Sykes Enterprises, Incorporated
Q1 2018 Earnings Call Transcript

Published: 11 May 2018

[Operator:]

Good morning, ladies and gentlemen, and welcome to the Sykes Enterprises' First Quarter Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that this event is being recorded. Management has asked me to relate to you that certain statements made during the course of this call, as they relate to the company's future business and financial performance, are forward-looking. Such statements contain information that are based on the beliefs of management as well as assumptions made by and information currently available to management. Phrases, such as our goal, we anticipate, we expect and similar expressions as they relate to the company are intended to identify forward-looking statements. It is important to note that the company's actual results could differ materially from those projected in such forward-looking statements. Factors that could cause actual results to differ materially from those in the forward-looking statements were identified in yesterday's press release and the company's Form 10-K and other filings with the SEC from time to time. I would now like to turn the call over to Mr. Chuck Sykes, President and Chief Executive Officer. Please go ahead, sir.

[Chuck Sykes:]

Thank you, Denise, and good morning, everyone, and thank you for joining us today to discuss Sykes Enterprises' First Quarter 2018 Financial Results. Joining me on the call today are John Chapman, our Chief Financial Officer; and Subhaash Kumar, our Head of Investor Relations. Let me start with a quick recap of the quarter and then make some general comments. John will take you through our financial results, and then we'll turn the call over for Q&A. First quarter 2018 results exceeded our business outlook. Revenues came in much better than we anticipated. The relative outperformance was broadly distributed across our base of clients, operating segments, and verticals. We even saw better demand in the communications vertical versus expectations, despite overall communications being the significant headwind on the year-over-year basis. The fact that we are able to grow our overall constant currency revenues despite the 23% decline on a year-over-year basis in the communications vertical is a testament to our diverse portfolio mix of offerings and capabilities. It is through ongoing investments and our differentiated full customer life cycle capabilities that has strategically broadened our service mix. This is uniquely positioning us to capitalize on every aspect of the customer journey and increase our addressable market opportunity vastly beyond the traditional client and vertical market segments. On the operating margin front, the results were also better than expected. The combination of higher revenues and strong execution across the revenue base drove better operating margins even as we incurred costs to rationalize underutilized capacity. As you know in the third quarter of 2017, we outlined initiatives to optimize our margins in the face of labor tightness and wage pressures in the U.S. These include everything from leveraging our at-home agent platform to shifting work to other facilities, either in the U.S. or internationally, while undertaking rationalization of underutilized capacity. We are also seeking price increases where feasible. Meanwhile, we are targeting up to 10% of our total capacity for rationalization using our first quarter 2018 capacity figures as our baseline. As we have indicated, the capacity rationalization we are undertaking is expected to add roughly 100 basis points to our consolidated operating margins on an annualized basis once it is completed; the bulk of which we are targeting by the middle to lateral part of 2018. I would now like to make some general commentary about the industry backdrop and underlying trends. The demand fundamentals of the industry on balance look encouraging, and we continue to see growth opportunities across much of our vertical market segments. The drivers are both new economy logos and incumbents with a variant mix of catalysts. Even the communications vertical or the comparables have been tough for the past 1.5 years. Unfavorable comparisons should ease as we exit 2018. We also are just beginning to unlock the potential of leveraging our capabilities with Clearlink and XSELL. We are starting to penetrate new economy logos and win logos within our vertical markets universe previously under the radar that now have the potential to offer substantial growth to our overall revenue trajectory. Meanwhile, the trend toward further vendor consolidation appears to be moderating as clients calibrate demand levels with changes in our end markets. From a cost perspective, frontline wage pressures in aggregate, particularly in the U.S., still remain top of mind. The pace and magnitude, however, could be close to peaking as the wave of announcements around wage hike seemed to have tapered off since the enactment of the new tax law in 2017. Still we are working with clients to help them with short-term and medium-term strategies to mitigate the impact of those pressures on both their business and our business. Other industry trends worth calling out include the area of robotic process automation, chatbots, artificial intelligence and machine learning. In fact, they are worth commenting on because of the mind share they are garnering in the press. Our view is that these platforms have the potential to make a positive impact on operational efficiency and effectiveness and make a positive impact in the overall customer experience. That said, we also believe that we are in the very early stage of this innovation cycle, and that it will require continued investment and continued learning as to how this technology is best deployed. In that regard, we have made strategic investments in various companies and technologies that are supporting numerous internal and external pilot projects that utilize in A.I.-augmented workforce across sales and service transactions. These investments support our continuing efforts to create a differentiated offering and remain relevant to the changing market landscape. So in closing, we are making progress through some of our near-term margin challenges in the U.S., which should reach an inflection point toward the latter part of 2018. Simultaneously, we are beginning to unlock opportunities through our differentiated capabilities that have the potential to get the scale in the medium term even as we are positioning for growth and margin expansion for the long term. And with that, I'd like to hand the call over to John Chapman. John?

[John Chapman:]

Thank you, Chuck, and good morning, everyone. On today's call, I'll focus my comments on the first quarter results, particularly key P&L, cash flow and balance sheet highlights. After which, I'll turn to the outlook for the second quarter and full year. From a revenue perspective, the quarter was strong despite the continued headwinds from the communications vertical. We came in at $414.4 million for the first quarter of 2018, exiting the midpoint of revenue outlook range by more than $4 million. As Chuck stated in his remarks, virtually all of the revenue outperformance in the quarter relative to the business outlook was demand-driven, which expanded the range of clients in vertical. On a year-over-year comparable basis, revenues were up 7.9% on a reported basis and up 4.7% on a constant currency basis. By vertical market on a constant currency basis, financial service was up around 41%. The other vertical, which includes retail, was up 23%, transportation and leisure up 6%, technology up 5%, health care up 3%, more than offsetting the impact of the communications vertical, which is down roughly 23%. First quarter 2018 operating margin decreased to 3.4% from 6.8% for the comparable period last year. First quarter 2018 operating margin includes an impairment charge as well as severance and other expenses of $4.4 million or approximately 110 basis points associated with rationalization of capacity across several facilities versus $0.2 million or 10 basis points in the year ago quarter. On a non-GAAP basis, first quarter 2018 operating margin was 5.8% versus 8.3% in the same period last year due to a combination of factors. These include higher operational costs and inefficiencies around recruitment and retention, primarily in the U.S., the cost of carrying underutilized capacity and short-term inefficiencies created by the progress in implementing initiatives to rationalize underutilized capacity. First quarter 2018 diluted earnings per share were $0.26 versus $0.45 in the same period last year and was impacted primarily by the operational inefficiencies, coupled with the impairment charge as well as severance and other expenses of approximately $0.08 per share, more than offsetting the impact of the lower tax rate. On a non-GAAP basis, first quarter 2018 diluted earnings per share were $0.43 versus $0.54 in the same period last year due to the previously discussed factors. First quarter 2018 diluted earnings per share were $0.15 higher relative to the midpoint of the company's February 2018 business outlook range of $0.26 to $0.29. Of this $0.15 beat, roughly $0.12 was operational in nature in terms of higher demand, stronger operating performance with the remainder $0.03 per share due to a lower-than-projected tax rate. Turning to our client mix for a moment; we continued to have one 10% client, our largest client, AT&T which represents various contracts, including the demand generation business from Clearlink, representing roughly 10% of revenues in the first quarter of 2018 versus 16% in the year ago period, driven by a combination of shifts internationally, lower demand and operational inefficiencies. Our second largest client, which is in the financial services vertical, represented almost 7.4% of revenues in the first quarter versus 6% from the year ago period due to higher demand. On a consolidated basis, our top 10 clients represented approximately 46% of total revenues during the first quarter of 2018 down from 50% from a -- the year ago period, due solely to a significant decline in revenues from our largest client. Now let me turn to select cash flow and balance sheet items. During the quarter, capital expenditures were down by almost 1/3 to 3.2% of revenues from 4.4% of revenues in the year-ago period. Trade DSOs on a consolidated basis for the first quarter were 73 days, unchanged comparably. The DSO was split between 71 days for the Americas region and 84 days for EMEA. Our balance sheet at March 31 remained strong with cash and cash equivalents of $172.6 million, of which approximately 94.8%, or $163.7 million, was held in international operations. The majority of which will not be subject to additional taxes if repatriated to the United States. On 31st of March 2018, we had $100 million in borrowings outstanding, with $340 million available under our $440 million credit facility. We continue to hedge some of our foreign exchange exposure for the second quarter and full year of 2018 we're hedged approximately 86% and 78% at weighted average rates of PHP 51.51 and PHP 51.77 to the U.S. dollar, respectively. In addition, our Costa Rica colón exposure for the second quarter and full year are hedged approximately 72% at weighted average rates of roughly CRC 580.75 and CRC 585.78 to U.S. dollar, respectively. Now let's review some seat count and capacity utilization metrics. On a consolidated basis, we ended first quarter with approximately 53,600 seats, up 5,700 seats comparably. Included in the comparable first quarter increase in seat count are 2,900 seats associated with the acquisition of the customer engagement assets of our Global 2000 telecommunication service provider. Even excluding the acquisition, the comparable seat count increased, reflecting net capacity additions outside the U.S., including APAC, Latin America and EMEA. The first quarter seat count can be further broken down to 46,400 in the Americas and 7,200 in EMEA. Capacity utilization rates at the end of the first quarter of 2018 were 66% for the Americas and 79% for the EMEA region versus 73% for the Americas and 81% for the EMEA in the year ago quarter. The decrease in the Americas utilization was driven by operational inefficiencies, capacity additions in certain geographies to address demand opportunities and also in part to short-term inefficiencies created by the progress and implementing initiatives through rationalized underutilized capacity. The capacity utilization rate on a combined basis was 68% versus 74% in the year ago period with a decline mainly due to the previously stated factors. Now I'd like to turn to the business outlook. We are increasing our full year 2018 diluted earnings per share due to better-than-expected first quarter 2018 results. Full year 2018 revenue outlook, meanwhile, is being revised, split roughly equally among unfavorable foreign exchange movements relative to the outlook provided in February 2018, shift in existing demand to international delivery geographies and slightly lower projected demand. We continue to execute on various actions to address labor tightness and wage inflation crosscurrents in the U.S. These entail employing a combination of tactics ranging from negotiating price increases where feasible, to shifting some existing and new client demand to either better position facilities or to at-home agent model or to other international geographies. Given that these tactics are starting to yield results, we are executing on initiatives to rationalize up to 10% of our total seat capacity based on the first quarter 2018 capacity levels on a gross basis. We expect that the bulk of the rationalization to occur in the second and third quarters with the remainder completed by either year-end 2018 or early 2019. Separately, we expect demand seasonality to follow historical patterns. We've projected second quarter revenues and implied operating margins are expected to be lower than the first quarter 2018 actual results. Our second quarter 2018 business outlook anticipates a pretax charge of approximately $7 million, or $0.12, on an after-tax basis related to capacity rationalization. The pretax charge is expected to be split roughly evenly between non-cash asset impairment as well as cash severance and other expenses. The full year outlook also reflects a pretax charge of approximately $14 million, or $0.25, on an after-tax basis with roughly similar split between cash and non-cash. Our revenues and earnings per share for the second quarter and full year are based on foreign exchange rates as of April 2018. Therefore, the continued volatility in the foreign exchange rates between the U.S. dollar and the functional currencies of the markets we serve could have a further impact, positive or negative, on revenues in both GAAP and non-GAAP earnings per share relative to the business outlook for the second quarter and full year. We anticipate total other interest expense of approximately $800,000 for the second quarter and $3.5 million for the full year. The amounts in the other interest income expense, however, exclude the potential impact of any future foreign exchange gains or losses. We expect a slight reduction in the full year 2018 effective tax rate compared to what was provided in our February 2018 outlook, due largely to a shift in geographic mix to lower tax jurisdictions. Considering the above factors, we anticipate the following financial results for the three months ended June 30, 2018

[Operator:]

Thank you. Mr. Chapman. [Operator Instructions] And your first question will be from Bill Warmington of Wells Fargo.

[Bill Warmington:]

Good morning everyone.

[Chuck Sykes:]

Good morning, Bill.

[John Chapman:]

Good morning.

[Bill Warmington:]

So I wanted to ask about how much of the U.S. revenue portfolio is coming under pressures from wage and attrition headwinds at this point.

[John Chapman:]

Bill, I mean, 80% to 90% of our U.S. revenues have really been impacted in some way due to labor market issues in the U.S. Not all clients are equal, not all sites are equal and not all verticals are equal. We've already indicated that the telecom vertical is where we felt the largest impact from the labor market tightness. However, the majority of the sites and clients have some sort of impact. And that's clear. If you look at the impact this issue is having on our global margins, you can see there's no surprise that is impacting a significant piece of the U.S. business. So I'd say it's 80% to 90%.

[Bill Warmington:]

And so if the clients don't give you price and they won't go offshore with you and they won't do the at-home option, are you willing to walk from some of these clients?

[John Chapman:]

Yes. I mean, if you look at -- I mean, clearly, whilst we would -- we want to try and do everything we can to serve our client and find a solution. I think, we've shown in the past if you remember back to 2015, we were at similar challenges that we just couldn't work through a solution that worked for both us and our client. If you remember back, I think, we had a revenue headwind of about 3% globally because of that. And we made the hard decision whilst it's not where we think we'll go with a vast majority of what we're speaking about. We've shown that sometimes that's the right thing to do when we did that back in 2015. It did give us some headwind in terms of revenue. But once we were through that, if you look back, you will see our margins actually improved following the action. So whilst we do not see that being the answer to the vast majority, if it came to that, then that's what we have to walk out for both the benefit of ourselves and the client.

[Bill Warmington:]

Yes. And then also on Clearlink, I know that Clearlink's got a fair amount of telecom exposure. There's, obviously, been a lot of disruption in the vertical. AT&T revenue was down overall, but was Clearlink revenue down as well?

[John Chapman:]

No. I mean, I think all of the comments in terms of the telco issues. Whilst the vertical, you're absolutely right, is challenging, all of our challenges are in our core business.

[Chuck Sykes:]

Yes. Bill, this is Chuck. And the logic for that, if you think of it is, I think every industry that's in play today is going through some form of digital transformation. And I think within the communications vertical, the one thing that's different on the Clearlink side is that they're helping our clients grow their business. So there is more emphasis and investment and wanting to continue to put efforts into that to capture market share versus on the service side, you're seeing some impact from a reduction in effective contact rates that are occurring just from some of the simplicities that they're able to implement on the technologies and things such as that.

[Bill Warmington:]

Okay. And then one housekeeping question just to ask about that $164 million in offshore cash. And what your plans were for that? Are you going to be repatriated? Can you do repurchases with it? What do you want to do with it?

[John Chapman:]

We're looking at that, Bill. We've obviously got to do things to make sure to be -- how we get back and that can take time in terms of what we're working on. We've not made a decision as to what we will do. We will communicate that as and when that becomes clear.

[Bill Warmington:]

Got it. All right, that very much.

[John Chapman:]

Thank you.

[Operator:]

The next question will be from Vincent Colicchio of Barrington Research. Please go ahead.

[Vincent Colicchio:]

Yes, good morning guys. Chuck, what verticals are causing the lower-than-expected demand in the guidance?

[Chuck Sykes:]

Yes. The biggest thing, Vincent, right now it's really the communications. I think, there's some -- in my comments talking about like a 23% reduction year-over-year. And you've got two things that are driving that primarily. It's -- we are seeing a reduction within the communications vertical through the success of some of these self-served tools and things we're deploying. I do believe in speaking with our clients. They really believe that if you will, has been kind of decreasing at a decreasing rate. I think that's something that's been taking place over the last two to three years. And some of the things that may be mitigate the impact to us before kind of comes down to where, if you're picking up account share, where we've always done pretty well, it may be offset some of the impact to us in that case. But today, I think they're pretty set in their supplier mix, as it stands. And so the contact rate has impacted pretty much everyone across the supplier base. And now as you couple that with our labor challenges in the U.S., really, the best solution is then to get them into the proper delivery market, which we believe today, it's the offshore delivery market. So, now as we're addressing that and getting that work shifted into the proper place, you're seeing just unit revenue reduced. Long term, it's still good for us because the labor markets will support it. We're going to reduce and get away from the recruiting and attrition expenses and be able to take care of the clients more effectively in that case. But contact rates and really, the shifting to offshore, those are the things that are making it particularly heavy on the communications side.

[Vincent Colicchio:]

And on that thought, for yourself or John, can you quantify how much revenue leakage you're seeing from shifting business offshore in your guidance?

[John Chapman:]

Yes. I mean, it…

[Vincent Colicchio:]

For the year?

[John Chapman:]

Yes, I mean, if you look at for the year, Vince, I would say we're looking at 2% headwind through those actions.

[Chuck Sykes:]

That's put in the forecast.

[John Chapman:]

And yes, in the forecast for the full year. Yes.

[Vincent Colicchio:]

Okay. And then, Chuck, you talked about new economy business picking up. How big a portion -- how do you define that? And how big a portion of revenue does that comprise today? And how fast has it been growing?

[Chuck Sykes:]

Yes. I know the terminology is, I think, about that it's a word that captures, I think, for a lot of segments. But just as I kind of think through our core verticals just to kind of define, if you will, what we mean when we say new economy. If you look in communications, the traditional segment, if you will, is our wireless and cable companies, kind of the new economy or to kind of think the over-the-top media services and social media. When you get into financial services, our traditional guys are banking and credit card, and now the new economy is all the FinTech where you're seeing. Interestingly, health care for us is still kind of in the traditional part of insurance, but what's new is that we're seeing Clearlink really helping us have a success there and starting to break in, because, again, it's more on the revenue side of the equation. So we're really encouraged by that. Retail, you think of the traditional retail stores that we've served, but today it's the e-commerce guys in the new economy. And transportation and leisure, it's kind of the, you think, we saw how the hotels and car rental companies and things such as that. But in the new economy, it's the e-commerce sites and kind of the shared economy component of that sector. And technology, what's interesting there, is that in the past it's been a lot around networking. It's been a lot about the peripherals that kind of hang off of the network or you think about our personal computers. And what we're seeing now in the new economy there is really more about the consumer digital home products that many of us are deploying in our apartments, in our houses and things, and the other is cloud computing. So those are the things, just to kind of give you a leg, when you just think broad base, the industries we report on. We still continue to see significant size in our company from the traditional segment. And we're seeing the traditional segment really wanting to adopt some of the attributes of the new economy entrants into their own space. So they're going to look to us for some of that innovation and things. Hence why we're investing in things like A.I. and robotics and companies like, Clearlink and XSELL, so we can help them on that. But meanwhile, the answer to your question, I mean, we're still at the point where 80% of our growth is still kind of coming from our installed base, 20% really coming from new, but it's just more matter that, that 20%, we want it to be coming from this new economy segment. So I would say those numbers are still holding true that it's still the 80-20. But what you guys can't see is the 20% is mainly comprised of those types of new economy companies that I just kind of walked through.

[Vincent Colicchio:]

Yes. Then I may have missed just on what you said on health care. Just curious, overall, what was driving the growth there currently?

[Chuck Sykes:]

Yes. Health care, what I -- yes, what I was calling out, Vincent, there is health care for us at this time is not necessarily like what I think a new economy component. But what's new for us and breaking into the traditional aspect when we think of health care is really leading with our Clearlink capabilities versus kind of leading with our customer service side.

[Vincent Colicchio:]

Got it. That's it from me, thanks guys.

[Chuck Sykes:]

Thank you.

[Operator:]

[Operator Instructions] Your next question will be from Robert Bamberger of Baird. Please go ahead.

[Robert Bamberger:]

Yes, thanks for taking my question. So first, I guess on guidance, the lower tax rate seems to be about $0.03 of the raise. You're only raising full year EPS guidance by around $0.04 at the midpoint. I guess, my question is why aren't you raising full year EPS by more than that $0.04 given the strong $0.12 core beat in Q1? And could this be a little bit conservatism here?

[John Chapman:]

We're really encouraged by Q1 beat, but we want to reflect in our guidance the current client forecast and current expectations of when and how we see the U.S. challenge is playing as we move -- as we kind of move through the year. It's fair to say as we can see from the revenues slight reduction that we are seeing a larger-than-expected volume of clients that are looking international. That in no way, as Chuck mentioned, is negative to the longer-term. In fact, it's positive. But it does give us additional noise in 2018, which we have really built into this guidance. So we don't want to get ahead of ourselves. We are encouraged by Q1, but as we give our guidance, we want to reflect what we see today and that's what we've reflected in the guidance. So that's kind of answer as to why we're seeing a -- not all flow through as we do have some additional short-term noise due to the mix of shore between U.S. and international.

[Robert Bamberger:]

Yes. It's very helpful. And then also on -- with regard to any large one-time costs, were there any costs that you incurred from moving work offshore? And has that already started in Q1? Or do you think that will start ramping in Q2 through Q4?

[John Chapman:]

Yes, we don't want to get into very specific parts of what's in, what's not. All I'd say, as we've consistently said that the U.S. business unit is dragging our operating margins with more than 200 basis points from where we would want it to be. While we'd say it's Q1 was really in excess of those 200 basis points, and we see that continuing until the second part of the year, and that's embedded in our guidance, so without giving you very specific items as to what's in our non-GAAP number in terms of the impact of ramping down, what we'd say is the impact overall is still in excess of 200 basis points.

[Robert Bamberger:]

Great, thank you.

[John Chapman:]

Thank you.

[Operator:]

And ladies and gentlemen, this will conclude our question-and-answer session. I would like to hand the conference back over to Mr. Chuck Sykes for his closing remarks.

[Chuck Sykes:]

Thank you, Denise. And no real closing remarks, just thank you for your participation on today's call and we look forward to speaking with you guys next quarter. Everybody, have a good day.

[Operator:]

Thank you, sir. Ladies and gentlemen, the conference has concluded. Thank you for attending today's presentation. You may now disconnect your lines.