed knowledge, it is recognized by clients as the strongest lever to realize the reduction of total cost of ownership. We remain committed to that firming of demand, as well as shorter decision cycles compared to last year is healthier. And we remained focused on the opportunities we have to continue to work closely with our clients.

Bharat Desai

And if I can add to that, again, rather than offer a standard kind of commodity- type service for this healthcare customer, it is a customized financial recovery offering that they’re piloting that leverages our knowledge of their business, technology and operations very much consistent with the strategy that we have of providing custom integrated IT KPO solutions.

Vincent Colicchio – Noble Financial

Thanks. And one last question, most of my other were asked. Any plans on deploying your cash position? It’s substantial, it’s been that way for quite some time, you’ve talked from time to time about doing the small acquisition, any thoughts?

Bharat Desai

Our board continues to look at the best uses of the cash we have. We feel fortunate to be in a position where our balance sheet is strong. And opportunistically, we will look at growth opportunities that would help accelerate growth. And we’ll do it in a manner that’s consistent with our overall strategy.

Vincent Colicchio – Noble Financial

Thanks guys.

Bharat Desai

Thank you.

Operator

Our next question comes from Puneet Jain from JP Morgan.

Puneet Jain – JP Morgan

Hey guys, good quarter. Obviously solid performance during this quarter. Can you also talk about month-by-month demand trends during the quarter? How was the demand environment for the month of June compared with that in the month of May and the month of April?

David Mackey

I think overall, Puneet the demand environment in the second quarter was fairly healthy across the board. I don’t think we saw anything materially different month to month, so fairly consistent.

Puneet Jain – JP Morgan

Okay, and about second half, outlooks. You said the pipeline is strong, decisions cycles are short, and visibility is also high. So what has to happen for you to report at the low end of your guidance for calendar then? What are you assumptions on the season cycles like on macro environment?

David Mackey

I think as Prashant mentioned, Puneet, the guidance, philosophically is consistent with how we provide it in the past. We have 91% committed to the low end our guidance, which means we have signed contracts in hand with that amount of revenue, which is obviously a very good position to be in.

Like any other business there’s always a certain amount of inherent growth that needs to place to meet targets, and given that number what you’re looking at is 9% of the low end, or approximately $45-50 million that has to be booked, which is not currently booked at this point in time.

So for us to meet the low end we certainly have to continue to execute. We have to convert some of the opportunities that are in the pipeline into hard contracts. The sooner we do that, obviously, the more likely we are to meet or beat the low end of our guidance.

For us to get to the higher end of the guidance, we need a number of things to happen. We need the business environment to remain stable. We need clients to, as development becomes a higher percentage of our portfolio, we need clients to not only replace that revenue as it begins to fall off, but replace and grow off of it, which creates a separate set of challenges.

I think long and the short, when you look at our full year guidance, it’s consistent with where we’ve been in the past at this point in time. The healthier the business environment the healthier our clients our, the more opportunities there is. We continue to move forward in this manner. It’s been successful for us in the past and we’ll certainly provide you with an update on the guidance in October.

Puneet Jain – JP Morgan

Thank you. So given that decision cycles shorter than what they would last year or maybe two years back. You can potentially put a price to the low end of guidance with shorter cycles right now. Is that right assumption?

David Mackey

I think the current level of decision cycles would have been incorporated into our guidance. We’ve made some assumptions about what we think is in the pipeline today that will convert. Those assumptions and that approach is consistent with how we’ve done that in the past. It’s not necessarily consistent with, for example, 2009 levels where we knew that the pull through from the pipeline was going to be extremely low, but it’s consistent with what we’ve seen in the last quarter. So we’re not assuming acceleration or a deceleration in our numbers.

Arvind Godbole

As we mentioned, the methodology remains consistent and the reflection of shorter decision cycles and firming up of demand is reflected in our [inaudible] the low revenue items.

Puneet Jain – JP Morgan

And the last question on attrition rate. It’s up slightly, is that calculated on a trailing 12-month basis or annualized quarter earnings?

Arvind Godbole

That is annualized basis, and as I mentioned earlier, it did go up a little bit and that is consistent with the timing which is 12-month increments and typically attrition rates go up a bit a bit after the increments are implemented.

David Mackey

Q2 and Q3 have historically been our highest attrition quarters, and we would expect that to continue.

Puneet Jain – JP Morgan

Right. And did you also share the gross headcount attrition contribution during that quarter?

David Mackey

We did not give the gross, but we did give the attrition rate and we did give the net average which is 1,200 – so it is calculatable.

Puneet Jain – JP Morgan

Yes, we can calculate it.

David Mackey

Thanks, Puneet.

Operator

Our next question comes from Srinivas Anantha – Oppenheimer

Srinivas Anantha – Oppenheimer

Yes, good morning thank you. Got a question on the State Street contract. As a part of the new deal that you guys entered into, have you guys gained any kind of financial flexibility where you can potentially market the services to other financial services companies? And what I am looking at on the volume front for KPO for 2Q, is that a good ground rate going forward or should we expect some sort of a upside especially now that the contract negotiation behind?

David Mackey

I think as we disclosed in our 8K, Srinivas, the only changes we made to our existing contract were States Street waved their right to purchase the joint venture until February of 2012. And the joint venture provided economic concessions. Those were the only changes to the agreement.

With respect to the KPO run rates I think as we have discussed the little bit earlier we did see one month worth of impact from the renegotiation in the second quarter. We do have an additional two months obviously to get to a standard run right here is Q3. So there is a small headwind from a revenue perspective.

Overall the KPO revenues, we are hopeful we can get them back and make sure we stay relatively flat quarter to quarter, but we need to need to see some acceleration in existing volumes for existing services. And also to either add some new services or add some new clients during the quarter to be able to maintain the run rate where it was in Q2.

Srinivas Anantha – Oppenheimer

How much was the impact on that one month?

David Mackey

We’re not going to disclose the impact. When you see our third quarter results you’ll have a better sense in terms of what a normalized rate will look like.

Srinivas Anantha – Oppenheimer

Got it. When we look at your Applications Outsourcing clearly that came in well ahead of expectations. Your guidance kind of implies the sequential plans are pretty much going to be flat to get to the lower end. Any reason why we should expect that sequential growth to pretty kind of moderate so much from the double digit to very-low single digit, or pretty much single digit, low single digit.

David Mackey

I think Srinivas, obviously the top-line performance in the second quarter was exceptional both in the terms of the absolute number and in terms of – the contribution, comparative to what we have done historically. As Prashant mentioned earlier, with respect to the low end of the guidance and the fact that there is very limited growth implied, the low end of our guidance is consistent with how we have given guidance in the past. There is 91% visibility at this time. This is how we are comfortable providing guidance as a company and the methodology has worked for us.

You can draw from those conclusions what you would like, but the bottom line is this is where we are comfortable at this point in time. From a low end we had given a high end that’s at 522 and we can provide you with an update to that in October.

Srinivas Anantha – Oppenheimer

Okay, thanks a lot.

David Mackey

Thanks Srinivas.

Operator

Our next question comes from Reik Read – Robert Baird & Company

Reik Read – Robert Baird

Just a follow up on the attrition question, it’s clearly been a topic in the industry and we are seeing that get a little bit more challenging. So just a question on the SG&A, does that suggest that you guys, despite being forward, thinking about it, still have to ramp up recruiting resources? And I guess the second question would be, if we see attrition continue to get more challenging is there chance for a second wage increase during the year at some point?

Arvind Godbole

They mentioned earlier in Q2 and Q3 we have seen updates and attrition on a starting basis. So clearly this year in the reflection of firmness in demand, the absolute levels are higher but the change from quarter to quarter, from Q1 to Q2, and Q2 to Q3, we don’t expect it to be unusual.

As far as your question related to SG&A ,we actually have a prepared ourselves for hiring reflected by the last quarter’s. So we have the right talent in place, a right theme in place to be able to support our guidance, our day-to-day operations.

And your last question about wages. We are in a dynamic environment, we know we have the manageable business, so we’ll continue to watch the trend and ensure we do the right things to take care of all our customers and ensure employee satisfaction and fairness against the market levels.

Bharat Desai

And if I can add to that Prashant, again to reiterate what I said a few minutes ago. Our long-term vision is to hire the best people coming out of college. That certainly will be a large proportion of our hiring pool at all times. There continues to be a strong healthy supply of those people. So we feel very comfortable that is well positioned and we’re comfortable with the sustainable long-term supply.

David Mackey

And I think the other thing, right, to remember is when you look at our overall utilization levels and the hiring that we’ve done, it was for a combination of things it was for visible demand, it was from growth opportunity in the pipeline. But we also had kept in mind that there was going to be a pickup in attrition. We’re not surprised that it happened, and when you look at our utilization levels and the impact on our margins, it’s clearly baked into the numbers. We’re more than comfortable in our ability to meet and service demand, and to grow with the overall economy.

Reik Read – Robert Baird

Okay. And just one follow up and I guess this is more of a clarification than with the Tier 2 and 3 clients you referred to before, David. I think you basically said it really wasn’t an acceleration in transformation or strategic programs associated with discretionary spending. So I’m just trying to confirm that, and can you get into a little bit more detail as to why that ramp occurs now. Is it the client partner process that’s accelerating that or are there other things in there that’s causing that to occur?

Arvind Godbole

And I guess to clarify that our top clients historically have grown at a higher rate than our overall business growth. Now with our understanding of our clients domain and business. Relationships through client partners and other programs like David alluded to, our customers beyond the top five have actually grown at a high rate. And we believe potential to continue to get higher wallet share of their business provides us strong opportunities. And our investments will continue to be in strengthening and increasing our size of our client-partner program. So he’s offering to take advantage of that opportunity.

David Mackey

Just to give you a little color, Reik, and I think it will kind of help drive home this point. When you look at the customers and their contribution to Syntel’s revenue in 2009, and compare that to the run rate from those same customers as we go into the first half here of 2010, you look at our top two clients. They’ve grown at about 14% year over year.

If you look at the balance of our top-ten clients, they’ve grown at about 19% year over year. The rest of Syntel’s existing customers from 2009 have grown at 22%. So clearly some of the things we’re doing to try in the firm and try and leverage some of these existing relationships is starting to take hold and we’re starting to see good traction and good acceleration.

As Prashant mentioned, it’s having the right people and place to drive value to our customers. It’s also making sure we’ve got the right services out there to be able to cross sell and increase that value we’re delivering. There’s more of the same, there’s also additional services that we’re selling. This is truly how you’re going to expand these relationships.

Reik Read – Robert Baird

Thanks guys, thank you much.

David Mackey

Thanks Reik.

Operator

There are no questions at this time you can make your concluding remarks at this time.

Bharat Desai

Thank you everybody for joining us today. Syntel’s Second Quarter results reinforce our belief that the company’s investment strategies and execution plans are on track.

These programs are focused on driving long-term sustainable business value for all key Syntel stake holders, including our client’s, employees, and investors. With the backdrop of improving demand environment and an evolving services landscape, Syntel continues to believe that our history, culture, and capability have us well positioned for success. We look forward to talking to you next quarter. Good bye, and thank you.

Operator

This concludes Syntel’s Second Quarter Earnings Call. A replay of today’s call will available until July 29th, 2010 by dialing 1-800-642-1687 and entering the pass code, which is 884605 – I’m sorry 88460450. Thank you.

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Source: Syntel, Inc. Q2 2010 Earnings Call Transcript
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