Virtusa's (VRTU) CEO Kris Canekeratne on Q3 2016 Results - Earnings Call Transcript

| About: Virtusa Corporation (VRTU)

Virtusa Corporation (NASDAQ:VRTU)

Q3 2016 Earnings Conference Call

February 8, 2016 9:00 am ET

Executives

William Maina - SVP, ICR Inc.

Kris Canekeratne - Chairman, CEO

Ranjan Kalia - EVP, CFO

Raj Rajgopal - President, Business Development and Client Services

Analysts

Mayank Tandon - Needham & Company

Joseph Foresi - Cantor Fitzgerald

Anil Doradla - William Blair

Frank Atkins - SunTrust

Brian Kinstlinger - Maxim Group

Vincent Colicchio - Barrington Research

Operator

Good day and welcome to the Virtusa Corporation Fiscal Third Quarter 2016 Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Will Maina of ICR. Please, go ahead sir.

William Maina

Thank you, operator and welcome to Virtusa's third quarter fiscal year 2016 earnings conference call where we will be discussing our financial results for Virtusa's third quarter ended December 31, 2015. On the call with me are Kris Canekeratne, Chairman and Chief Executive Officer; Ranjan Kalia, Executive Vice President and Chief Financial Officer; and Raj Rajgopal, President of Virtusa.

Certain statements made on this call that are not based on historical information are forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. During this call, we may make expressed or implied forward-looking statements relating to, among other things, Virtusa's expectations and assumptions concerning management's forecast of financial performance, the growth of Virtusa's business, the ability of Virtusa's clients to realize benefits from the use of Virtusa's IT services, the timing and impact of the closing of the Polaris acquisition on Virtusa's results of operations, Virtusa's ability to assimilate and integrate the operations of acquired businesses, and management's plans, objectives, and strategies.

These statements are neither promises nor guarantees and are subject to a variety of risks and uncertainties, many of which are beyond Virtusa's control which could cause actual results to differ materially from those contemplated in these forward-looking statements. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. Virtusa undertakes no obligation to update or revise the information disclosed during this call whether as a result of new information, future events, or circumstances otherwise.

Other statements on this call also include certain non-GAAP financial information as defined by the SEC. We present constant currency revenue to provide a framework for assessing how our revenue performed excluding the effect of foreign currency rate fluctuations. We provide non-GAAP adjusted operating income, non-GAAP adjusted net income and non-GAAP earnings per share, which we believe provide insight into the operational performance of our business.

Reconciliations of non-GAAP to GAAP measures are included in today's earnings press release and data sheet which can be found on the Investor Relations page of our Web site. We also present a reconciliation of cash, cash equivalents, short-term and long-term investments that we believe provide insights into the total cash position and overall liquidity. For additional disclosures regarding these and other risks faced by Virtusa, see the disclosures contained in Virtusa's public filings with the Securities and Exchange Commission and our earnings press release.

With that, I'd like to turn the call over to Kris.

Kris Canekeratne

Thanks, Will, and thank you, everyone, for joining us on our third quarter fiscal 2016 earnings conference call.

We are pleased with our results for the third quarter, particularly given the impacts of the unexpected flooding that occurred in Chennai, India, in early December. Approximately 25% of our IT professionals are based out of Chennai and I'm happy to report that all of our Chennai team members and their families are safe and sound.

I want to also take this opportunity to thank our team members for their hard work and dedication during a trying and difficult time and I want to thank our leadership team for their efforts in successfully deploying and executing our business continuity plan. Excellent on-the-ground leadership, BCP, and our dedicated team members minimized disruption to our business operation and allowed us to swiftly resume full operations in the region. Thank you, team. All of you set a high bar.

Turning to our summary of our results, for the December quarter revenue was $150.6 million, an increase of 5% sequentially and 22% year-over-year in reported currency. Third quarter operating income was $14.1 million and diluted earnings per share were $0.38. We are pleased with these results in light of the Chennai headwinds we faced.

In the third quarter, we continued to face strong underlying demand for our portfolio services across the geographies and industries we serve. The drivers of this demand are largely consistent with what we have seen in prior quarters. Our clients continue to focus their IT spend in areas that address the dual mandate they are facing; that is, to reduce costs by increasing operational efficiencies and mitigating risk, while also driving incremental revenue growth through digital transformation.

Our value proposition of enabling our clients to run the business more efficiently, take care of the business and grow the business continues to resonate particularly well in today's market and is enabling us to win wallet share.

On [another] [ph] business side, organizations are under growing pressure to reduce costs by increasing operating efficiencies. We are helping our clients address this requirement by increasing productivity and reducing the cost of their BAU, or business as usual, operations through a combination of solution and services that improve efficiencies across their IT environment and business processes.

By leveraging our deep domain expertise in the industries we serve, combined with our industry-leading platforming expertise in application consolidation and rationalization, we have consistently demonstrated that we provide far greater efficiencies and cost reduction as compared to generation-one offshore IT services companies.

Additionally, our best-in-class business process techniques and transformational solutions contribute meaningfully towards improving our clients' BAU operations. We believe that this is setting us apart from our competitors, enabling us to differentiate and create strategic value for our clients. Consequently, we are winning larger strategic engagements, helping us increase our percentage of recurring revenue, one of our stated strategic objectives.

One such recent engagement is with a large regional healthcare insurance company serving millions of members in the United States. For this client, we partnered to build a new enterprise enrollment and inventory management platform that provides a consolidated and automated enrollment process for the organization. Our client has realized significant efficiency improvements as a result of the implementation of this platform, resulting in meaningful return on investment.

Notably, the success rate of automated enrollment in our client's health plan has improved dramatically from approximately 50% with the old system to 97% with the new system. That means faster enrollment and significantly less time consuming and costly human intervention due to system faults in the enrollment process.

In addition, this new platform has reduced our client's work assignment effort related to member enrollment by over 80% through the use of automated work scheduling and work assignment software.

Finally, we helped our client increase the accuracy of data manually entered into the enrollment system to over 95%. This was driven in part by the development of a new, intuitive user experience that provides employees a more efficient and effective way of inputting member data and enabled employees to more accurately identify and resolve issues on their own.

This is a great example of how Virtusa is extending domain expertise and delivering innovation and transformation in order to provide clients with strategic differentiation and a measurable improvement in productivity, quality and cost reduction.

Another area where we are seeing significant client demand is around cyber security and regulatory compliance. Particularly in industries such as banking and financial services, their sensitive financial information is under constant threat and regulators continue to increase their scrutiny of financial institutions' practices and procedures. Virtusa has made significant investment in this area to meet our clients' growing needs and our value proposition is increasingly being recognized in the market.

For example, we recently began working with a leading global payment processor to help them manage their cyber security operations. This client, who faces significant exposure to security incidents, was looking for a better way to handle sophisticated cyber security attacks and thereby lower their business risk. Virtusa implemented a security compliance management solution, which, among other things, consolidated and standardized our client security system to reduce inefficiencies and errors and establish proactive vulnerability notification, detailed threat analysis and attack metric reporting.

Executing this through our global security operation centers outfitted with cutting edge infrastructure has also enabled our client to drive greater efficiencies, expand coverage and realize a reduction in operating costs. The end result was a drastic overall improvement to our client's security compliance, while also reducing the cost of running their BAU operations.

In the third area I mentioned, which was grow the business, we continue to see strong demand in the market for digital solutions aimed at helping enterprises expand their addressable markets and accelerate revenue growth. In today's digital age, companies must leverage technology to drive market differentiation or risk being left behind. Through an integrated delivery of consulting, design and technology services, Virtusa is helping our clients reimagine their digital storefronts and build a best-in-class digital consumer experience.

For example, we were recently engaged by a major global telecom provider as their transformation partner to design, develop and maintain their omni-channel digital customer experience platform. This omni-channel digital solution will span their brick-and-mortar points of sale, mobile POS, web presence and call centers to provide a seamless and distinctive millennial experience across all customer touch points and channels.

The objective of this program is to increase their addressable market by improving their overall consumer experience, increasing competitiveness and driving cost savings by identifying and implementing frontline efficiencies. Our focus on key business goals and solution scalability, as well as our strong track record in digital transformation, were key factors to our ability to engage with this client.

Our heritage of working at the nexus of our clients and their end consumers across large business-to-consumer industries, combined with the ongoing investments we've made to strengthen our digital capabilities, has led Virtusa to be regarded as a trusted partner who provides thought leadership and best-in-class execution on large digital programs.

Before closing, I would like to briefly touch on the Polaris transaction. We currently expect to close the transaction in late February. Over the past three months since announcing the Polaris acquisition, we have worked aggressively to close the transaction. During that time, my belief that the combination of Virtusa and Polaris will greatly benefit both of our companies, as well as our valued clients, has further solidified. We are very enthusiastic about closing the transaction and moving forward.

In summary, we are pleased with our third quarter performance, which reflects the strength of our business model and our ongoing strategy of investments in services and solutions that directly address both sides of our clients' dual mandate. The demand environment for IT services entering calendar year 2016 remains healthy and Virtusa is well-positioned to gain market share through our ability to help clients reimagine their digital business model to expand their addressable market and drive business transformation to improve operational efficiencies, reduce costs and lower risk.

While we expect to see some short-term headwinds as a result of currency movement and reduced spend by our large insurance client, we are confident that we are well-positioned to grow market share by building deep domain expertise and leveraging our industry knowledge. This is a very important factor to Virtusa's long-term success and our pending acquisition of Polaris Consulting & Services is squarely aligned with this strategy. I am confident that the Virtusa platform is well-positioned for the next phase of growth.

Now let me turn the call over to Ranjan, who will provide more details on our results and our fourth quarter and fiscal year 2016 guidance. Ranjan?

Ranjan Kalia

Thanks, Kris, and good morning to everyone.

Let me start by summarizing the results of our third quarter of fiscal year 2016. I will then provide our current guidance for both the fourth quarter and full fiscal year ending March 31, 2016, before opening the call for questions.

Revenue for our fiscal third quarter was $150.6 million. This represents 5% sequential growth in reported currency and 6% in constant currency. Year-over-year, our third quarter revenue increased 22% in reported currency and 23% in constant currency. As you probably read in our earnings press release, the floods in Chennai, India, in December 2015 temporarily affected business operations at our Chennai facility.

Our business continuity plan enabled us to experience no meaningful disruption in service to our clients; however, we did have an approximately $800,000 negative impact to our Q3 revenues.

Gross margin in the third quarter was 35.7%, compared to 34.6% in the prior quarter and 37.3% in the year ago period. The sequential improvement in our gross margin primarily reflects benefits from a reduction in use of subcontractors and benefits from our ongoing FX hedging program.

GAAP operating income for the third quarter was $14.1 million, compared with $13.3 million in the prior quarter and $14.6 million in the year-ago period. This resulted in GAAP operating margin of 9.4% for the third quarter of fiscal 2016, compared with 9.3% in our prior quarter and 11.9% in the year-ago period. The sequential change in our operating margin this quarter reflects higher gross margin, partially offset by $400,000 of costs from the deployment of our business continuity program and $1.2 million of Polaris transaction related expenses, which exceeded our original expectation of approximately $600,000.

Third quarter other income was $1.7 million and our income tax rate was 28.3%, compared with our prior guidance of 27.5%. GAAP net income for our December quarter was $11.3 million, compared with $11.1 million in the prior quarter and $11.8 million in the third quarter of fiscal 2015.

GAAP diluted earnings per share was $0.38 in our third quarter versus $0.37 in the prior quarter and $0.40 in the year ago period. GAAP EPS was below our guidance range of $0.39 to $0.41, primarily due to the impact of the Chennai floods, which reduced our EPS by approximately $0.02.

We also incurred higher than expected Polaris transaction expenses, which had a negative $0.01 impact to our earnings. We continue to expect to incur an additional $8.8 million of Polaris transaction and integration expenses in the fiscal fourth quarter of 2016.

Moving to our non-GAAP results, non-GAAP operating income was $20.7 million, compared with $18.7 million in the prior quarter and $19.1 million in the year ago period. Third quarter non-GAAP operating margin was 13.8%, compared to 13.1% in the prior quarter and 15.5% in the year ago period. The sequential increase in our non-GAAP margin reflects our gross margin performance, partially offset by $400,000 of costs associated with the Chennai floods.

Non-GAAP diluted earnings per share was $0.54 in our third quarter of fiscal 2016 versus $0.50 in the prior quarter and $0.51 in the year ago period. We are pleased with our non-GAAP EPS performance, which was within our $0.54 to $0.56 guidance range, in light of the negative impact from the floods in Chennai.

Turning to the balance sheet, ending cash at December 31, 2015 was $201.2 million, inclusive of cash equivalents and short-term and long-term investments, a decrease of $2.2 million from September 30, 2015. Our Q3 ending cash balance excludes $20.3 million of restricted cash held in escrow for the proposed mandatory unconditional offer related to our acquisition of Polaris.

Cash flow from operating activities was $22.4 million in the third quarter, or 14.9% of revenue. Our strong cash flow performance in the quarter enabled us to keep our cash balance essentially flat despite the $20.3 million we placed in escrow for the Polaris transaction.

Our DSO, including unbilled receivables, was 70 days, compared to 76 days in the prior quarter.

Now I will turn to some additional quarterly financial and operational metrics, beginning with those related to our third quarter of fiscal 2016 revenue. Revenue across our industry groups and geographies was as follows. BFSI increased 7% year-over-year and was flat sequentially, representing 51% of revenue.

On a sequential basis, our results reflect strong growth with our financial services clients, offset by declines in the insurance segment and a modest decline in the banking segment. However, banking was slightly better than our expectations for the third quarter.

Communications and technology grew 38% year-over-year and 12% sequentially, representing 38% of revenue. CMP performance in the quarter was primarily driven by the growth at our recently acquired telco clients and our growing healthcare segment.

Media information and other grew 73% year-over-year, primarily driven by clients from our Apparatus acquisition. On a sequential basis, this vertical grew 12%, which was slightly better than our forecast for the quarter.

North America revenue grew 27% year-over-year and 4% sequentially, making up 70% of total revenue. North America revenue growth was in line with our expectations when excluding the impact of the Chennai floods. Europe grew 8% year-over-year and grew 7% on a sequential basis, representing 23% of total revenue and in line with our forecast.

Rest of world increased 33% year-over-year and 15% on a sequential basis and accounted for the remaining 7% of revenue. Results were driven by growth at our BFSI clients.

During the December quarter, we commenced work with four new clients; one in C&T, one in BFSI and two in media information and other.

Before turning to our guidance, I would like to provide an update to the proposed Polaris transaction. The regulatory approval process has taken longer than our previously anticipated timeline. We expect to conclude the regulatory approval process soon and to close the transaction in late February. Due to the delay, we currently anticipate Polaris to contribute approximately $20 million of revenue and to be approximately $0.10 dilutive to non-GAAP earnings per share in the fourth quarter of fiscal 2016, compared to our prior revenue and EPS dilution estimates of approximately [$17 million] [ph] and $0.08, respectively.

Now, I will provide our current guidance for our fiscal fourth quarter and fiscal year ending March 31, 2016. Revenue in the fourth quarter of fiscal 2016 is expected to be in the range of $172 million to $175 million. GAAP diluted earnings per share in the fourth quarter of fiscal 2016 is expected to be in the range of negative $0.01 to positive $0.01. Our EPS guidance anticipates approximately $0.36 of dilution from Polaris, inclusive of approximately $0.20 of dilution from acquisition related expenses and $0.02 of dilution from interest expense and debt.

Non-GAAP diluted earnings per share in the fourth quarter of fiscal 2016 is expected to be in the range of $0.44 to $0.46, including $0.10 of dilution from Polaris. Our Q4 earnings per share guidance anticipates an average share count of approximately 30.2 million.

For the fiscal year ending March 31, 2016, we now expect revenue to be in the range of $600.4 million and $603.4 million. GAAP diluted earnings per share for fiscal year 2016 is expected to be in the range of $1.07 to $1.09 and anticipates approximately $0.39 of dilution from Polaris, inclusive of approximately $0.23 of dilution from acquisition related expenses and $0.02 of dilution from interest expense and debt.

Consolidated non-GAAP diluted earnings per share for fiscal year 2016 is now expected to be in the range of $1.96 to $1.98, including $0.10 of dilution from the acquisition of Polaris. Full fiscal year 2016 EPS anticipates an average share count of approximately 30 million.

Our current GAAP and non-GAAP guidance is also based on several set of assumptions, including tax rate, interest income, foreign exchange rates, capital expenditures and certain non-GAAP metrics that can be found on our data sheet located in the Investor Relations section of our Web site.

Now, I would like to spend a moment providing you with some additional detail on our fourth quarter and fiscal year 2016 guidance. Overall, early indications point to flattish IT budgets for calendar year 2016, with reduced spending on legacy platforms, while additional spend continues to be funneled towards initiatives focused on driving revenue growth via digitization and transformation, as well as improving operating efficiencies and mitigating risk.

In BFS, we see early indications of a slight increase in spending, with clients continuing to balance their investments in compliance and customer-facing applications. Within our insurance segment, we are seeing primarily flat budgets across our client base, with the exception of one of our largest clients, who is experiencing cost pressures driven by company-specific factors.

Telco budgets remain consistent. Demand for programs aimed at driving greater operating efficiencies continue and the resultant cost savings are being invested in digital initiatives.

M&A activity in this segment is expected to drive further demand for IT solutions aimed at cost efficiencies. Our fourth quarter guidance calls for growth across all industry groups, which offset revenue headwinds from our insurance segment and strengthening of the U.S. dollar.

Based on recent exchange rates, we expect an approximately $2.5 million foreign currency impact for our Q4 reported revenues. In our geographies, we anticipate continued growth in North America and rest of world, while we expect sequential growth in Europe to be impacted by approximately 600 basis points, due to the strengthening of the U.S. dollar. On a constant currency basis, growth in Europe is expected to be slightly above than the company average.

In Q4 fiscal 2016, we expect non-GAAP organic margins to be consistent with Q3 levels as we absorb the impact of revenue changes versus our prior guidance, additional Chennai BCP expenses during the month of January and increased S&M expenses in support of revenue for the current quarter and fiscal 2017. GAAP organic margins will also be impacted by the same factors, as well as an increase in the stock compensation expenses.

In Q4, we anticipate non-GAAP combined operating margins will reflect an approximately 350 basis points impact on Polaris. On a GAAP basis, combined operating margins will reflect an additional 600 basis points of impact from Polaris transaction related expenses, including amortization of intangibles and stock compensation.

Consistent with past years, we will provide fiscal 2017 guidance when we report our fourth quarter results in May. However, on a preliminary basis, in fiscal 2017, we currently expect Virtusa organic revenue to continue to grow above offshore IT services industry growth rate.

As we ingest the impact of Citi's reduction in spend, we anticipate that Polaris revenue will grow in the single digits in FY'17, off of the expected annualized Q4 run rate. With respect to fiscal year 2017 non-GAAP earnings, we expect our consolidated EPS to grow faster than our revenue growth rate, even after dilution from the Polaris acquisition.

Looking to FY'18, we expect improved EPS accretion as we absorb most of the reduction in the Citi revenue from productivity initiative and realize expected revenue synergy from the acquisition. Finally, as a reminder, beginning fiscal year 2017, we will only be providing earnings per share guidance on a non-GAAP basis.

In conclusion, Virtusa will remain focused on executing against our strategic growth initiatives, including our efforts for a seamless integration of Polaris and Virtusa. Despite the headwinds we faced from FX and the Chennai floods, we delivered solid fiscal third quarter results. We continue to see growth across our portfolio of clients, driven by healthy demand for our industry leading digital and transformational solutions.

I will now turn the call over to the operator to begin Q&A. Thank you.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we'll take our first question from Mayank Tandon with Needham & Company.

Mayank Tandon

Thank you. Good morning, Kris and Ranjan. Ranjan, just to kick things off, I wanted to clarify guidance. So you gave us a lot of color, but in terms of the EPS guidance for fiscal 2016 on a non-GAAP basis, I think it's a $0.13 reduction at the midpoint versus what you had provided back in early November. Could you walk us through the impact from the various factors that gets you down to that $1.96 to $1.98 range? I think your previous range was $2.07 to $2.13, if I'm not mistaken.

Ranjan Kalia

I agree with you, Mayank. You're absolutely right on the $0.13. So the makeup of the $0.13 is really $0.11 coming from organic and $0.02 coming from incremental Polaris transactions. Polaris dilution previously used to be $0.08, now it's $0.10 because of delayed close and lesser revenue.

And then, the makeup of the $0.11 on the organic side is -- about $0.06 is really all due to the revenue changes we are taking. From the midpoint of our guidance, the revenue is lower by about $5.3 million. That's made up of about $2.5 million just from FX and the other piece is made up of impact on our insurance segment, primarily from the largest client that I have. That's the $0.06.

Then we will still continue to have additional Chennai BCP expenses in the month of January, so the Q3 and the month of January added together will be about $0.02. Then we are taking up one -- another facility in Chennai, which is going to be another $0.01, and then lastly is just some SG&A expenses. So that rollup of $0.06 plus $0.02 in Chennai BCP, plus $0.01 at facilities, that will get you $0.09, adding up to the $0.11 for organic.

Mayank Tandon

Right. Okay. That makes sense. I just wanted to be clear. And in terms of the guidance that you gave for -- preliminary guidance you gave for fiscal 2017, I just want to be clear. You said that -- maybe you could remind us in terms of the revenue impact. And then, also, do you still expect the Polaris deal to be, I believe you had said, slightly dilutive in fiscal 2017 and then accretive thereafter?

Ranjan Kalia

Yes. So you are right, Mayank. So we still believe, like I said in my prepared remarks, we believe Virtusa will continue to grow above industry growth rates. Polaris will more likely grow in single digits off of the Q4 run rate. If you look at it from the Q4 run rate, we still have to incorporate a little bit more Citi productivity and impact going forward in the quarterly. In their calendar Q4, it's not fully baked in yet, so that will continue to have an impact, which will mean that the non-Citi revenue will grow even faster, enabling Polaris to grow at single digits.

And yes, we did say that Polaris would be slightly dilutive before. And when I said slightly dilutive, the vision was it will probably be under $0.05. It is a little bit higher. It's looking more so in $0.06 to $0.08, primarily because some of the due diligence expenses that we were going to incur in Q4 are really getting moved into FY'17. The core operating profitability of Polaris, there's really been no change between what we talked last time and what we are thinking now.

Mayank Tandon

Sorry, just to be clear. You said, Ranjan, $0.06 to $0.08 dilution in fiscal 2017?

Ranjan Kalia

That's right.

Mayank Tandon

Okay. Thank you for clarifying that. And then if I can just squeeze one more question in, more high level, maybe for Kris. Kris, Cognizant reported this morning and they sort of talked about where client budgets stand, pretty consistent with what you said. But I believe they called out healthcare and they called out a weakness in banking and financial services, specifically insurance. Again, it's consistent with what you had said. Maybe you could just walk us through in terms of what you're seeing from your clients. Where are the spending cuts coming? Is it more macro related? Or the other specific factors that may be weighing on demand, at least early in the calendar year. Thank you.

Kris Canekeratne

So Mayank, overall we are saying that budgets are going to be flattish in 2016. As you decompose and you sort of dissect the spend areas, you are seeing almost across the board, specifically in banking and financial services, insurance, healthcare, even communications and media, you are seeing that all of our large enterprise clients have a stated objective to fairly dramatically cut their runs of business costs or their BAU costs. Simultaneously across the board, across almost all the industries that we operate in, we are basically seeing a doubling down in business models specifically around digital transformation.

So overall, Virtusa is very well-positioned to be able to help our clients reduce their business-as-usual expenses, not typically with how generation-one firms have done this, but specifically by implementing and introducing other platforming approach, which dramatically reduces inefficiencies and essentially reduces the costs that they incur today. Simultaneously, we are also very well-positioned across the board, across our clients, in terms of helping them with new business models specifically around digital transformation and helping our clients to reimagine their digital storefronts.

In addition what we are seeing especially in banking and financial services, there we believe, at least from what we have seen, that their spend is going to be slightly up, especially in terms of the types of work that Virtusa does, is around things like cyber security and compliance and regulatory initiatives.

So across cyber security compliance and regulatory, especially in banking and financial services, they are investing. In digital transformation, they're investing and doubling down. They are reducing their BAU expenses, but they are also looking for partners who can help them transform their BAU by specifically reducing the number and the complexity of the IT application estate. So we feel we are very well-positioned across the board in all of the industries that we are operating in.

Mayank Tandon

Great. Thank you for the color.

Operator

And our next question comes from Joseph Foresi with William Blair.

Joseph Foresi

I'm not sure if that was me, but I'll --

Operator

From Cantor Fitzgerald.

Joseph Foresi

Okay, great, all right. I didn't switch firms today. Just on the swing factors for Polaris's growth expectations, I'm thinking specifically for FY'17, maybe you can give us a little bit more detail around the Citi relationship. And what kind of confidence do you have in the visibility for that growth rate expectation?

Ranjan Kalia

Joe, first and foremost, I got to tell you that as we have spent more time with Polaris, specifically Polaris clients, gotten a really good sense now since our announcement around the type and type of relationships and the type of work and how established Polaris is. We couldn't be more pleased about combining with Polaris at this point in time.

Having said that, we have shared that there is and will be some headwinds specifically with Citigroup, who are going through a reduction in, spend across the board at Citi, and consequently, this has an impact on the Polaris/Virtusa relationship with Citi. We have discussed in great detail with Citi that we will instrument their goal around their reduction in spend objectives by implementing an efficiency improvement program whereby we will help them reduce their spend.

We expect that the headwind around Citi will be absorbed in 2017 or in fiscal 2017 and we will resume growth at Citi thereafter. It's very important for me to share with you that Citi were very much endorsing of this transaction and that they have signed up to a strategic preferred partnership with Virtusa and Polaris upon closing of the transaction. This is actually a very meaningful relationship and it will be the combined company's largest client. And we have a high degree of confidence that Citigroup will continue to be a strong strategic account for Virtusa/Polaris and give us the opportunity to implement the efficiency improvement plan and thereafter continue to grow and scale the relationship.

So despite the fact that we are implementing the efficiency improvement plan to help Citi reduce their spend, we also have the opportunity, as a result of being selected as a strategic preferred partner upon closing the transaction, to actually pursue opportunities across all of Citi technology, which is a very, very large spender of IT and as you can imagine is true of the rest of banking, we have some very specialized solutions and services that can help our clients and specifically Citigroup, reduce their spend, demonstrate efficiencies and thereby take on additional work. Notwithstanding, we also have the opportunity to pursue new work at Citi.

Having said all of this, we expect that the rate and speed of the efficiency improvement program will be faster in terms of lowering the spend with us than our ability to pursue new opportunities and then scale and expand. And that's why we believe that the revenue impact from Citi will be mostly in the first part or the majority of fiscal year 2017 and as we approach the end of 2017, we should start seeing increasing momentum and ideally an opportunity to grow the Citi relationship.

Joseph Foresi

Okay. And then, obviously the closing date moved a little bit and the costs increased. I think you talked about some regulatory approvals that were necessary. Maybe you can just give us some idea of why that date changed and what exactly those costs consist of.

Ranjan Kalia

Sure. So Joe, from a regulatory compliance perspective, we are supposed to get three type of significant approvals. One is called a CCI; one is called a SEBI, which is like the U.S. SEC and the other is the RBI. Actually, this morning, we will see the RBI approval. And the CCI and the SEBI are pretty much in their final stages. So we believe right now the transaction close is more so late February. And the operating profitability of Polaris, really there's really no change to it. The only reason for the $0.08 to the $0.10, if you look at it, it's the revenue impact, the gross margin impact from the revenue. And the big piece is -- we have a chunk of revenue deferrals that are going to happen to bring the Indian GAAP revenue onto the U.S. GAAP, and that impact, that deferral of revenue, ends up being a little bit more pronounced because it's over a one-month period versus previously would have been over a three-month period.

Joseph Foresi

Got it. Okay. And then, lastly, in financial services and insurance, some of the commentary that came forward today was that the discretionary spending is slower out of the gate heading into this year versus last year; that's obviously calendar year. Maybe you could talk about where you think the slowdown is happening. I know you've talked about the difference between discretionary and sort of lights-on stuff. But are you seeing a slowdown in discretionary spending right out of the gate? Can you quantify how big that is, in financial services and maybe extrapolate that for the year? Thanks.

Ranjan Kalia

So Joe, we had talked about even in our Q3 that we were seeing some impact inside our insurance segment. It was primarily related to our large account. That impact started becoming more and more pronounced in the month of December, as I think there's a lot of public information that's out there, the impact that this one large client is facing, which is taking significant, significant cost cuts, which is going to mean a reduction in IT budgets, which is really their -- means there is going to be a reduction in discretionary budgets. And we are watchful of that, how that will impact in FY'17, but right now we did see a pretty significant impact in the month of January coming out of the bottoms-up analysis of this large client.

Kris Canekeratne

Ranjan, if I can just build on that. If I look at this qualitatively, we are not seeing any clients slowing down the decision-making for economic reasons as of yet. Now we do have a cyclical pattern where client decision-making slows down in this quarter as new budgets get allocated and that budget pattern is being maintained, but it's consistent with prior years.

Joseph Foresi

Got it. Thank you.

Ranjan Kalia

Thank you. Next operator?

Operator

And we will take our next question from Anil Doradla with William Blair.

Anil Doradla

Hi, guys, a couple of questions. So you talked about the slowdown in this insurance client into the March quarter. How much visibility do you have for the remainder part of the year? And what makes you feel that -- do you think that this guy is going to come back or what's the trajectory of this particular client?

Kris Canekeratne

So Anil, first and foremost, I just want to share on an over-arcing basis that momentum in our insurance segment is strong, offset by our large insurance client who is going through a restructuring, and consequently, they are reducing IT spend specifically, short-term discretionary spend, which impacts our current fiscal year.

Notwithstanding, we have a strategic long-term partnership and a significant opportunity to further help our large insurance client improve their IT efficiencies and reduce their run the business costs. So what's really important for me to share is that while some of the discretionary spend at this large insurance client is reducing, we have several engagements with them on helping them improve the efficiency and the efficacy of running their business operation, specifically by leaning out, rationalizing and consolidating their complex IT environment.

So we've already demonstrated in several instances that we can take work away from incumbent providers or generation-one providers and demonstrate a step-function improvement in productivity and cost efficiency at this client. We have a strategic relationship and preferred partnership with this client and we believe that in this particular moment in time that we have an opportunity to take some of the things that we do so well and help them with their requirement of reducing their costs.

In terms of the relationship, in terms of the opportunities that we are pursuing, in terms of the overall nature of what we expect moving forward, nothing has changed. What has changed is that as a result of their restructuring, which actually is quite out there in the public domain, they have stated that they are taking a restructuring charge and they are reducing their costs across the board and that does include some of the work that they are doing, but it does not include the longer-term work that they are doing specifically around helping them with reducing their costs.

Anil Doradla

Okay, great. And switching gears a little bit to Polaris, you talked about with Citibank some of the dynamics that are playing out. But with the strategic partnership that you have with Citibank, presumably you would be able to bid for contracts across the firm, which you did not have before. So while you did give some color on fiscal 2017, if there were to be an upside, so to speak, in terms of your relationship with Citibank, where would that come from? I mean would that come from you guys getting a little bit maybe more into the retail side at Citibank or do you think it's more driven primarily by Polaris, at least in fiscal 2017?

Kris Canekeratne

So I think it's -- initially, I think what we will see is that where we already have a stronghold, where we have a beachhead and where we have very strong relationships, while Citigroup goes through a reduction in spend, there could be adjacent areas to the programs that we currently have under management that we could pursue and win to offset some of the reduction in spend. Longer term, we believe that we can take some of the solutions that Virtusa has that are very strong at, if you will, and then penetrate new areas at Citigroup where we now have the right to work in, where in the past we didn't.

But Anil as you well know, a reduction in spend initiative normally has an impact sooner than pursuing and actually engaging and activating new revenue streams. And that's why we believe that in the first few quarters of fiscal year 2017 that there would be an overall headwind that we would face that would then slowly taper down, hopefully plateau. And then, resume growth as we pursue and win some of these programs, whether they are on existing work under management and the adjacencies to that work or whether they be in new areas of Citigroup that neither firm, Polaris nor Virtusa, have worked in before.

Anil Doradla

Very good. And finally, Kris, if you don't mind me sneaking this last one in, in terms of retention of talent at Polaris since the acquisition, can you comment upon whether you've been able to hold up on all the talent? There's been some movement. Any comments would be helpful.

Kris Canekeratne

Very quickly, Anil. We have not seen any significant or even, for that matter, slight attrition in Polaris. We have retained anyone and everyone that we want to retain as a part of the transaction and we have been actually very pleased with the progress that has been made.

Anil Doradla

Great. Thanks a lot.

KrisCanekeratne

Thanks Anil.

Operator

And our next question comes from Frank Atkins with SunTrust.

Frank Atkins

Thanks for taking my question. I wanted to ask a little bit about as you look for the mix of fixed versus T&M materials, what impact Polaris will have on that as well.

Kris Canekeratne

Polaris is largely a T&M work. So I think the plus that it will have an impact to is our recurring revenue would increase. Not necessarily the T&M versus fixed pricing would change. If you look at it, Virtusa is pretty efficient in that we are running our T&M on -- our fixed price is almost 40%. But I don't think that's going to change that much. But the recurring pieces over a period of time would start to increase with the combination of Polaris and Virtusa.

Frank Atkins

Okay. That's helpful. And then, can you just speak a little bit on the communications and technology vertical, what you are seeing there in terms of driving growth?

Kris Canekeratne

Raj?

Raj Rajgopal

Kris, do you want me to take that call?

Kris Canekeratne

Go ahead, Raj.

Raj Rajgopal

Great. In the communications and technology area, we are seeing that a couple of trends. The first one is that digital is being seen as a revenue strategy and investments are being funded from, as Kris said, some of the cost savings and compression that is happening on the business as usual side. So we are seeing large customer experience improvement programs especially around client engagement.

The second thing we are seeing, this again is on the BAU side, we are seeing increasing interest in robotics process automation specifically as a cost play, where essentially cost is being taken out from existing spend and being invested in automation. If I look at the overall pipeline, the pipeline is actually expanding quite handsomely, especially around these large digital programs. And actually, these tend to be more multiyear also, so it gives us a little bit more revenue visibility.

Kris Canekeratne

Thanks Raj.

Frank Atkins

That's helpful. Thank you.

Operator

Our next question comes from Brian Kinstlinger with Maxim Group.

Brian Kinstlinger

Yes. Thanks. A couple of quick ones, first of all, the $0.06 to $0.08 dilution for Polaris in fiscal 2017, does that include the incremental interest expense related to the debt? And if so, how much is that of the $0.06 to $0.08?

Kris Canekeratne

Yes, it does include that. Continue -- just ask me the next question, I'll go get --

Brian Kinstlinger

Sure. Then also on Polaris, the losses, the makeup of your $0.10 loss in the short period of time in the current quarter is $0.02 debt and $0.08, I guess, operating results, operating income? But before, it was $0.07 debt out of the $0.08 total, so what's changed on the operational side that we are going from a very small loss to a much larger loss?

Ranjan Kalia

So like I said, the biggest piece, Brian, is the impact -- if you look at it as the impact of the revenue deferral. The impact of the revenue deferral itself, which is now going to be over $20 million revenue base versus previously being over a $70 million revenue base that is almost $0.07 out of the $0.10.

Brian Kinstlinger

I see. So that doesn't repeat itself; that's a one-time.

Ranjan Kalia

That's right. And then, your question, the $0.24 is the interest impact for FY'17.

Brian Kinstlinger

So $0.24 suggests the operations is offsetting that by a good amount. You are going to generate operating income from this transaction.

Ranjan Kalia

That's right. So like we said previously, Polaris on an organic core EBITDA is going to be in the mid-single digits.

Brian Kinstlinger

Okay. The last question I have, can you highlight whether you plan to be cutting cost or if there are synergies on the cost side from Polaris that gets you to that goal or is the plan to run the operation as is? Thank you.

Kris Canekeratne

So Brian, the strategic vision of this transaction was really all about expanding the addressable market. And we believe that in doing so initially we will actually need to make investments in the SG&A to really have SG&A for us at scale and growing from there. We do believe after we exit FY'17 we will see more SG&A leverage, we will see more SG&A synergies, but we are not really focused on that in FY'17 to start with.

Brian Kinstlinger

Great. Thank you so much.

Operator

[Operator Instructions] We will take our next question from Vincent Colicchio with Barrington Research.

Vincent Colicchio

Ranjan, just a quick two for me. Most of mine were asked. How much did Apparatus and Agora contribute in the quarter?

Ranjan Kalia

They contributed about $9.5 million.

Vincent Colicchio

And then, the healthcare side, how big is that business now? And maybe some color on the key drivers there would be helpful.

Ranjan Kalia

Sure. Vince, just keep in mind that Apparatus and Agora were not -- the $9.5 million was not new this quarter. Those were the acquisitions that were there prior quarter. With regards to the healthcare, the healthcare is now running at about 15% of the company revenue and actually grew above the company revenue in the quarter. So healthcare continues to be very strong for us.

Vincent Colicchio

Okay. Any more color on that, what the key drivers might be?

Kris Canekeratne

Ranjan, can I pick that up?

Ranjan Kalia

Yes. Sure, sure.

Kris Canekeratne

So as Ranjan mentioned, I think the pipeline is growing well, both in number of deals, which is actually quite important as well as the total value of the pipeline. And I'd say there are probably two major trends focused primarily on some of the investments that we've been making over the last year. So one is this whole shift in the healthcare organizations around fee-for-value over the traditional fee-for-service, with essentially -- increases the growth potential that is sharing contracts between payers and providers.

So what's happening is given the same clients exploring kind of multiple paths to effectively engage members from healthy to chronically ill in programs that can help manage their health outcomes, essentially which improves the sorts of services that Virtusa provides from population health management using our customer experience type of capabilities.

The second one essentially is the fact that the Affordable Care Act has dramatically changed the types of businesses our payers are going after from commercial businesses to more individuals and government lines of businesses. And again, this is requiring our clients to invest heavily in the sales quoting, enrollment, claims solutions, call center solutions, et cetera. So essentially both of these are driving demand in our healthcare space. We invested early in these spaces and now we are reaping the benefits of that.

Vincent Colicchio

Thanks for the color, guys. I appreciate it.

Operator

And that concludes our question-and-answer session. I would like to turn the call back over to Kris Canekeratne for additional and closing remarks.

Kris Canekeratne

Thank you, operator. Thank you, everyone, for joining our Q3 2016 earnings call. I want to take this opportunity to thank our global team members for their dedication and commitment to our clients. I also want to thank our leadership team and our Chennai team members for minimizing business disruption post the Chennai floods. Thank you.

Operator

And that concludes today's conference. Thank you for your participation.

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