ExlService Holdings, Inc. — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014; unaudited, prepared under U.S. GAAP. ExlService provides business process solutions through Outsourcing Services and Transformation Services, with clients principally in the U.S. and U.K.
Financial performance and liquidity
Amounts below are in millions of U.S. dollars, except per-share data and percentages. Comparisons are with the corresponding 2013 period.
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $119.7 | $116.0 | $241.5 | $232.0 |
| Gross profit | $38.5 | $42.1 | $85.4 | $85.2 |
| Gross margin | 32.1% | 36.3% | 35.3% | 36.7% |
| Operating income | $6.1 | $12.8 | $21.6 | $24.9 |
| Operating margin | 5.1% | 11.1% | 8.9% | 10.7% |
| Net income | $7.8 | $9.2 | $18.9 | $19.0 |
| Net margin | 6.5% | 8.0% | 7.8% | 8.2% |
| Diluted EPS | $0.23 | $0.27 | $0.56 | $0.56 |
- Revenue mix: Q2 Outsourcing Services revenue was $94.3 million, down 3.1%; Transformation Services was $25.4 million, up 36.1%. For the half-year, outsourcing revenue was $194.4 million, down 0.3%, while transformation revenue was $47.1 million, up 27.0%.
- Cash flow: Six-month operating cash flow was $27.8 million, versus $25.4 million. Investing used $18.0 million, including $16.6 million of fixed-asset purchases; financing provided $1.8 million. Cash and cash equivalents rose to $160.9 million from $148.1 million at year-end.
- Liquidity and obligations: Cash, cash equivalents and short-term investments totaled $168.5 million at June 30; $82.0 million was held by foreign subsidiaries and management said it intended to reinvest overseas earnings. Total current assets were $272.9 million and current liabilities $69.6 million. The company reported $2.0 million of capital lease obligations and no off-balance-sheet arrangements. Its three-year credit agreement expired during the quarter.
- Other balance-sheet data: Total assets were $494.3 million and total liabilities $85.0 million. Fixed assets, net, increased to $46.0 million from $34.6 million at December 31, 2013.
Material changes and management commentary
- Revenue growth was modest despite strong transformation-services growth. Reported revenue includes reductions for Travelers disentanglement-cost reimbursements: $5.7 million in Q2 and $8.2 million in the first half. Management attributed outsourcing revenue pressure to these reimbursements and foreign exchange, partly offset by client-volume growth.
- Travelers gave notice in November 2013 to terminate its services agreement. Management estimated the transition would reduce 2014 revenue by $12 million to $20 million, in addition to the reimbursements. The filing does not provide a revised full-year revenue or earnings forecast.
- Q2 operating income fell 52.5% year over year as cost of revenue rose 9.9% and operating expenses increased. Management cited annual wage increases, more delivery personnel, new operating centers, higher facilities and technology costs, and Travelers-related revenue reductions. First-half gross and operating margins also declined.
- The Q2 tax benefit of $0.9 million, compared with $3.6 million of tax expense a year earlier, reflected a $2.2 million reversal of an unrecognized tax benefit and lower U.S. income associated with Travelers disentanglement-cost reimbursement. First-half effective tax rate was 15.7%, versus 25.8%.
- Management expected $10 million to $15 million of additional capital expenditures during the remainder of 2014, primarily for facilities and technology to support client growth. It said operating cash flow would fund ordinary investment, working-capital needs and smaller acquisitions; significant acquisition-led growth could require additional financing.
- On July 1, 2014, after quarter-end, the company acquired Blue Slate Solutions, LLC for $6.235 million cash, subject to working-capital adjustments, and agreed to issue 46,950 restricted stock units to key employees.
Risks, contingencies and unusual items
- Indian tax disputes: Tax-authority demands related to transfer pricing and permanent-establishment matters totaled $18.7 million at June 30. The company had paid or provided bank guarantees for $15.4 million. Management, relying on tax advisers, considered ultimate liability remote and recorded no accrual; additional assessments remain possible.
- Client concentration and termination: The top ten clients represented 52.5% of Q2 revenue and 53.4% of first-half revenue. No single client exceeded 10%, but management expected significant revenue concentration to continue in the near term. Travelers transition execution and staff/infrastructure redeployment are identified uncertainties.
- Operating and market risks: The filing highlights competition and pricing pressure, multi-vendor client arrangements, hiring and retention, international operations, foreign-currency movements, technology or telecommunications disruption, data confidentiality, and possible changes to government incentives. The company hedges foreign-currency exposures, principally involving the Indian rupee, U.K. pound and Philippine peso; it reported no material change in market-risk exposure during the half-year.
- Commitments: Contractual cash obligations totaled $44.9 million, including $24.8 million of operating leases and $7.4 million of fixed-asset purchase obligations. This excludes $2.8 million related to uncertain tax positions whose amount and payment timing were not reliably estimable.
- The company reported effective disclosure controls as of June 30, 2014, no material change in internal control over financial reporting, and no other legal proceedings expected to have a material adverse effect, apart from the tax matters described.
Important facts for investors to verify
- Track Travelers’ transition, remaining reimbursements, and whether management’s estimated $12–$20 million 2014 revenue impact changes.
- Assess whether transformation-services growth can offset flat-to-declining outsourcing revenue and restore gross and operating margins.
- Review employee, facility and technology cost growth against revenue growth, planned capital spending, and operating cash generation.
- Monitor the Indian tax disputes, any additional deposits or assessments, and the status of the expired credit agreement or new financing arrangements.
- Evaluate the Blue Slate acquisition’s integration, purchase accounting and contribution to future performance; this transaction occurred after quarter-end.