Grid Dynamics Holdings, Inc. (GDYN) Q1 2020 Earnings Call Transcript

Greetings and welcome to Grid Dynamics First Quarter 2020 Earnings Conference Call. Please note, this conference call is being recorded.

Good afternoon and welcome to Grid Dynamics First Quarter 2020 Earnings Call. Before we begin, let me remind everyone that today's discussion will contain forward-looking statements based on our current assumptions, expectations and beliefs, including our second quarter 2020 financial guidance, the growth of Grid Dynamics' business, objectives and other business strategies, as well as other forward-looking statements. Please refer to the disclosure at the end of the company's earnings press release and Form 8-K filed with the SEC today for information about forward-looking statements that may be made or discussed on this call.

Thank you, Lilly, and good afternoon, everyone. Thank you for joining us today. We're excited to be hosting our first call as a public company, albeit under unique circumstances given the COVID-19 situation. I would like to thank the entire Grid Dynamics global team for their dedication and hard work in achieving the significant milestone of becoming a public company, and to all our investors for their ongoing support. On today's call, we'll discuss our first quarter results, our assessment of the demand environment, along with the impacts of COVID-19, company-wide initiatives put in place to manage the near-term and our plans to leverage opportunities in the current crisis. Before we begin, however, the past few months have posed unprecedented challenges for communities around the world, and our hearts go out to all those affected by the COVID-19 pandemic. On behalf of Grid Dynamics, I want to express my gratitude to all the essential and frontline workers for their hard work and sacrifice for the benefit of everyone. Now, turning to some first quarter financial highlights. Total revenue for the first quarter was $32.5 million, an increase of 24% year-over-year and 2% sequentially. Our GAAP net income was a loss of $4.6 million or a loss of $0.09 per diluted share, and non-GAAP net income was $1.9 million or $0.04 per diluted share. We exited the quarter with a total customer count of 37, up from 24 in the first quarter of 2019. More importantly, we continue to execute well on our stated goal of market diversification as our technology, financial, CPG, and manufacturing segments grow at a faster pace than our overall business. Within the top 5 clients, 2 are technology, Apple and Google; 2 are retail, Kohl's and Macy's; and 1 is a financial services client, Raymond James. Although we had a strong first quarter performance, the strength in the quarter was offset by economic deterioration caused by COVID-19 from the second half of March onwards. Our first quarter results would have been stronger, both on the revenue front and more so on the profitability front, had we not experienced the sharp and sudden impacts of the pandemic. As you all know, the COVID-19 pandemic is an unprecedented crisis with no comparable in recent times. Across our customer base, the response to the pandemic has been varied and driven by customer-specific as well as industry-specific dynamics. At our retail customers, the impact of the pandemic has expectedly been more pronounced. The impacts of store closures and their consequences to their business have resulted in their brick-and-mortar retailers pulling back their spendings and going into cash preservation mode. While Grid Dynamics supports critical digital solutions tied to the client revenues, headwinds from the current crisis were too strong to keep these important programs out of harm's way. It is also worthwhile to mention that despite temporary pauses at some of these customers, we have experienced only a few immature client terminations. In such cases, where our customers have pulled back, the impact on our business has largely been in the form of scale back of Grid Dynamics' employees and customer projects, temporary SOW pauses, and requests for longer payment terms. When we look at the broader customer base of Fortune 1000 companies across technology, financial, CPG, and manufacturing, the impacts have been less pronounced, and the reaction to the crisis has largely been driven by customer-specific factors. Some customers have viewed the current situation as an opportunity to expand. We have also witnessed additional noteworthy trends. Some customers who have been less open to using offshore resources in the past have reconsidered their viewpoint and are now more favorably inclined towards offshore. We have also witnessed customers seeking greater diversification away from their overdependence on India for outsourcing operations towards Eastern and Central Europe. Many customers have decided to accelerate the timing of their digital transformation strategies, although the impact of this acceleration will probably not be felt until the second half of the year when the initial COVID-19 shock subsides. In this new economic reality, virtually all of our clients are realizing that a stronger focus on digital transformation, cloud, data analytics, and automation is critical to survive. Since March, we have taken several initiatives that have positioned the company well to deal with the current crisis and, more importantly, leverage opportunities once we come out of it. Moving quickly to protect the health and safety of our global team members and their families and ensure we continue to provide safe and uninterrupted service to our clients, we enacted a work-from-home policy in mid-March. Today, all our personnel are working remotely from home. Since early on, every one of our engineers has been equipped with a laptop, robust VPN capabilities, and state-of-the-art collaborative tools, giving us the agility and flexibility to provide seamless support to our clients. We also initiated a cost savings program to realign ourselves in the current environment. Some of the steps we took include salary and compensation reduction at the Board, executive, and employee level; further reduction in executive cash compensation in Q2; and the implementation of a restructuring program to align our bench. Over the past couple of months, we have viewed the current crisis as an excellent opportunity for the company to invest in programs and initiatives that we believe will expand our differentiation relative to our competition. We are accelerating our R&D efforts with over 20 different programs to create multiple innovation solution accelerators. As an example, our knowledge in artificial intelligence and machine recognition that has been used to put up online retail through catalogs is now being applied in areas outside of the retail industry. On the machine learning front, our experience in developing pricing and promotion optimization for department stores has now been retooled to drive revenue generation at top brands. With some of our marquee clients, we are co-investing to help them deliver innovative programs. For example, we've partnered with a top lifestyle brand to help them drive business decisions from the wealth of data generated by their connected products. We expect to be a part of several innovation programs with this customer toward the end of the year. On capability fronts, we are expanding our expertise across all 3 cloud platforms: Google Cloud, Amazon Web Services, and Microsoft Azure, with our certifications and blueprints. This will accelerate Grid Dynamics' presence in segments outside retail. We believe the current crisis has presented incremental opportunities on the M&A front. Our strong and flexible financial position allows us to be more aggressive than many in the uncertain market environment. We are currently evaluating multiple opportunities with an emphasis on geographic and vertical expansion. Given the heightened uncertainty and diminished visibility, the current pandemic has reduced our ability to forecast our business. Consequently, we are withdrawing our previously announced guidance for 2020. That said, we are providing some color around our second quarter revenue. For the second quarter, we expect revenue to be in the range of $21 million to $22.5 million. We believe our second quarter revenue will be the low point and expect the company's revenue to progress on the recovery path from Q3 onwards. While the magnitude and timing of the recovery is still uncertain, there are a couple of things that may be incrementally positive. Since the start of Q2, we have added at least 5 new customers. These companies have a global presence, similar in size to our tech companies, and our engagement with them is focused on data science and analytics. Another customer is a European-based global online grocery platform. We're assisting them with their platform development. We also signed a deal with a global online payment platform company, and we'll be working with them around customer data analytics. Finally, we've signed with a global CPG customer, with whom we are using a data science prediction model to assist them in their COVID recovery. With our existing large customers, in technology, CPG, and manufacturing, we see it kicking off some significant programs that we expect to ramp up in the second half of 2020. From a financial standpoint, we are well positioned to weather the effects of COVID-19. On March 31, 2020, cash on our balance sheet was $121 million, and we have no debt. The foundation of our long-term growth strategy is based on deep strategic relationships with our clients and our land and expand model, and the essential drivers of this model remain strong. The need for digital transformation is universal. Our leading strategy consulting and digital technology services, agile global delivery model, and deep domain expertise will continue to benefit Grid Dynamics.

Thanks, Leonard. Good afternoon to everyone, and I hope everyone is staying safe and healthy. Let me start by summarizing our first quarter 2020 results. Our revenues for the first quarter were $32.5 million, implying a year-over-year growth of 24% and a sequential growth over the fourth quarter 2019 of 2%. As Leonard highlighted in his opening remarks, while business trended favorably in January and February, towards the latter part of March, we started witnessing the impacts of COVID-19 on our business. Absent that external slowdown, our revenues and EBITDA performance would have been even stronger. Coming to the details of the revenue mix, revenues for the 3 months ended March 31, 2020, from the retail segment was slightly less than 50% of the total revenue, a drop of over 10 percentage points from the same quarter of 2019. The first time in Grid Dynamics' history that this vertical falls below 50%; technology was 29% of total revenue, up from 26% of revenue in the year-ago quarter; financial was 12% of revenue, up from 10% in the year-ago quarter; CPG and manufacturing was 6%, up from 2% of revenue in the year-ago quarter; and finally, the other segment was 3% of revenue, up from 2% of revenue in the year-ago quarter. All segments of our business grew on a year-over-year basis, with technology, finance, CPG, and manufacturing, and other segments significantly outpacing the growth in the retail segment. We exited the first quarter 2020 with 1,357 employees, down from the fourth quarter headcount of 1,430 and up from 1,149 employees in the first quarter of 2019. The sequential decline in headcount was driven by a restructuring program that we initiated to align the headcount with the current business environment. During the quarter, we had 3 10% customers. Revenues from our top 5 and top 10 customers were 64% and 86%, respectively. During the same period a year ago, our top 5 and top 10 customer concentrations were 70% and 93%, respectively. The greater diversification in our business was achieved by a combination of new logo additions and faster growth in the non-retail segments relative to the retail segment. This happened by design, not by accident, and we expect this trend to become more pronounced in the future. We exited the quarter with 37 customers, up from 24 customers during the same period a year ago, and the strength in the new customer addition was more weighted towards the technology market segment. Moving to the income statement. Our GAAP gross margins during the quarter were $9.8 million or 30%, down from $10.3 million or 39% in the 3 months ended March 2019. The key reason for the decline was a combination of increased stock-based compensation, retention bonuses, and other costs. On a non-GAAP basis, our gross margin was 36%, down from 40% in the same year-ago period. The year-over-year decline of 400 bps was largely driven by increased offshore costs. Adjusted EBITDA during the quarter that excluded stock-based compensation was $3 million or 9% of revenue, down from $3.8 million or 15% of revenue in the first quarter a year ago. The decline was largely driven by higher operating costs associated with becoming a publicly traded company, combined with lower gross margins. Our GAAP net income totaled a loss of $4.6 million or a loss of $0.09 per diluted share based on 49 million shares compared to a GAAP net income of $0.7 million or $0.04 per diluted share based on 20 million shares. On a non-GAAP basis, our net income was $1.9 million or $0.04 per diluted share based on 49 million shares compared to $2.5 million or $0.12 per diluted share based on 20 million shares. On a non-GAAP basis, in the first quarter, using a normalized tax rate, our net income totaled $2.4 million or $0.05 per diluted share. The decline in GAAP and non-GAAP income was due to a combination of reasons highlighted earlier, both on the gross margins and operating expenses front. Coming to the balance sheet, our cash, cash equivalents, and short-term investments totaled $121 million compared to $42 million as of December 31, 2019. This significant increase was primarily due to the successful merger between ChaSerg and Grid Dynamics on March 5, 2020. Our balance sheet remained strong, and we're confident this will help us successfully navigate through the current downturn. Given the risk associated with the pandemic in some of our customers' businesses, most notably in the retail sector and their ability to fulfill their payment obligations, we've taken an allowance with our accounts receivables in the first quarter. In the first quarter, we have reserved a total amount of $0.9 million for allowance of doubtful accounts. We review our accounts receivable on a regular basis and have put in place incremental processes to ensure payments from our customers. As Leonard highlighted in his opening comments, the uncertainty with the COVID-19 pandemic has reduced our visibility, thereby diminishing our ability to forecast our business. We have decided to withdraw our previously announced guidance for 2020. That said, we're providing revenue guidance for the second quarter and expect revenues to be in the range of $21 million to $22.5 million. In the future, as the business environment stabilizes for our major customers, we intend to resume our guidance practice.

Our first question comes from Maggie Nolan with William Blair.

I wanted to ask about your frequency of touchpoints with clients in this environment. Are you starting to get a sense of how much of the spend reduction that you're seeing and from your Q2 guidance is kind of that initial shock from COVID versus how it may progress over time? Or is there still a large level of uncertainty there?

Thank you, Maggie. Obviously, it's a first question and first answer from my side. The point of view I have in the situation is kind of aligned with what you described. There was definitely a sharp and bold first reaction from the client, and that's understandable. However, as time settled, everybody is engaged in their own way on the path to recovery. We stay in very close touch with all our customers, some who have better clarity about how they're going to proceed, and some less. As you know, as the country and individual states are heading towards some opening from the quarantine, we'll have better results from their process thinking as we go forward. At this point in time, we're in touch. We have a good line of communication. We're waiting for more specifics.

And then you mentioned that the customers had responded in a variety of ways, pushing out some clients, asking for extended payment terms. I'm wondering what the conversations have been around pricing and your ability to see that pricing power that you've enjoyed kind of hold up in this environment.

Well, we don't provide specific guidance for individual customers and pricing. In general, I definitely see some flexibility in the way our customers, especially retail customers, respond in a situation like that. We're in cash preservation mode, making investments where it's appropriate. But I don't see a trend on pricing pressure as much as the terms. There are definitely some customers inquiring about longer terms, which will be assessed accordingly as the situation with customers becomes clearer, as I mentioned in the previous question. To summarize, there is pressure, but more on the terms for some customers. However, we act accordingly with each individual customer based on our relationship and partnership.

And then, on the expense side, you've already taken some initial actions, it sounds like to do some restructuring and protect those margins. What was the impact of some of that, that you may have seen in the March quarter versus how we can expect that to play out in the June quarter?

Good. I'll have two parts of the answer. First, I'll answer myself. Second, I'll ask Anil to jump in with the numbers. Even though the situation unfolded rapidly, we had some planning in place a little ahead to understand how the situation would unfold. We made a couple of very key decisions. The first decision was to keep most of our people in place to return to total extent because we believe the majority of this first knee-jerk reactions will recover, especially demand from the digital sector. The business continues to grow even in some tough segments like retail department stores. At the same time, the challenge always comes with the fact that March, typically in our business, is the inflection point of growth. As you know, in our business, there is some seasonality, and March is expected to be the growth month, which it has been but not to the extent we obviously expected a couple of weeks prior. So it impacted our Q1 profitability numbers and required some realignment of the extra resources we planned for growth in Q2 compared with Q1. We did have some adjustments, implementing other cost actions I talked about. But most importantly, there's no dramatic impact on our capability, and we decided to weather the storm with the balance sheet we have.

Yes, Maggie, Leonard qualitatively summarized what our efforts were. As you can see, we had a little bit of a restructuring that we kicked off in late Q1. The minute we saw the kind of outlook, we reacted very quickly and started this program. The benefits will obviously fall into Q2. On Q2, what we've done is, as Leonard pointed out, the workforce has been kept intact based on our outlook. However, all discretionary spending has been put on hold. We have taken some initiatives to align our costs with the current business environment.

Are there further initiatives that you intend to push forward? And what are some of those potentially that could still take place moving forward?

Well, right now, we have given some Q2 guidance. We have a couple of models laid out towards the second half of the year. We have several options to consider. But for now, we're focused on Q2 to execute well. We do have a couple of options, which will depend upon how the environment looks and the return of the demand.

I want to add one more thing to Anil. I strongly believe, along with the management team, that we see a good opportunity for Grid Dynamics to leverage the situation where more businesses are accelerating their digital transformation. So as we're expanding our customer projects, we're adding more fuel to the fire with capabilities in data science, data engineering, and machine learning. The number of projects we're doing is increasing. My priority right now is to invest to grow. This includes recovery and then expansion.

Congrats on this first quarter even in unusual circumstances. It's exciting to hear your voices.

Thank you, Maggie.

Thank you, Maggie.

I was hoping, since this is the first call, you could briefly touch on broader dynamics that you see in digital? What gives you guys the competitive advantage over peers?

Thank you, Drew. It's good to hear you, and thank you for your critical question. We are a unique company in the sense that we are a pure-play digital company. We have strong technical capabilities and the ability to solve complex issues for our clients. We build our vertical knowledge in retail, which we have now scaled outside of retail. It's not only about individual technology knowledge, but also about the strong teams and project managers associated with that. We leverage our onshore/offshore model and continue to do so. We invested not only to build a strong engineering team across Central and Eastern Europe, but also build local capabilities in the United States. More than 20% of our engineering workforce is in the United States. This combination of technical skills on senior client systems management and adding new capabilities and a strong onshore presence makes us feel very good going forward. Additionally, our cash availability helps us to build stronger and weather the storm as we always do.

Can you provide some color on what you're seeing over the last few weeks? Just trying to understand how clients are reacting? What did you see in April? Did it start to recover? Are you starting to see stabilization?

Thank you, Drew. I will not tell more stories because it's hard to go week by week. But of course, as a CEO, I do look day by day. I would say that there were a couple of key milestones. In late March was a big surprise with a lot of uncertainty, especially during the first week of April. As April unfolded, there was more understanding in terms of how the business will proceed. To our success in terms of retooling, we made an instantaneous transformation to a work-from-home environment. This ensured safety while maintaining productivity. Some customers were very understanding that the environment was different. They trusted our security capabilities and teams. We were able to stabilize and maintain business operations working from home. As we reached late April and early May, I saw some recovery; don’t forget that we added customers in late Q1 and continue to do so. There is a positive trend. We provided our forecast, which is reflected in our Q2 guidance; time will tell how these initiatives will translate into financial benefits.

The key point is that the five accounts we've discussed are global accounts, significantly impacting our business long-term. Witnessing these five new accounts come to us in this environment is a testament to our expertise and ability to assist these global companies in their digital transformation journey, tied to revenue-generating opportunities. We have observed that in some segments of our customers, there is an acceleration in their digital transformation. Historically, we've seen in crises companies like ours emerge stronger, and I believe this to be the case now.

What is your perspective on the pipeline? Does it strengthen in the near term as people look toward digital? Or does it take a hit? How quickly could it rebound?

From a strategic standpoint, we see a return in our pipeline from new opportunities. Some will not be immediate. We work with large Fortune 1000 companies, and some planning has begun, although the benefits will come in the second half of the year. The expertise we have in depth in digital and cloud attracted big organizations that realize they can no longer afford to delay their digital initiatives. This encompasses not just traditional e-commerce, but also manufacturing companies realizing supply chains are vital. We have unique skills to apply to various platforms, and there are broad initiatives we are exploring. The technology sector is experiencing rapid growth, and that's the fastest growth we are seeing right now, which presents incredible dynamics.

In terms of guidance, are all the weakness focused on retail? Should we understand that you're essentially taking that out of the numbers?

Yes, we won't get into specific breakdowns by segment, but we have taken a conservative look at retail. We've derisked that part significantly for Q2.

E-commerce is vital for our retail clients, and they will continue investing in these initiatives. Although we cannot provide exact details, e-commerce is a significant part of our strategy and we will keep investing and growing in that area.

Regarding the new customer additions, how do you size potential aggregate contributions from those new customers? Can you give an estimate for this year and their full potential down the line?

We focus on large enterprises, with our strategy aimed at building significant relationships which yield higher revenues. Our focus is on upper revenue tiers, meaning these five new customers also reflect this potential. All five customers fall into the category of having upper revenue capacity, with potentials that align with $10 million and above. The timeframe for realizing that potential will depend on several factors.

Given the current environment, what are your thoughts on acquisitions? Should we expect to see activity in 2020?

This is a key part of our strategy, looking at geographic and vertical expansions. We see opportunities for M&A both in 2020 and beyond. At this moment, we're exploring many options and seeking synergy with potential targets.

The opportunities for M&A are robust in this environment, and we will ensure that any potential acquisitions align with our company culture and objectives.

Thank you, everyone. This concludes Grid Dynamics' first earnings call. We had a turbulent quarter behind us, wrestling with the dual challenge of building a newly minted public company while experiencing the unprecedented disruption of COVID-19. Our strong Q1 performance, combined with swift actions to help alleviate the near-term unpredictability, gives me confidence in our midterm recovery. We have implemented a number of external and internal initiatives designed to boost our competitiveness. The number of new clients and innovative programs amid strict quarantine is a testament to Grid Dynamics' value in the accelerating world of digital transformation.

This concludes today's conference, and we thank you for your participation.