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Virtusa Corporation (NASDAQ:VRTU)

F1Q09 Earnings Call

July 30, 2008 5:00 PM ET

Executives

Krishan A. Canekeratne - Chairman of the Board, Chief Executive Officer

Thomas R. Holler - Chief Financial Officer, Executive Vice President - Finance

Kori Doherty - Investor Relations

Analysts

David Cohen - J.P. Morgan

Jonathan Maietta - Needham & Company

Timothy Mchugh - William Blair & Company, LLC

Operator

Welcome to the Virtusa Corporation first quarter 2009 earnings conference call. At this time all participants are in a listen-only mode. Following the presentation we will conduct a question and answer session. Instructions will be provided at that time for you to queue up for questions. I would like to remind everyone that this conference is being recorded.

I would now like to turn the conference over to Ms. Kori Doherty, Investor Relations.

Kori Doherty

Good afternoon and welcome to Virtusa’s first quarter 2009 earnings conference call where we will be discussing our financial results for the quarter ended June 30, 2008. On the call with me are Kris Canekeratne, Chairman and Chief Executive Officer, and Tom Holler, Executive Vice President and Chief Financial Officer 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 performance of Virtusa’s IT services, acquisition of new clients and growth of business, the ability of Virtusa’s clients to realize benefits from the use of Virtusa’s IT services, planned Hyderabad campus, the share repurchase program, and management’s plans, objectives and strategies. These statements are neither promises nor guarantees but 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, or otherwise. For additional disclosure regarding these and other risks faced by Virtusa, see the disclosure contained in Virtusa’s public filings with the Securities and Exchange Commission.

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

Krishan A. Canekeratne

Thank you for joining us today on our first fiscal quarter conference call. Let me start with Q1. Q1 revenue net of BT was in line with our expectations and we made very good progress with new client wins and expanding new client relationships. As we indicated in our preliminary announcement earlier this month we experienced some unexpected challenges at British Telecom which negatively impacted our financial results for the quarter. However, I want to assure you that we are taking several steps now to return to profitable growth during the second half of FY09.

Turning to our results of the June quarter, total revenue was $42.5 million an increase of 14% year-over-year but a decrease of 5.5% sequentially. Our operating income was break-even resulting in earnings per diluted share of $0.03. These results were below our May 20 guidance due primarily to the shortfall at BT.

Let me now provide you with highlights from the quarter which include progress we have made in new client wins across all industry groups and geographies as well as in our financial services operating group.

As we have mentioned on earlier calls, we have been making targeted strategic investments in sales and marketing resulting in improving our pipeline and in winning more new accounts. During the first quarter we started work with seven new accounts. The strength of the new client additions is noteworthy given the overall state of the economy and indicates the importance of our value proposition. Our new client additions were also geographically dispersed with three in North America, two in Europe, and two in the Middle East. The two new clients in the Middle East highlight our early success with our recent initiatives to expand into new geographies which can be served efficiently through our global model. New client wins and expansion build a foundation for sustainable long-term growth.

The clients we have won over the last several quarters are starting to contribute more meaningfully and we expect that they will continue to do so later this year and become growth drivers for our business. Our new client additions span across our service offerings and market segments, and we are already seeing many of them evolve from initial engagements to longer-term outsourcing relationships. Within the first quarter our non-top 10 accounts grew 13% sequentially and 33% year-over-year. We are pleased with these efforts and will continue to make investment in new client acquisition and intensify expansion initiatives because we see opportunity in front of us.

Another bright spot in the quarter was our financial services industry group which grew 31% year-over-year and 5% sequentially. While there continue to be economic pressures in parts of this market, financial services will remain a healthy industry group for Virtusa and will be a growth driver in fiscal 09 and beyond. Within financial services we are seeing success in our ability to leverage some of our existing partner relationships and build successful go-to-market strategies around these competencies. For example, in collaboration with one of our partners we have created a business process management also known as BPM offering for financial services and insurance companies. Our experience shows that BPM is becoming a powerful method for streamlining and accelerating application innovation in enterprises today.

Our consultative collaborative approach and delivery tools can help clients implement business process improvements faster and more successfully. As an example, we were recently awarded a project with an existing client, a major financial institution, to integrate two BPM applications into one. The integration of the two applications will result in a single solution that will be rolled out globally by the client to over 102 countries. This single solution will allow for a global service structure in sub-regional or country specific model that they have today resulting in lowering their total cost of ownership, improving the speed at which they introduce new products and services that grow their client base, and greatly improving their customer experience. This is a representative example of value created through our platforming approach and is a key differentiative as we pursue win and expand with our clients.

Turning to British Telecom, our revenue for the first quarter was $9.2 million representing 22% of our revenue for the quarter. This is a sequential decrease of approximately 30% and while we expected our BT revenue to be down sequentially, clearly this was more than we were anticipating. As we said in our pre-announcement on July 7, we were unable to secure budget allocation for certain projects at BT for which we had reason to believe we were selected and therefore commenced work. With an established plan such as BT it is not unusual to begin work while a purchase order is being finalized and in the case of BT the final process can often take some time. What has now become apparent to us is that British Telecom is tightening budgets around discretionary spending with many of its partners, and while we remain confident in the strength of our relationship and the minimum contractual commitment, we believe it is prudent to make some new assumptions about the amount of expansion on new work we expect to perform with them. However, the fact remains that our platforming approach is strategically aligned with BT’s direction; we execute through one of the most optimal global delivery models in our industry; and we have a track record of providing high quality service at BT. This together with our $200 million strategic five-year partnership positions us well to continue to be a strong partner to British Telecom.

While we are pleased with our new client acquisitions and project starts and see areas of strength across our industry groups, we now expect the overall business to grow more slowly than our prior guidance. This revised outlook takes into consideration adjusted assumptions of British Telecom revenue for the remainder of this year and the increasing impact the macroeconomic environment is having on our clients’ IT spends. Given the near term more conservative assumptions about draught, we have initiatives underway to examine our cost structure, optimize our global resources, and realize efficiencies as quickly as possible in order to improve profitability in the second half of this fiscal year. This includes improving utilization, leverage automation, and enhancing internal productivity. We are also applying more focus to our go-to-market strategies to ensure that we continue to expand our footprint at our clients. More broadly speaking, we continue to see strong secular growth trends in global IT outsourcing and believe we are well positioned to capitalize on these trends based on our strategic positioning, differentiated services offerings, and the industry groups we serve. We remain very confident in the [sellby] long-term outlook for our business.

Based on this, I am very pleased to announce that the Board has approved a $15 million share buy-back program which will enable Virtusa to invest in our company on behalf of our shareholders.

With that I will turn the call over to Tom Holler to review our financials in more detail.

Thomas R. Holler

Good evening to everyone. Let me start by summarizing the results of our first quarter of fiscal 2009 and then I will conclude with our second quarter and full fiscal year guidance. Please note that all the numbers being discussed are US GAAP.

Revenue for the first quarter came in at $42.5 million. This represents year-over-year growth of 14% and a sequential decline of 5.5%. First quarter revenue was below our original guidance as a result of the lower-than-expected revenue contribution from British Telecom which Kris discussed moments ago. Excluding British Telecom, first quarter revenue grew 20% year-over-year which was in line with our original guidance.

Our operating income for the quarter was break-even. This compares to an operating income of $3.2 million in the same period last year. First quarter operating margin decreased 850 basis points year-over-year. The operating margin was impacted year-over-year by the unexpected lower revenue in the first quarter of 2009 by the related lower utilization and by higher delivery related expenses which lowered our gross margin. Gross margin was negatively impacted by approximately 530 basis points due to lower utilization, by approximately 20 basis points due to the Indian rupee exchange rate net of hedging contracts, and by approximately 300 basis points due to increased use of contractors, travel and other expenses.

Other income increased $600,000 year-over-year primarily driven by an increase in interest income on higher cash balances as a result of our IPO and year-over-year change in foreign currency translations related to intercompany balances. We had an income tax benefit in the quarter of approximately $50,000. Our effective tax rate guidance for the fiscal year is now revised based on our forecasted geographical mix of profit. We currently are forecasting an effective tax benefit rate of 10% for fiscal year 2009.

Net income for our June quarter was $800,000 versus $2.7 million in the prior year period. Diluted earnings per share were $0.03 in our first quarter of fiscal 2009.

Turning to the balance sheet, cash and cash equivalents, short-term and long-term investments totaled $94.8 million on June 30, 2008. Our DSO including unbilled receivables was 77 days. This was a one-day improvement from our March quarter. Cash flows used for operating activities were $600,000 in the first quarter. Capital expenditures were $3.8 million in the quarter inclusive of $2.5 million for the construction of our Hyderabad campus. We currently expect our campus spending for the fiscal year to be approximately $11 million. Depreciation and amortization expense in the quarter was approximately $1 million.

Now let me turn to some additional quarterly metrics beginning with those related to our first fiscal quarter revenue. Revenue by geography was as follows: North America was 71% of revenue growing 13% year-over-year; Europe was 27% of revenue growing 8% year-over-year; other geographies contributed 2% of revenue. Revenue growth across our industry groups was as follows: Banking, financial services and insurance was once again our fastest industry group growing 31% year-over-year representing 42% of total revenue in the quarter; communications and technology represented 35% of revenue and declined 1% year-over-year; media, information and other contributed the remaining 23% of revenue growing 12% year-over-year. Revenue across our services offerings was as follows: Application outsourcing represented 69% of our revenue and grew 11% year-over-year; IT consulting and implementation services was 31% of revenue and grew 20% year-over-year; power and material contracts were 75% of revenue, with fixed price contracts being the remaining 25% of total revenue in the quarter.

We are extremely pleased with our ability to win new business, having started work for seven new clients during the quarter. We ended the quarter with 58 active clients up from 42 in the first quarter of last year. Our top client British Telecom contributed 22% of revenue in the quarter. Our top 10 clients for the quarter represented 72% of revenue. 88% of our revenue came from clients we have partnered with for more than one year.

Turning to other operating metrics, global utilization excluding trainees was 61% in our first quarter falling below our target range of 70% to 75%. We are confident that we will increase utilization back to our target range during the fourth quarter of this fiscal year and we are working to align our global team of IT professionals with our expanding list of clients. We finished the quarter with 4,574 global team members. We had strong hiring in the quarter. We increased the number of IT professionals by 307 or 8% to finish the quarter with 4,270 global IT professionals. Total employee attrition calculated on a trailing 12-month basis was 21% for the period ending June 30, 2008 equal to our prior quarter. However, we did see improvement in absolute attrition in our first quarter. As we stated last quarter, we have several corporate initiatives underway to help improve attrition and bring it in line with our goals. We remain focused on attracting, hiring and retaining the best IT talent.

Consistent with past performance we deliver our services using an industry-leading highly efficient global delivery model. Our build effort mix was 19% on site and 81% offshore.

I would now like to provide some more color on our new share repurchase program. As stated in our press release the program authorizes the company’s management to repurchase up to $15 million of the company’s common stock over the next 12 months. The program underscores management’s confidence in the company’s financial future and our commitment to increasing shareholder value.

Now I will provide our current guidance for the September quarter and full fiscal year 2009. As a reminder, all of our numbers are on a US GAAP basis. Revenue in the second quarter of fiscal 2009 is expected to be $41.5 million to $43 million. Diluted earnings per share in the second quarter of fiscal 2009 is expected to be -$0.06 to $0.01. Earnings per share assumes an average share count of approximately 24.4 million. Please note that the second quarter share count is approximately 5% higher than the second quarter of fiscal 2008 primarily driven by our IPO in August 2007.

For the full fiscal year ending March 31, 2009 our revenue range is currently expected to be $172 million to $180 million. Fully diluted earnings per share for the full fiscal year 2009 is currently expected to be in the range of $0.20 to $0.42. Full year EPS assumes an average share count of approximately 24.4 million. The share count for full fiscal year 2009 is approximately 5% higher than for fiscal year 2008 primarily driven by our IPO.

Our guidance is based on the following set-up assumptions: In other income we model interest income using an annual effective interest rate of 3% on our average projected cash balance including long- and short-term investments. We have not considered any potential impact to other income associated with foreign gains or losses on our intercompany balances. Foreign currency hedges are in place for the remainder of the fiscal year covering approximately 85% of our forecasted Indian-borne expenses at an average Indian rupee to US dollar conversion rate of 39.6. We currently expect to have a tax benefit rate of 10% for the full fiscal year. Our effective tax rate is sensitive to the geographical mix of profit for the fiscal year across all of our operating entities. If our geographical mix of profit for the full year changes from our current forecast, our effective tax rate is subject to change. In addition, fiscal 2009 guidance does not consider any potential impact of the new share repurchase program.

Before concluding I’d like to share some additional insight into our fiscal 2009 guidance. British Telecom remains a strategic partner and our outlook for the long-term success of the relationship remains positive. However, at the present time we are forecasting our BT revenue to be 21% to 22% of total company revenue for the full fiscal year 2009. Additionally, due to some new procurement processes in place at BT we may experience timing delays in the near term and therefore our second quarter guidance reflects flat to modestly lower BT revenue sequentially. Also, the current economic environment has resulted in a more pronounced slowdown of IT spending than we had previously anticipated and we expect this will have an impact on our revenue growth for the remainder of the fiscal year. The change in our outlook for British Telecom revenue coupled with general economic weakness overshadows areas of strength in our business.

We continue to see good momentum in our BFSI industry group and both existing and new clients. Additionally, a key area of growth is our expanding portfolio of new clients we have added over the past few quarters. While it will take time for these clients to contribute meaningfully relative to total company revenue, we are pleased with their overall rate of expansion and will continue to invest in furthering their growth. We also believe our continued success of adding new clients will lead to sustainable long-term revenue growth and lower our revenue concentration over time.

As a result of our revised revenue guidance we are focusing efforts on resource optimization initiatives to improve our gross and operating margins. We believe these efforts will result in profitability improvement in our third and fourth fiscal quarters.

We are also taking measures to tightly manage our general and administrative expenses. However, as we have stated in the past we have made commitments to investing in our Hyderabad campus and to expand into a special economic zone in Chennai during fiscal 2009 that will lead to enhanced operating leverage long term. These investments will increase operating expenses during fiscal 2009. Our Hyderabad campus remains a strategic part of our long-term infrastructure plans which will provide a world class working environment for our team members as well as allow us to take advantage of the tax benefits of a special economic zone. However, we are delaying the opening of our Hyderabad campus to late in our third fiscal quarter to better manage our near term operating expenses.

In summary, although we face near term challenges due to general economic weaknesses we are committed to achieving profitable growth in the second half of fiscal 2009.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from David Cohen - J.P. Morgan.

David Cohen - J.P. Morgan

Now that you’ve had some time to hopefully get a better handle on what went on at BT, can you help us understand if there are things that you could have been doing differently and then changes that you’re making in working the relationship there to have better visibility into the opportunities at BT?

Krishan A. Canekeratne

Let me start and then Tom can certainly add more color to this. What we described earlier, this was caused by BT not allocating budgets to some of the work we had started. As you well know at BT we are one of the preferred IT services partners. BT spent $9.2 million with us during the quarter representing 22% of our revenue and we continue to have a very strong relationship with BT and quite candidly an outstanding track record of service excellence. Now, clearly when we found out that these budgets didn’t get allocated late in the quarter and we certainly as a result of that have gone through and evaluated many of the processes that we have followed. We have over a period of time worked with BT; we have not had a situation like this happen before; and it’s not unusual for us to start an engagement with an established client pending the purchase order which is exactly what happened in this particular instance. I will turn this over to Tom who will provide a little bit more detail.

Thomas R. Holler

As Kris said, particularly at British Telecom it is not unusual for us or other vendors to start work ahead of receiving a purchase order or other evidence of arrangement. We’ve had a relationship for four years working within BT’s processes and have been accustomed to receiving paperwork late in the quarter, particularly for projects that start in quarter. Having said that, BT and Virtusa are both aligning their processes more closely. We’ve been working with the procurement function to ensure that this situation doesn’t repeat itself in the future.

David Cohen - J.P. Morgan

In terms of the kind of work and the skill set of the people, would you talk a little bit about what the work was and how long you think it’s going to take? It sounds like it’ll take some time to reallocate the team members.

Thomas R. Holler

Yes, the work was primarily related to consulting engagements, heavy on site but a global model. And we are working on initiatives to improve utilization part of which is redeploying our resources and aligning them in areas of growth of the business. It will take us until sometime in our fourth quarter to return to our normalized utilization range of 70% to 75%.

David Cohen - J.P. Morgan

On the economic weakness that you talked about getting a little bit worse, would you talk a little bit about where you’re seeing that because you indicated that BFSI you still expect to be pretty strong? Can you just provide a little bit more detail around where the weakness is and the kind of services that are more under pressure? Help us understand that better please.

Krishan A. Canekeratne

When we last spoke a little bit over two months ago, we characterized the economic environment as uncertain. In the past two months what we have seen is that this uncertainty has resulted in clients taking a more measured approach to its IT spending. So over the last few months we have seen the economy become more challenging and this has clearly impacted some of our growth assumptions. Having said this, we have seen good momentum with new clients. As you well know we closed 17 new clients during the last two quarters. In financial services we’ve seen good growth. We’ve grown 5% sequentially quarter-over-quarter. And we’ve also seen geographic expansion as a matter of fact designed to accounts in the Middle East as we’ve expanded our geographical presence. So we have taken all of this into consideration as we have provided consultive guidance for the remainder of this year.

Operator

Our next question comes from John Maietta - Needham & Company.

John Maietta - Needham & Company

I was wondering if you could characterize BT and the reduced spend this year. How much of that is a function of them just pulling back on their purse strings as opposed to actually allocating work to other vendors, and I’m thinking of their in-house joint venture with [Mahendra]?

Krishan A. Canekeratne

Let me start John and good to have you on the call. A large part of this is based on BT’s state of direction and strategy directory to reduce IT spend over the year or during this year. Now, as I mentioned earlier we continue to be a very strong strategic partner to BT. They have an equity investment in Virtusa. We have an outstanding track record of service and service excellence at BT and beyond that we are strategically extremely well positioned and very well aligned on a platforming approach, which is one of their strategic IT directions and clearly a strong suite and strength of ours. Now as far as other providers, it’s hard for me to provide much color on what’s happening with the other providers but suffice it said that although some budgets didn’t get allocated and that’s certainly an impact on our first quarter, we do believe that over the long term the BT relationship is going to continue to be very strong and we are extremely well positioned to continue our strategic partnership with British Telecom.

Tom, do you want to add anything to that?

Thomas R. Holler

No, I think that covers it well. We might see a slight downtick this quarter and that has more to do with aligning ourselves with their procurement process and it could potentially lead to slight delays in some of the work streams.

Krishan A. Canekeratne

Just to add one more comment to that. I think it is also worthwhile to note that of all the IT services partnership that BT has, we happen to be one of two in which they have an equity investment. And I do believe that clearly it’s something that will all go well for us as we move forward.

John Maietta - Needham & Company

Tom, with regard to the bottom line EPS range, you have a wide range there. Is that just a function of uncertainty around how quickly you can get folks off the bench and productive?

Thomas R. Holler

Yes John. It is a wide range and that is really, you’re right, it’s a function of the time that it will take to improve our utilization over the next couple of quarters and also that we have a somewhat fixed G&A cost structure so an $8 million revenue range because of that cost structure to the profit range is a bit large at this point.

Operator

Our next question comes from Timothy Mchugh - William Blair & Company, LLC.

Timothy Mchugh - William Blair & Company, LLC

I wanted to ask about the cost optimization you’re talking about. Should we expect headcount to actually be down sequentially here in the second quarter or is it more an issue of just growing into the people that you’ve added here during the first quarter?

Thomas R. Holler

Clearly the biggest drivers in managing utilization are the rate of hiring, attrition and clearly revenue growth. And we will look to manage our utilization more aggressively going forward or levers to bring up utilization to achieve 70% to 75% utilization in our fourth quarter. Having said that, we do anticipate that we’ll slow the rate of hiring and that our actual billable headcount on September 30 will be lower than our June 30 headcount.

Timothy Mchugh - William Blair & Company, LLC

Are you also looking at SG&A for cost optimization at this point or is that pretty fixed at this point?

Thomas R. Holler

There are some programs that we’re taking a look at. We mentioned that we’ll open our Hyderabad campus a little bit later in the year than we originally planned. That’s primarily to help our operating expenses. We are looking at some discretionary budget items that we’ll likely defer and we’ll manage our G&A expenses very tightly going forward and we’ll look to increase productivity of our shared services functions leveraging past investments and automation.

Timothy Mchugh - William Blair & Company, LLC

What gives you confidence in the second half of this year in terms of the sequential improvement in revenue given the macro comments you made about spending outside of BT and the macro impact on that spending level?

Thomas R. Holler

A couple of things. Clearly we approached our guidance setting similar to how we’ve done it in the past, doing an internal review account by account. But the guidance contemplates British Telecom revenue at or slightly above their minimum commitment to the company and we’ve applied we believe a bit more conservative approach to our revenue estimating this time around given the general economic weakness.

Krishan A. Canekeratne

Let me add to that. We’ve also closed 17 new accounts just in the last two quarters and I think 24 accounts during the last fiscal year. As you well know, when you close a new account what you really look for is the potential that the account can provide over a period of time, typically in year plus one, year plus two, year plus three, and clearly over the years we have had a tremendous, tremendous sort of learning about starting work at accounts and then systematically growing that work to tens of millions of dollars. We believe that today we have a very strong cadre of accounts where we can unleash some of those learnings. We’ve built partnerships; we have gotten through some of the early phases and the early stages. These accounts are nearing in some cases a year with us and we have tremendous confidence today that as we get into the second half of this year that we’re going to see growth from some of our existing accounts, several of the new accounts that we’ve closed, and we also are confident in BT reaching at least the minimum threshold of commitment that they have with us. So that’s all a part of the analysis that we’ve gone through as we’ve developed our guidance a conservative outlook for FY09, but with a great deal of confidence that we will attain the guidance that we set forth.

Timothy Mchugh - William Blair & Company, LLC

Tom, a quick numbers question. The tax rate. Did you say a benefit of 10% for this year?

Thomas R. Holler

That’s correct Tim. It has to do with our profit distribution globally across our entities and more specifically, we will be incurring a loss in the US and that’s where we pay the most of our tax since we have tax holidays in our Asia entities.

Timothy Mchugh - William Blair & Company, LLC

Will that be focused on the second quarter then here? Should we model that seasonally different?

Thomas R. Holler

Our effective tax rate’s modeled on the full fiscal year estimates and that’s what we accrue to each quarter, which will be a 10% benefit as our current estimate.

Timothy Mchugh - William Blair & Company, LLC

The share repurchase, how aggressively do you plan to be on that? Is that something you have in hand if there is further weakness or do you plan to be pretty active on that going forward?

Thomas R. Holler

I can’t comment on the specifics of how aggressive we’ll be. We’re just in the process of implementing it. It should be implemented very soon and we do plan on utilizing it and moving forward with the program. But the exact quantity and how aggressive we are is difficult for me to comment on today.

Operator

There are no further questions at this time. I’ll turn the conference back over to our speakers for any additional or closing comments.

Krishan A. Canekeratne

In closing, we remain committed to improving profitability in the second half of the year and believe the recent successes we’ve had with winning new and growing clients builds the foundation for long-term sustainable profitable growth. British Telecom continues to be a strategic partner to Virtusa and we remain very confident in the strength of this relationship. Thank you all for joining us.

Operator

That does conclude today’s conference call. We thank you all for your participation and you may now disconnect.

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