Earnings Call Transcript - EXLS Q2 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Second Quarter of the 2023 ExlService Holdings, Inc. Earnings Conference Call. Please be advised today's conference is being recorded. I would now like to hand the conference over to your speaker today, John Kristoff, Vice President of Investor Relations. Please go ahead, John.

John Kristoff, Vice President of Investor Relations

Thanks, James. Hello, and thank you for joining EXL's second quarter 2023 financial results conference call. On the call with me today are Rohit Kapoor, Vice Chairman and Chief Officer; and Maurizio Nicolelli, Chief Financial Officer. We hope you've had an opportunity to review the second quarter earnings release we issued this morning. We've also posted an earnings slide deck and investor fact sheet in the Investor Relations section of our website. As a reminder, some of the matters we'll discuss this morning are forward-looking. Please keep in mind that these forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Such risks and uncertainties include, but are not limited to, general economic conditions, those factors set forth in today's press release, discussed in the company's periodic reports, and other documents filed with the SEC from time to time. EXL assumes no obligation to update the information presented on this conference call today. During our call, we may reference certain non-GAAP financial measures, which we believe provide useful information for investors. Reconciliation of these measures to GAAP can be found in our press release, slide deck, and investor fact sheet. And with that, I'll turn the call over to Rohit.

Rohit Kapoor, Vice Chairman and Chief Officer

Thanks, John. Good morning, everyone. Welcome to EXL's second quarter 2023 earnings call. I'm pleased to be with you this morning reporting another strong quarter. We continued our growth momentum in the second quarter with total revenue of $405 million, representing growth of 17% on both a reported and constant currency basis. We grew adjusted diluted EPS 21% to $1.82 per share. Our balanced portfolio across data analytics and digital operations and solutions makes our business resilient by focusing on both growth enablement and cost management for our clients. This has enabled us to generate continued strong double-digit growth despite a slow growth economic environment. In Analytics, we delivered revenue of $182 million for the quarter, up 13% year-over-year, which included strong growth in decision analytics services, data management, and payment integrity. This growth was driven by clients leveraging analytics to drive cost efficiencies, manage risk and increase effectiveness. Analytics growth was impacted by a decline in marketing analytics, which is a trend we have highlighted previously. In a slow growth and high-interest rate environment, banks and insurance companies have slowed down their investments for new customer acquisition. We have been successful in diversifying our marketing analytics client portfolio across other industry verticals. We have already won some new business in health care and marketing analytics for Medicare Advantage, which will convert to revenue later this year. Overall, our Analytics business continues to show strong growth across industries and geographies, which we expect will be further boosted by our focus on generative AI. Looking at our digital operations and solutions business, during the second quarter, we generated revenue of $223 million with a growth of 2% sequentially and 20% year-over-year. This is the ninth consecutive quarter where we have grown this business by double digits. This strong growth was driven by momentum across all of our digital operations and solutions businesses as our new and existing clients focus on lowering costs improving efficiencies and enhancing end customer experience. Our data-led strategy, combined with our deep domain expertise continues to resonate with our clients and fuel our growth. This has significantly increased our total addressable market and grown our sales pipeline, particularly in large transformative deals. I'm very encouraged by the size, scale, and complexity of the deals we are winning, which is driven by our ability to embed market-leading data analytics, digital, and AI competencies into our clients' core operations. Looking at the overall demand environment, we continue to hear from our current and prospective clients that their priorities over the next 12 to 18 months include cost reduction, increased efficiency, and improved customer experience. There is strong demand from clients for using generative AI to achieve these priorities. As our clients plan their generative AI investments, they need a partner who has deep business domain knowledge, can harness the data, create the appropriate use cases and implement them as part of the workflow. Our clients view EXL as an ideal partner who combines all these capabilities. During the quarter, we launched our new generative AI platform, which builds on our strength in analytics, AI, and digital operations and solutions. It includes our AI workbench, plug-and-play AI accelerators, data security and compliance framework, and our enterprise data management capabilities. Our platform launch attracted more than 1,000 attendees and has created a very strong pipeline. As we engage with our clients, we are helping them in three areas: first, we help them evaluate, select, build, and roll out generative AI use cases; second, we help them make that data AI-ready, which includes data engineering, unstructured data management, data security and data and cloud operations; and finally, we help them reimagine and design new AI-enabled operations with human in the loop. I'd like to share a couple of real-world examples where we are already deploying generative AI solutions for our clients. The first is with a large international insurance client. The client's objective was to streamline their claims process to reduce cost and improve customer experience. We developed a generative AI-based smart claim solution. It uses open source large language models and leverages the latest retrieval augmented generation architecture. Our innovative AI solution swiftly accesses end-to-end claim information and delivers accurate and concise insights through a user-friendly interface. This streamlines the claim agent's workflow and reduces the amount of time needed to process the claim, resulting in lower costs and improved customer experience. Another example involves a large energy company in the U.K. where EXL is implementing a generated AI-led agent assist solution across all of their contact center operations which will run on our cloud. This solution provides live assistance to the contact center executives while they're engaged with end customers. It monitors conversations in real-time using large language models to extract relevant information and provides both proactive nudges and on-demand procedure guidance. Our solution not only helps improve compliance and first call resolution rates but also reduces the amount of time customers spend with contact center executives, thus improving customer experience. These are just two examples of how we are currently deploying generative AI-based solutions, differentiating ourselves in the marketplace and creating value for our clients. We expect generative AI to create new revenue sources for us as well as augment our existing data analytics and digital operations and solutions businesses. We will continue to invest heavily in our generative AI capabilities, including creating a center of excellence with more than 1,500 dedicated generative AI specialists. With our continued focus on talent, I'd like to recognize two new leaders that recently joined our senior leadership team. First, Pam Harrison joined as Executive Vice President and Chief Human Resources Officer. Pam has helped execute HR strategies for large and complex global organizations. Her extensive domain expertise will make her an invaluable resource in developing HR strategies as we continue to grow and recruit top talent, particularly in digital and AI. And most recently, Vishal Chhibbar has rejoined EXL as our Chief Growth and Strategy Officer. You may recall that Vishal served as CFO from 2009 to 2019, where he instituted some of EXL's foundational growth strategies. In his new role, Vishal will spearhead our growth initiatives, leading strategy, marketing, sales governance, M&A, and strategic partnerships. As our business continues to grow at a rapid pace, Vishal's practical insights and keen instincts will be tremendously valuable. I'm thrilled to have both Pam and Vishal on our team. Looking ahead, we are encouraged by the momentum in our revenue and EPS growth, our growing sales pipeline, and the resiliency in our business model. We are making significant progress on our generative AI offerings, and we will continue to build off that momentum as we invest further in advancing our capabilities in the coming quarters. I want to extend my sincere gratitude to every member of the EXL team for their unwavering dedication and relentless pursuit of innovation to better serve our clients. Given these factors and our current visibility for the remainder of the year, we are raising our 2023 revenue and EPS guidance. Maurizio will walk you through the details in a few moments. Finally, I want to reflect on our recent decision to execute a five-for-one forward stock split. This split brings several expected benefits, including increased liquidity, improved transparency, and lower trading costs for our stockholders. Additionally, the lower post-split share price enhances accessibility for our employees to participate in the company's employee stock ownership program. But perhaps most importantly, it demonstrates the confidence we have in our ability to continue to grow the company and generate long-term stockholder value. We have a highly resilient business model with long-term clients, a large percentage of recurring revenue and a balanced portfolio of business across data analytics and digital operations and solutions. Coupled with our increasing total addressable market and leading position in data analytics, digital and AI in the markets we serve, I am very excited about the opportunities that lie ahead of us. And with that, I turn the call over to Maurizio.

Maurizio Nicolelli, Chief Financial Officer

Thank you for joining us this morning. I will share our financial performance for the second quarter and the first half of 2023, along with our revised outlook for the year. We had a strong second quarter with revenue of $405 million, reflecting a 16.8% year-over-year increase based on reported figures. On a constant currency basis, revenue grew 17.1% year-over-year and 1% sequentially. Our adjusted EPS was $1.82, marking a 21.3% increase year-over-year. All revenue growth figures mentioned will be on a constant currency basis. Revenue from our digital operations and solutions businesses, excluding Analytics, was $222.8 million, showing a year-over-year growth of 20.8%, with an increase of 1.8% sequentially from the first quarter of 2023. In the Insurance segment, we reported revenue of $128.5 million, up 19.2% year-over-year and 2.2% sequentially, driven mainly by the expansion of existing client relationships. The Insurance vertical, which includes both our digital operations and solutions and Analytics businesses, saw a 16.5% year-over-year growth with revenue of $164.4 million. The Emerging segment experienced a 25.4% year-over-year revenue growth and a 1.1% sequential increase to $67.2 million, driven by the growth in existing client relationships and new client acquisitions. The Emerging vertical, which combines our digital operations, solutions, and Analytics businesses, grew 14.3% year-over-year with revenue of $152.4 million. The Healthcare segment generated $27.2 million in revenue, representing a 17.9% year-over-year increase and a 1.7% sequential growth, driven by heightened volumes in our clinical services business. The Healthcare vertical, combining our digital operations, solutions, and Analytics businesses, saw a 23.4% year-over-year growth with revenue of $88.2 million. In the Analytics segment, we achieved $182.2 million in revenue, reflecting a year-over-year growth of 12.8%. As mentioned by Rohit, we saw significant growth in our decision analytics services, data management, and payment integrity businesses during the quarter, although this was partially offset by a decline in marketing analytics due to reduced marketing spend by clients in insurance and banking. We successfully reduced SG&A expenses as a percentage of revenue by 40 basis points year-over-year to 18.2%, benefiting from cost discipline and operational leverage. Our adjusted operating margin for the quarter was 20%, up 130 basis points year-over-year, attributed to higher volumes and operating leverage. This margin includes about 1% of non-recurring revenue with lower associated costs in our digital operations and solutions business. Our effective tax rate for the quarter was 23.9%, increasing by 60 basis points year-over-year due to higher U.S. state taxes. Our adjusted EPS for the quarter was $1.82, a 21.3% increase year-over-year on a reported basis. Regarding our six-month performance, revenue for this period reached $805.6 million, representing a 20% year-over-year increase on a constant currency basis. This growth is attributed to both our digital operations and solutions and Analytics businesses. The adjusted operating margin for the period was 19.7%, up 130 basis points year-over-year. Six-month adjusted EPS was $3.56, showing a 21.9% increase year-over-year on a reported basis. We maintain a strong balance sheet, with cash, including short- and long-term investments, totaling $263 million as of June 30, while our revolver debt stood at $220 million, giving us a net cash position of $43 million. Our cash flow from operations in the first six months was $64 million, compared to $53 million during the same period in 2022, an improvement driven by the expansion of our adjusted operating margin. During the first half of the year, we invested $26 million in capital expenditures and repurchased $65 million of our shares at an average price of $160 per share. Looking ahead to our outlook for 2023, we are raising our expectations for the year based on our strong performance in the first half and our current visibility across all segments. We now forecast revenue to be between $1.605 billion and $1.625 billion, indicating year-over-year growth of 14% to 15% based on reported and constant currency figures. This marks an increase of $8 million at the midpoint of our prior guidance, which was $1.595 billion to $1.62 billion. We anticipate a foreign exchange gain between $1 million and $2 million, with net interest expense around $1 million, and an effective tax rate for the full year in the range of 22% to 23%. Consequently, we expect our adjusted EPS to fall between $6.90 and $7.05, symbolizing year-over-year growth of 15% to 17%, surpassing our previous adjusted EPS guidance of 12% to 15% growth. We project capital expenditures to range from $47 million to $52 million. In conclusion, our business model remains robust due to long-term client contracts, significant recurring revenue, and a well-balanced portfolio in our data analytics and digital operations and solutions segments. Our data-led strategy, along with our expanding capabilities in data management and generative AI, positions us favorably within an expanding total addressable market, ensuring we can consistently outperform in the long term.

Operator, Operator

Our first question comes from Puneet Jain from JPMorgan.

Puneet Jain, Analyst

Thanks for taking my question. So, I quickly wanted to ask about overall demand trends, specifically as it relates to Operations Management. So that segment was up 20%, has been growing double digits for a while. Given the potential impact from generative AI there, how should we think about medium-term growth rates for that segment?

Rohit Kapoor, Vice Chairman and Chief Officer

Yes. Puneet, this is Rohit. From our perspective, the demand environment continues to remain very favorable, particularly for digital operations and solutions, we are seeing continued strength in that segment. For us, this seems to be resonating really well because our ability to bring in analytics, technology, and automation and combine that into the operations, that's exactly what clients are seeking. As we get into the adoption of generative AI, it's becoming clearer and clearer to us that we are likely to see a further increase in demand for digital operations. Therefore, we think we are positioned really well as far as that is concerned. Keep in mind one other thing, which is the slow growth economic environment is actually causing companies to focus a lot more on expense reduction and, at the same time, improving the end customer experience. So, what we are seeing is clients, which previously would not have thought about digital operations and solutions outsourcing, are now kind of coming forward and engaging with us. We are seeing more midsized companies come forward. We are seeing more mutuals in the insurance segment come forward. We're seeing more clients in Europe come forward. I think that's a very good and healthy trend for us. So frankly, the demand environment is great. We are seeing larger deals in the pipeline. We think the digital operations and solutions business will continue to do well in this kind of environment.

Puneet Jain, Analyst

Got it. And then on Analytics, like generative AI should benefit Analytics on an overall basis, but will that work represent incremental opportunity, driving higher than previously expected growth in the segment? Or could it just crowd out other investments from clients in Analytics and the overall growth could remain in the mid-to-high teens levels over next few years?

Rohit Kapoor, Vice Chairman and Chief Officer

Sure. We think in order for any client to adopt generative AI, there are a few prerequisites to enable that. Number one is to have a business understanding and a domain knowledge understanding so that you have the applicable use cases that you can apply generative AI to. The second more important piece, particularly for analytics, is the data that needs to be used for large language models; that data prep and the data architecture and the ability to use data, represents a huge need from all clients to upgrade their platforms and data availability. In our Analytics business, we think we're going to get a significant boost from the data management side because we can help clients architect and manage their data, making it available. A lot of unstructured data is required for generative AI, and this entails cleansing and vectorizing databases. Thus, we believe this will provide a net tailwind for our analytics growth rate and portfolio.

Puneet Jain, Analyst

Got it. Thank you.

Operator, Operator

Our next question comes from Bryan Bergin from TD Cowen.

Bryan Bergin, Analyst

Good morning. Thank you. I wanted to start on Analytics here as well. Can you comment on how 2Q did relative to your plan? Maybe talk about the current demand trends there versus maybe three months ago. Any change in your target for Analytics growth in 2023?

Rohit Kapoor, Vice Chairman and Chief Officer

Sure, Bryan. The Analytics business is a very attractive, high-growth vertical for us. We believe the growth rate for that segment should be 15% to 18% over the medium term. If you take a look at the growth rate of our Analytics business in the first half of 2023, it is 17%, so a healthy growth rate. Specifically, Q2 growth for Analytics was lower at 13%. We did see an impact from marketing analytics, which was a negative growth rate for us quarter-on-quarter and year-on-year. That was not something we had planned for and reduced our growth rate in Analytics for the quarter; however, we think that is a temporary phenomenon. As insurance companies and financial institutions return to customer acquisition, we anticipate our growth rate in Analytics to climb back up. Analytics services, data management, and payment integrity all grew at a healthy pace. With generative AI creating more demand for data management and analytics, we believe the growth rate of 15% to 18% over the medium term is likely to persist.

Bryan Bergin, Analyst

Okay. Understanding that, do you plan for Q3 to actually decline sequentially too? Or do you think it's stabilized?

Rohit Kapoor, Vice Chairman and Chief Officer

We have factored in our assessment of marketing analytics' performance in the second half of the year. As we have diversified our marketing analytics capabilities into other verticals, like health care, which is not interest rate-sensitive and has a stable demand environment, we believe the volatility associated with marketing analytics growth will diminish, enabling us to better protect and grow the portfolio.

Bryan Bergin, Analyst

Okay. And if I could sneak one more in on margins, can you comment on second-half cadence expectations?

Maurizio Nicolelli, Chief Financial Officer

Yes, Bryan, it's Maurizio. We have performed very well in the first half of the year on margins. Our adjusted margin was 19.7% for the first half of the year, reaching 20% in Q2. Keep in mind that, in both quarters, we had the benefit of non-recurring revenues, particularly approximately $4 million in Q2, with low associated costs. Looking ahead, we will be investing heavily in generative AI to drive revenue growth in both digital operations solutions and analytics, along with front-end sales. Therefore, you should expect margins in the second half of the year to be around the 18% range.

Operator, Operator

Our next question comes from Maggie Nolan from William Blair.

Maggie Nolan, Analyst

Thank you. You just gave some good color on the marketing analytics, particularly in the second half of the year. But I'm curious, are there any other factors to consider for how you're thinking about demand and the growth rate for the business in the second half versus the first half at the consolidated company level?

Rohit Kapoor, Vice Chairman and Chief Officer

Maggie, for us, in digital operations and solutions, we are very happy with the new client wins and the expansion of work from existing clients. It's about execution and implementation, and we think that momentum will continue into the second half of this year and even next year. The Analytics part, particularly in data management and payment integrity, continues to show good growth. While marketing analytics may remain soft for some time, we expect increased activity in health care marketing analytics in Q4, which we've factored in. Overall, our portfolio is performing well, with 55% of the business in digital operations and solutions growing at 20% in the first half, and 45% in data analytics growing at 17%. This balanced portfolio is resilient, performing well in both favorable and slow-growth environments, enabled by the integration between analytics and operations. We expect generative AI to further enhance this integration.

Maggie Nolan, Analyst

Thank you. Can you also discuss wage dynamics since last quarter, and how wage inflation intersects with current demand trends to inform your pricing expectations for the next couple of quarters?

Rohit Kapoor, Vice Chairman and Chief Officer

On wage inflation, this is something we factored in previously. We typically give salary increments across the company on the first of April. Notably, we observed a slowdown in the economic environment earlier in the year, allowing us to plan accordingly. Salary increments across the industry have been moderate compared to last year, which has been beneficial. Some specific skill sets might require higher wage inflation, particularly in digital, analytics, data management, and specialized domain skills. We will continue to ensure that we remain competitive in those areas. Overall, wage inflation has not posed significant challenges this year.

Operator, Operator

Our next question comes from Ashwin Shirvaikar from Citi.

Ashwin Shirvaikar, Analyst

When you reported Q1, your expectation for Q2 was to be comparable to Q1 for revenues adjusted for one-time revenue, so around $395 million. You did not expect the marketing analytics decline. You closed the quarter at $401 million, including $6 million in non-recurring revenue. What helped you exceed expectations?

Maurizio Nicolelli, Chief Financial Officer

That's a very good observation. We saw continued acceleration in digital operations and solutions, which grew 23% in Q1 and 20% in Q2. This was the differentiating factor, contributing to our exceeding expectations. Our positive momentum indicates the potential for continued strong performance in the second half of the year into 2024.

Ashwin Shirvaikar, Analyst

Understood. Rohit, you mentioned that you expect marketing to snap back. Does that mean beginning next year or later this year?

Rohit Kapoor, Vice Chairman and Chief Officer

We expect strength in marketing analytics by the fourth quarter, primarily due to campaigns for Medicare Advantage plans. As insurance carriers address inflationary pressures and regulatory requirements in California and Florida, normalizing may take some time, allowing for a temporary impact on marketing analytics in the short term.

Operator, Operator

Our next question comes from Mayank Tandon from Needham.

Mayank Tandon, Analyst

Rohit, regarding recruiting for generative AI, what skill sets will you focus on? Additionally, how does this impact attrition long term?

Rohit Kapoor, Vice Chairman and Chief Officer

For generative AI recruitment, our focus is on individuals with strong data understanding and familiarity with large language models. As generative AI is relatively new, training will be crucial. Fortunately, we have substantial internal expertise with 8,000 data scientists, including 1,500 trained in AI. The need for skilled talent from high-tech companies undergoing layoffs presents additional recruitment opportunities for us.

Mayank Tandon, Analyst

What impact do you foresee in terms of the size and scope of deals over time due to generative AI? Given the productivity benefits, will you pass on more to customers versus traditional offerings?

Rohit Kapoor, Vice Chairman and Chief Officer

Generative AI is expected to increase deal sizes due to wider deployment across enterprises, creating larger opportunities. We believe the complexity of our digital operations mitigates cannibalization risks associated with productivity benefits. The most significant impacts will be in large call centers, but we will be positioned to implement these strategies for our clients, presenting a net positive outlook for us.

Operator, Operator

Our next question comes from Moshe Katri from Wedbush.

Moshe Katri, Analyst

Can you describe how project ramp for the new deal flow is developing?

Rohit Kapoor, Vice Chairman and Chief Officer

The demand remains strong, and decision-making cycles continue as before. Project implementation timelines are stable, with limited discretionary expenditures. Our portfolio, which focuses less on advisory work, continues to be advantageous in maintaining growth.

Moshe Katri, Analyst

Are there noticeable volume reductions during the quarter, particularly in insurance and banking sectors?

Rohit Kapoor, Vice Chairman and Chief Officer

We have not observed volume reductions during the second quarter. Our digital operations and solutions business grew 20%, exceeding our expectations without any losses in volume.

Moshe Katri, Analyst

What initiatives are in place to sustain healthcare growth?

Rohit Kapoor, Vice Chairman and Chief Officer

Healthcare is a vast industry, rich with potential for applying digital solutions and AI. We are expanding our offerings, investing in new capabilities around risk adjustment, conversational AI, and generative AI integration, aimed at enhancing client operations and improving member experiences.

Moshe Katri, Analyst

Can you share insights into the generative AI pipeline growth and client interest?

Rohit Kapoor, Vice Chairman and Chief Officer

In generative AI, we currently have over 150 client conversations, with numerous advanced deal stages. We have developed 120 use cases across sectors and created 20 demos displayed on our website, showcasing how this will drive growth.

Operator, Operator

Our next question comes from Vincent Colicchio from Barrington Research.

Vincent Colicchio, Analyst

Regarding the 120 generative AI use cases, do you expect that to ramp up significantly in the upcoming quarter?

Rohit Kapoor, Vice Chairman and Chief Officer

Yes, we expect client adoption of these use cases to increase. However, clients need to ensure their data is ready and usable, requiring significant preparatory work surrounding confidentiality and integration with real-time data sources. The successful deployment of generative AI hinges on these factors.

Vincent Colicchio, Analyst

Can you comment on the quality of new logos added in the quarter and their strategic potential?

Rohit Kapoor, Vice Chairman and Chief Officer

The recent portfolio of new clients is robust, with many being first-time users of our digital solutions and analytics. We expect several of these opportunities to become strategic partnerships, enhancing our growth trajectory significantly.

Operator, Operator

Our next question comes from David Grossman from Stifel.

David Grossman, Analyst

Regarding the cadence of the digital ops and solutions business, how should we interpret this in relation to expectations for Q4 '23, given the strong bookings last year?

Rohit Kapoor, Vice Chairman and Chief Officer

In digital operations and solutions, the implementation of large client bookings takes 18 to 24 months. Thus, growth from these bookings will likely continue into '24, not fully reflected in '23 numbers. This sector is less volatile and maintains growth, offering positive prospects for continued outperformance.

David Grossman, Analyst

Is the seasonal uptick in healthcare analytics related to Medicare Advantage, or new business expectations for 2024?

Rohit Kapoor, Vice Chairman and Chief Officer

Yes, that business typically sees seasonality around the Medicare Advantage enrollment cycle at year-end, which may extend into Q1. However, it is primarily driven by the fourth quarter.

David Grossman, Analyst

Could you elaborate on the non-recurring revenue mentioned earlier?

Maurizio Nicolelli, Chief Financial Officer

We've experienced some unusual revenues from time to time, whether one-time payments or accrued revenue adjustments from prior periods. Highlighting these instances aids investors in future forecasting, reflecting our ongoing healthy margins and reinvestment in the business.

David Grossman, Analyst

Could this type of revenue occurrence be expected in the future?

Maurizio Nicolelli, Chief Financial Officer

It is possible that similar occurrences might happen again, but we will have to see how the contracts develop.

Operator, Operator

I would now like to turn the conference back to John Kristoff for any closing remarks.

John Kristoff, Vice President of Investor Relations

Thank you for joining us today, and as always, if you have additional questions, please reach out to me directly. Thank you, and goodbye.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.