ExlService Holdings, Inc. — Q2 2011 Form 10-Q
Business context and reporting period
Unaudited results for the quarter and six months ended June 30, 2011, compared with the same periods in 2010. ExlService provides outsourcing and transformation services, principally to U.S. and U.K. clients. Figures below are in U.S. dollars; amounts are rounded to millions unless stated otherwise.
Financial performance and liquidity
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Revenue | $85.0m | $60.6m | $157.9m | $115.1m |
| Gross profit / margin | $33.0m / 38.8% | $23.2m / 38.2% | $61.7m / 39.1% | $46.2m / 40.1% |
| Operating income / margin | $9.4m / 11.1% | $5.3m / 8.7% | $16.9m / 10.7% | $11.7m / 10.2% |
| Net income / margin | $8.5m / 10.0% | $4.9m / 8.0% | $16.8m / 10.7% | $10.5m / 9.1% |
| Diluted EPS | $0.27 | $0.16 | $0.54 | $0.35 |
- Q2 revenue grew 40.2%; six-month revenue grew 37.2%. Outsourcing services drove most of the increase, with growth from acquisitions, higher volumes among existing and new clients, currency movements, and a $2.2m one-time client payment with no associated costs. Transformation-services revenue also increased.
- Q2 gross margin improved year over year, while the six-month margin declined. Management attributed the six-month pressure mainly to higher delivery costs. Operating margins improved in both comparison periods as SG&A declined as a share of revenue.
- Foreign-exchange gains contributed $1.8m in Q2 and $3.5m in the first half, versus $0.9m and $1.5m, respectively, in 2010. The six-month effective tax rate was 21.1%, down from 25.0%, partly because of a $2.0m deferred-tax valuation-allowance release. Q2’s rate rose to 28.5% from 25.0%, partly reflecting expiry of Indian tax holidays.
- Operating cash flow was $26.8m for the first half, versus $7.0m a year earlier. Investing used $90.2m, mainly including $80.1m net cash paid for OPI and $8.6m for fixed assets; financing provided $31.2m, including $30.0m of revolver borrowings. Cash and equivalents ended at $79.4m, down from $111.2m at year-end; cash plus short-term investments totaled $83.9m.
- At June 30, total assets were $385.4m and current liabilities were $97.4m. Short-term borrowings were $30.0m; capital lease obligations totaled $8.0m. The company had a $50m, three-year revolving credit facility, with $30m drawn and a 2.2% stated interest rate at quarter-end. The facility is secured by substantially all assets of the borrower and material domestic subsidiaries and includes covenants.
Material changes versus the prior comparable period
- OPI was acquired on May 31, 2011 to expand finance-and-accounting outsourcing capabilities. Estimated purchase price was $100.9m, including adjustments; preliminary purchase accounting recorded $55.9m of goodwill and identifiable intangible assets. OPI contributed $7.4m revenue and $0.5m net income from June 1 through June 30. Reported 2011 results include only this post-acquisition period; pro forma results are also disclosed but are not presented as actual results.
- Goodwill increased to $99.3m from $43.4m at year-end, and net intangible assets rose to $39.6m from $18.6m, principally due to OPI. Fixed assets increased to $45.5m from $34.7m.
- Revenue growth outpaced operating-cost growth in Q2, but first-half cost of revenue rose faster than revenue, reducing gross margin. Cash declined largely due to acquisition spending, partly offset by operating cash flow and new borrowing.
Outlook, commentary, risks and contingencies
- No quantified revenue or earnings guidance is provided. Management expects revenue to grow through service and client expansion, organically and through acquisitions. It expects $15m–$20m of capital expenditures in the remainder of 2011, primarily for facilities, operations-center expansion in India and the Philippines, and technology; it also expects depreciation to rise as facilities expand.
- India tax holidays for certain operating centers expired April 1, 2011, increasing the taxability of profits from those centers. The Philippines tax holiday was expected to expire in mid-2012 unless extended. Failure to renew could raise the tax burden.
- Revenue is concentrated: the three largest clients represented 34.8% of Q2 revenue and 36.4% of first-half revenue. Centrica contributed 12.3% of Q2 revenue and its agreement was scheduled to expire in April 2012; Travelers contributed 12.1% and may terminate without cause on 60 days’ notice. American Express accounted for 10.5% of Q2 revenue; its outsourcing contract has a minimum-volume commitment, while its transformation-services agreement can be terminated on five days’ notice.
- Management cited risks from acquisition integration, client concentration and contract termination, offshore-outsourcing sentiment, hiring and retention, competition, foreign-exchange movements, pricing pressure and multi-vendor arrangements. Transaction-based pricing may increase the importance of operating efficiency and put margins under pressure.
- The company disclosed Indian transfer-pricing and tax disputes with total assessments of $18.2m, including interest. It had deposited $12.2m and provided $3.0m in bank guarantees. Management assessed the probability of loss as remote and recorded no accrual; similar assessments for subsequent years may arise. Indian export-incentive compliance is another potential exposure, though management believes requirements will be met.
- OPI-related acquisition costs were $0.6m in Q2 and $1.1m in the first half. The OPI purchase-price allocation remained preliminary and could be revised. Management reported effective disclosure controls; the acquired business was excluded from the internal-control assessment as permitted for a recent acquisition.
Important facts for investors to verify
- How much of revenue and earnings growth is recurring organic growth versus acquisitions, currency effects, and the $2.2m one-time payment.
- OPI’s post-acquisition performance, integration progress, and final purchase-price allocation, including the assumptions supporting goodwill and intangible values.
- Client concentration and renewal or termination exposure, particularly the Centrica, Travelers, and American Express agreements.
- Cash generation and capital needs after acquisition spending, planned capital expenditures, lease commitments, and use of the revolving facility.
- Potential tax-rate changes from expired or expiring holidays and the outcome, deposits, and any further assessments in Indian tax disputes.
- Whether improved operating margins can be sustained as delivery costs, foreign exchange, pricing models, and expansion-related depreciation change.