Grid Dynamics Holdings, Inc. (GDYN) Q4 2020 Earnings Call Transcript

Good day, ladies and gentlemen, and welcome to the Grid Dynamics' Fourth Quarter and Fiscal Year 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. I would now like to turn this call over to Ms. Lilly Tranova of Investor Relations. Thank you. You may begin.

Good afternoon and welcome to Grid Dynamics Fourth Quarter and Full Year 2020 Earnings Conference 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 first quarter 2021 financial guidance, the growth of Grid Dynamics' business, our objectives and business strategy as well as other forward-looking statements. You can 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 will be made on this call.

Thank you, Lilly. Good afternoon, everyone, and thank you for joining us today. I'm excited to share my thoughts on how the company is making strides across its business and then highlight the progress we have made since we spoke with you all several months ago. More importantly, on this call today, I will share my perspective on the full year 2020, how it has shaped us as a company leading to the present and why the future is exciting and we are all set well for 2021 and beyond. In many ways, 2020 was a unique year. Grid Dynamics went public on March 1, but in a very short time of two to three weeks after going public, we faced an unprecedented crisis from the global pandemic. Many of our retail customers were severely impacted, especially brick-and-mortar department stores. As the second quarter results highlight, the retail business was down 75% sequentially and on a year-over-year basis, brick-and-mortar department store customers were down even more substantially. Despite the headwinds, we bounced back and underpinning the strong recovery, we took some very important decisions. Our immediate focus was to preserve our core engineering team and prepare for the possibility of a prolonged impact from the pandemic. We are exploring our business development efforts toward non-retail opportunities. We initiated a number of strategic R&D projects and co-invested with some of our larger clients.

Thanks, Leonard. Good afternoon, everyone. Let me start by summarizing our fourth quarter 2020 results. Total revenue for the fourth quarter was $30.1 million, which included roughly $1 million from our recent acquisition of Daxx. Excluding revenues from Daxx, revenues in the fourth quarter of $29.1 million increased by 11% on a sequential basis and declined by 9% on a year-over-year basis and exceeded our guidance range of $27.7 million to $28.7 million. Other than our technology, media, and telecom commonly referred to as technology and financial verticals, all segments grew over the third quarter with strong quarter-over-quarter growth coming from CPG manufacturing, retail, and the other segment. Similar to the last couple of quarters, our technology vertical was the largest vertical in the quarter. Excluding the contribution from Daxx in the fourth quarter, our non-retail business, now representing 73% of revenues in the fourth quarter, was up 6% on a sequential basis and 49% on a year-over-year basis. During the fourth quarter and excluding Daxx, our retail segment representing 27% of our revenues grew 26% on a sequential basis. The growth in the quarter was largely driven by one of our top e-commerce-friendly retail clients and, to a lesser extent, by other retail clients. In spite of a 26% quarter-over-quarter growth, retail was down 56% on a year-over-year basis. Within the segment, while we are seeing a steady comeback from some of our retail clients, we are not witnessing a return to pre-COVID levels of business from some of our historic top customers. Our outlook and forecast for 2021 take this factor into consideration and our forward guidance is not predicated on the comeback from these retail clients. Our technology vertical, excluding Daxx, represented 37% of our fourth quarter revenues and grew 21% on a year-over-year basis but was down 16% on a sequential basis. The key reason for the sequential decline was a greater shift towards offshoring at some of our larger technology clients and although the headcount increased during the quarter, it was not enough to offset the revenue decline. We expect the offshoring trends at our technology customers to continue over the next couple of quarters and expect continued headcount increases.

At this time, we'll be conducting a question-and-answer session. Our first question comes from the line of Mayank Tandon with Needham & Co. You may proceed with your question.

Thank you. Good evening. Congrats, Leonard and Anil.

Thanks, Mayank.

From the close of 2020, I wanted to just start with the demand; curious in terms of the pipeline and the pace of deal conversions. Relative to say maybe a few months ago, as you've gone through the budgeting cycle of clients, what are you hearing now from customers in terms of their visibility and propensity to spend on digital projects?

Hi Mayank. This is Leonard. Thank you for your question. I would say there are two parts to the answer. The first part is we definitely see an uptick in the number of verticals. So, we do have engaged a better number of opportunities. On the other hand, I would say we'll get much better visibility on the conversion as we transition from Q1 to Q2. As you know during February, it's a lot of conversational time, it's a lot of projections. Like I said, we're excited about the product but we’ll have much better visibility as we move into Q2.

Got it. I just wanted to switch over to obviously revenue looks really good on the EBITDA side. I think you mentioned a few factors. Obviously, the Daxx acquisition does have some dilution in terms of profitability. How should we think about the EBITDA trajectory beyond the first quarter into Q2 and then really in terms of framing the EBITDA outlook for the full year, any guidance around that?

Sure. Thanks for your question, Mayank. Let's just break the whole EBITDA question into a couple of parts. When you look at our guidance for the first quarter, it’s around 7% to 9%, or 8% at this point. A couple of assumptions that we had there. As you know, Q1 tends to be a seasonal factor that comes into play. We typically start off at a lower level and work our way up. In a nutshell, the answer to your question is, we’re going to start off here and as the year progresses, we're going to see expansion. Also, in Q1, just to give you a little perspective, we have fewer working days. The holiday season in Central and Eastern Europe occurs in early January. Additionally, there is a little bit more robust hiring going on because the demand environment is shaping up well and obviously that all works. Finally, we got our acquisition of Daxx, which has lower gross margins and EBITDA margins and will have a full quarter impact. Also, as we've said over the past couple of quarters, we've got some strategic plans. We're going to be building up our sales force and developing our training internship programs. So those are kind of investments from a growth perspective, but as we come out of Q1, you should start seeing expansion as we move into Q2 onwards.

Great. And then, just finally in terms of revenue, again a very healthy outlook on an organic basis as well. How should we think about the breakdown between the various levers that you have in terms of pricing, utilization, and then headcount growth? Given the recent hiring trends, it would suggest that hiring is probably back to some level of normal levels for you, but I'd just love to get a breakdown of those three drivers of revenue for 2021. Thank you.

Sure. Well, anytime you look forward at some of the big units, remember, a year ago, we were very excited about March 1st and then March 17th happened. So let me be a little bit more subtle to restrain my excitement, but I would say that our hiring right now is above traditional levels. There is a lot of demand, especially if you think about it, our three key areas of our capabilities for growth relate to cloud migration, digital transformation, and customer experience, which includes great capabilities in artificial intelligence. All these areas require not just a robust pipeline but significant investment and growth in the technological capability of our workforce. I would say we are growing fast. In terms of the utilization levels, I think we're back to normal again. If you look at where we were last year, we were a little bit behind in some areas where we had to make an investment. So, I don't see a problem there. And what was the third area? I'm sorry, you asked about headcount utilization and?

Leonard, just your comments around pricing, what you're seeing on the pricing front in terms of trends? Thank you.

So, well, a lot of customers have different approaches toward pricing. If you look at the areas where we excel the most, there is a huge demand for continuing this. We offer solutions, we offer accelerators, we offer our own teams as our team excels beyond just regular engagement. So, I would say that we see a healthy uptick in our pricing relationships as well.

Thank you so much. Congrats on the quarter.

Mike, I just wanted to give you a little bit of perspective for everyone on the full year. If you look at our core grid growth that's at least 21.5% and 134, if you do the math right. We're starting off the year and obviously, we'll have incremental updates in the course of the quarter. We did a bottom-up analysis and when we looked at our full year, the commonly cited 85/10/5 rule that we typically talk about. The year is going to shape out more or less like that in the sense that as you know, most of our revenues come from customers who have been with us for some time. Just to provide a little more color there, we do expect technology to perform well. We expect it to be the largest segment. We're bullish on CPG and some pickup on retail, but we'll see how retail plays out for this full year. Overall, the environment looks good and we'll obviously provide updates.

Great. Thank you so much.

Our next question comes from the line of Joseph Vafi with Canaccord. You may proceed with your question.

Hey guys, good afternoon. Great results, nice outlook. Just wondering if we could talk on the business development front a little bit, any progress or anything notable in Q4 relative to sales force, hiring, or developments there? Then maybe some commentary on, I think you said your five new logo wins, maybe a little color on how those deals came about? Then I have a follow-up. Thanks.

Sure. Well, we talked about it last quarter. Since then, we added more capabilities from the sales side in various regions, particularly in South Texas. We added more capabilities in the Midwest and on the East Coast. So, certainly, the investment is there and it's starting to pay off. In terms of distribution of the customer base, I already said that they came from basically a number of different verticals, and again, I would not totally say that we are absolutely vertical agnostic. But if you summarize areas of expertise, right now anyone who moves into the broader digital world drives about the same level of demand. So, our skills are universal. We also added to our business development process some additional twists with respect to the competencies in specific specialization areas. So, we tend to work as a cross-functional business approach, which combines business competency and technical competency in particular areas and industries, along with the territorial presence and the relationships we've developed. Finally, we are seeing a significant uptick from our marketing campaigns. We see that our positioning from webinars has resumed and our direct dialogue with clients is very active. It's a broad initiative and we're seeing progress.

Okay. And then on the Daxx front, if I recall, I think they have a more European customer base. I was wondering if Daxx has been part of the company for a little while, what you see as opportunities in leveraging them in terms of joint sales capabilities or how you see the growth in the Daxx business in 2021 relative to how they might have been as a stand-alone? Then just one more on Daxx; I know the margins were a little lower, if there is a strategy for lifting that this year and moving forward? Thanks very much.

So, Joe, it's in the citation. Well, let me highlight a few points. First and foremost, you're absolutely correct. The focus in Europe has been a very strong appetite point for Grid Dynamics to proceed with the acquisition. If you look at the previous ownership structure of the company, there were several individuals from the Netherlands. So, the Netherlands position is historically strong and they have a sales presence in the country. That helps, followed by Germany, which is another good example of building a strong reputation. In terms of cooperation, we focus on a system approach, not just implementation but also project management, technology leadership, and architectural work. So, we are able to complement and expand services with new capabilities. The touchpoints are different; we focus on technology startups while they have a broader customer base. They also have strong CNC capabilities. Their engineering team in Ukraine has been beneficial in terms of our cooperation, so I would say the integration is going well.

Right. Thank you very much, Leonard.

Our next question comes from the line of Bryan Bergin, Cowen. You may proceed with your question.

Hi, good afternoon. Thank you. I want to follow up on headcount. So, certainly, a big increase on an organic basis that you had in the quarter. Can you talk about how you thought the operating model performed onboarding that many? Anything to call out there? Are we comfortable with that rate of expansion? What locations specifically are you increasing that offshore presence?

Brian, you always position your questions smartly. Well, we can share some parts of our kitchen, but Grid Dynamics has its own proprietary methods for bringing people up to speed, and one very key element is our practices. When we have technology practices in offshore locations, it's easier to absorb and integrate people. As we mature, they have the training information already available for them to get up to speed much quicker. If you think about onboarding people, the process is fast in general. The other part is we are getting a good influx from our internship program graduates, which is gaining momentum. Additionally, some of our larger clients have been increasingly relying on our services. When you look at geography, it's across all Eastern and Central European countries. Part of it is that some of our large clients and the shift toward distance work has made us comfortable expanding our technical teams globally. We're able to scale momentum by extending more of an international team. I think that we are preparing for this. I just want to add that the rate of growth will only accelerate.

That's good. Then on just on margin here. So, the composition of your margin assumptions taking Daxx into account, how should we be thinking about gross margin levels, as you get a full quarter here in Q1 and then as you walk through 2021 and then also further down, how should be thinking about the pace of G&A operating leverage as our scale?

Yes, thanks for the question, Brian. So, as we get a full quarter of that, the margin impact is going to be there. If you look at the differential between them, both the gross margin and operating margins or EBITDA margins are lower than our grid. The gross margin differential is more significant than the EBITDA margins, largely because their business model is slightly designed differently. So, as we move into Q1, we will have a full quarter of impact. You’ll see a near-term movement on the gross margin front, but as we go into the second quarter onwards, there is obviously leverage in our model that will offset that, and then, over time as we understand some nuances and uncertainties of Daxx, there’s potential for leverage too. There are several million dollars of public company costs, and Daxx is primarily located in the Ukraine area, so there is some leverage there that could benefit us throughout the year.

Okay, thanks. One last clarification, just on the tech clients you mentioned and the sequential decline from Q3 to Q4. That was entirely due to the shift to more offshore. So just the per capita impact, no other changes in relationships?

No, from that relationship, the relationships are robust, Brian. As a matter of fact, they're going deeper, and if you look at the year-end, of course, for some of these larger declines there were furloughs and shutdowns. There is the offshoring component which is a risk designation. As you move into Q1 onwards, we expect to see a pickup. So, we're very bullish on the sector and the relationships. Leonard, do you want to add anything to that?

Yeah, there is one subtle sector to take into consideration. If you recall, during some of the challenges of 2020, we made some aggressive temporary cost reductions by reducing compensations and bonuses. In Q4, we returned to our full compensation model. So, there is some transition related to that as well. It's not unusual to see a little bit of a Q4 situation. As you know, it's early time of the year when this transition occurs, and we’re still growing fast, so there was added cost because we restated our company compensation.

Thanks, guys.

Thanks, Brian.

Our next question comes from the line of Maggie Nolan with William Blair. You may proceed with your question.

Hi, thank you. Nice to see the positive trends. I'm wondering, are you expecting to see a change in the mix going forward between onshore versus offshore delivery given that you just moved work from that tech client offshore and then how willing are your clients to embrace offshore delivery and does that typically change over the life of the relationship?

Thank you, Maggie. We don't have a crystal ball to see what the future holds for us, but we've been trying to convince a number of customers for a long time that an offshore combination could be more favorable in terms of performance and efficiency. Some of them are a little resistant; they want to see how it works. What will happen when countries return to normal operations and people come back to their offices? I would say that there is a chance of seeing some sort of return to the previous model, but I don't think it will completely shift back to a conservative onshore approach. I think we have proven ourselves to be efficient, successfully supporting customer trends in their demands and managing data more effectively. So, I like the balance. We still need to have onshore presence; having quality top leadership in architecture is very helpful for efficient communication. We will continue to invest in onshore hiring, whether at customer offices or in the United States or nearshoring. For now, the trend is that we're growing fast in offshore locations.

Thanks, Leonard. Then, after what period of time are your sales professionals really truly productive? With that sales force ramping and you're starting to see those investments play out, should we expect to see a meaningfully higher level of new logo additions in 2021?

This is an answer I really don't like giving; it depends. We've put a lot of effort into recruitment; so the fruits of these relationships still require engagement time due to our unique service model. It’s high-quality specialized services which can sometimes take longer to expand; I would say 6 to 9 months is the typical range where we start seeing some good traction. Remember, we are not working with small engagements; we're dealing with top technology companies and global enterprises. So sometimes we see returns faster, sometimes it takes longer, but we are invested in long-term relationships, and we've found satisfaction with what we've invested.

All right, thank you for taking my question.

Thanks, Maggie.

Our next question comes from the line of Tim Savageaux with Northland Capital Markets. You may proceed with your question.

All right. Good afternoon. Hey, I have some questions on the acquisition. On the Daxx acquisition and really how indicative we should consider that in terms of what you might be interested in doing heading forward, or is this kind of more of a one-off opportunity? And I say that just because of some of the metrics here. You look to have paid something around the revenue level that you're guiding for next year, assuming that's the case here, obviously trading at several times that same thing with regard to enterprise value per employee in terms of acquisitions or maybe paying a tenth of what you're trading. On the other hand, revenue per employee does seem to be lower than historically where you’d like to be. So, with all those in mind, are there opportunities to bring those revenue metrics up in line with where Grid is historically and are, from your perspective, as you look at it now, are there a bunch of other Daxx's out there?

Thank you, Tim. I'm thinking about the best way to describe the situation. As you might or might not know, we have been interested in Eastern and Central Europe for acquisitions for quite some time, and this is not the first time we have had discussions with Daxx. Not too long ago, we were looking at a very different set of metrics for various acquisitions. We cast our net wide to areas where we were looking for—this includes the European market—seeking engineering-friendly companies. There are specializations, and some companies would be more geared toward certain verticals. It’s difficult to predict the next steps when trying to gauge a conclusion based solely on this acquisition. We will continue to explore good companies; I would say that no other company is precisely like Daxx. This acquisition has a different flavor, but we may see differing profiles in future investments. As I mentioned, our strategy is not solely restricted to two years ago, and our priority is to make our balance sheet the most efficient for company expansion. It's important to diversify the types of investments, which you will see going forward. One additional noteworthy point is that the revenue metrics per employee for Daxx are trickier to quantify due to the bulk of work being done in Eastern Europe. So, when Grid Dynamics works in combination with the United States and Eastern-Central Europe, the business models differ. Overall, it’s a great acquisition; we're very excited about it, and we have fantastic people. We have maintained friendly relationships between the integration groups, and thus far the experience has been very positive.

Great. And if I could follow up quickly, and I think you alluded to this earlier; I'm not sure I quite got it though. As you add the acquisition revenue and how does that impact your mix across verticals? It seemed like technology was a big focus there, but just want to make sure I got that right?

Yes. Tim, if you look at Daxx's exposure, just to give you a kind of a sense, roughly 60% of their business is in the TMT space. They tend to cover areas like high-tech software, cybersecurity, logistics; retail represents about 12% give or take, and financial services accounts for about 10%. They’re more diversified but most of their revenues come from the TMT sector. Coming back to your question, that’s why we feel incrementally confident that our technology vertical will continue to be the largest in 2021.

Okay. Thanks very much.

Thank you, Tim.

Ladies and gentlemen, we have reached the end of today's question-and-answer session. I would like to turn this call back over to Mr. Leonard Livschitz, CEO. Thank you for closing remarks.

Thank you everybody for joining us on the call today. 2020 will be remembered as dramatic for all of us in many ways, and that goes even for our company. For investors, we persevered and recovered. It was a year where the company was tested under unique situations, and as our results over the last three quarters have shown, we have successfully managed it. While the pandemic is not yet over, as we enter 2021, there are many reasons to feel positive and excited. With the pandemic slowly receding, as many people get vaccinated and the global economy recovers, businesses are returning to normal operations; we feel confident about Grid Dynamics' prospects in 2021. We look forward to sharing a business update in May during our next quarterly earnings call. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and enjoy the rest of your day.