ExlService Holdings, Inc. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Unless otherwise noted, financial amounts below are in millions of U.S. dollars. ExlService provides business process outsourcing and transformation services, primarily to clients in the United States and United Kingdom.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Revenue | $122.5 | $122.3 | $364.0 | $354.3 |
| Gross profit | $37.5 | $50.3 | $122.8 | $135.4 |
| Gross margin | 30.6% | 41.1% | 33.7% | 38.2% |
| Operating income | $5.4 | $19.5 | $27.0 | $44.4 |
| Operating margin | 4.4% | 16.0% | 7.4% | 12.5% |
| Net income | $6.1 | $13.2 | $25.0 | $32.2 |
| Diluted EPS | $0.18 | $0.39 | $0.74 | $0.95 |
- Revenue mix: Q3 outsourcing revenue was $91.2 million, down 8.5%; transformation revenue was $31.3 million, up 38.2%. Nine-month outsourcing revenue was $285.6 million, down 3.1%; transformation revenue was $78.4 million, up 31.3%.
- Cash flow: Nine-month operating cash flow was $44.3 million, versus $44.2 million. Investing activities used $30.6 million, including $23.8 million in fixed-asset purchases and $6.2 million for Blue Slate. Cash and cash equivalents increased to $161.4 million from $148.1 million at year-end 2013.
- Liquidity and balance sheet: At September 30, cash and cash equivalents plus short-term investments totaled $168.0 million; current assets were $273.1 million and current liabilities $74.1 million. Total liabilities were $89.4 million and stockholders’ equity $409.1 million. Capital lease obligations totaled $1.9 million.
Changes versus prior periods
- Q3 revenue was nearly flat, while nine-month revenue increased 2.7%. Reported revenue includes $9.6 million of Travelers transition-cost reimbursements in Q3 and $17.8 million for the first nine months, recorded as reductions to revenue.
- Management attributed lower outsourcing revenue mainly to Travelers-related reimbursements and the transition of services. Transformation growth reflected stronger analytics and finance transformation work, project engagements, and $1.5 million of Blue Slate revenue.
- Profitability weakened substantially: Q3 operating income fell 72.3%, and nine-month operating income fell to $27.0 million from $44.4 million. Management cited higher employee and facility costs, Travelers reimbursements, currency effects, and increased depreciation from investments in capacity.
- Effective tax rates declined to 14.2% for Q3 and 15.3% for the nine months, from 24.2% and 25.2%, respectively. The nine-month rate benefited in part from a $2.2 million reversal of an unrecognized tax benefit.
Outlook, developments and risks
- Following Travelers’ November 2013 termination notice, the company estimated a $12–$15 million reduction in 2014 revenue from services being transitioned away. Transition services may continue for up to 18 months; reimbursements of Travelers’ transition expenses further reduce reported revenue. The filing does not provide a full-year earnings forecast.
- Management expected $3–$6 million of additional capital expenditures in the remainder of 2014, primarily for client growth, facilities and technology. It stated operating cash flow would fund smaller acquisitions, capital spending and working capital; significant acquisition-led growth could require additional financing.
- On October 24, 2014, after quarter-end, the company acquired Overland Holdings for $53 million in cash, subject to adjustments, funded from existing cash. On October 27 it entered into a $50 million revolving credit facility. The filing does not state that any amounts had been drawn.
- Indian tax disputes involved $18.0 million of demands at September 30; $15.0 million had been paid or covered by bank guarantees. Management, relying on tax advisers, considered the likelihood of liability remote and had recorded no accrual. Additional assessments may arise.
- Key risks identified include client and industry concentration, Travelers transition and redeployment, competition and pricing pressure, hiring and retention, acquisitions and integration, foreign-exchange exposure, data confidentiality, regulatory changes, and Indian tax disputes. Top ten clients generated 52.2% of Q3 revenue; no single client exceeded 10%.
Most important facts for investors to verify
- How much of reported revenue and margin pressure is attributable to Travelers reimbursements and the service transition, and how quickly can affected capacity be redeployed?
- Whether transformation-services growth can continue to offset outsourcing declines, and whether higher labor and facility costs can be absorbed without further margin erosion.
- The final purchase accounting, integration costs and performance of Blue Slate and Overland, including the cash impact of the $53 million Overland acquisition.
- Current utilization and covenant terms of the $50 million revolver, and the company’s cash needs for capital spending, acquisitions and potential tax deposits.
- Progress and potential exposure in Indian tax proceedings, including any new assessments or changes to management’s view that liability is remote.