Nagarro SE (NA9) Earnings Call Transcript & Summary

Good afternoon, ladies and gentlemen, and welcome to the Nagarro SE earnings call regarding the Q2 and H1 2021 results. [Operator Instructions] Let me now hand the floor over to Christian Baha.

Thank you, Beatrice. On behalf of Nagarro SE, allow me to extend a warm welcome to you. You should have received a copy of the earnings release for Nagarro's second quarter 2021 results. If you have not received the press release, a copy of the release as well as of this presentation is available on nagarro.com in the Investor Relations section. I am covering for Christopher Grose. And with me on today's call are Manas Fuloria, Custodian of Entrepreneurship; and Gagan Bakshi, Custodian of Strategic Finance. Before I pass you over to Manas Fuloria, I would like to remind those listening that some of the comments made on today's call may contain forward-looking statements. These statements are subject to risks and uncertainties as described in the company's earnings release. Additionally, please also refer to the earnings release for the notice on reported results that are non-GAAP measures. With that, it is my pleasure to hand you over to Manas.

Thank you, Christian, and welcome to all of you from around the world to this earnings call. I'm going to assume that you all have been following Nagarro closely and have seen the Q1 results. And so I will focus more on Q2 than on the entire H1. Of course, you now also have the H1 report for your reference. And Gagan and I will be happy to answer any questions. Q2 has been a bit of a landmark quarter for Nagarro in a couple of nice ways. First, all through the spin-off and listing process, we have been saying that Nagarro's historical organic growth rate is close to 20%. And that our intrinsic capability to grow organically is also in that region. But because of the early impact of the COVID-19 pandemic, plus the management being a little distracted by the spin-off and the listing. You have had to wait to see this sort of growth. Now in Q2, we have reached the 20% level of organic revenue growth for the first time, recording a 21.1% organic revenue growth. Second, for the first time, we are able to present revenue growth in constant currency. This impact improves the organic revenue growth number in constant currency, which is now then 25% almost. So the story of this quarter is mainly a story of growth. We also added over 1,150 net new Nagarrians in this quarter, which is, again, sort of record number for us. This growth rate that you see has nevertheless been constrained by the supply side. As you must be aware, the demand for engineering talent, and in particular, the demand for the top digital talent has skyrocketed globally. There is also significant wage inflation as companies compete for scarce talent. Now on the positive side, we believe our business is rather price inelastic. We believe that the work we do is so important that clients would be happy to support reasonable margins for us. But there is a time lag between the wage inflation when it happens and the impact of the remedial measures like going back to clients for price increases. So you will see the results of that. The background to this entire quarter has been the COVID pandemic. The second wave hit India especially hard, and we lost several colleagues. We also lost a lot of working hours. Despite this, client satisfaction remained at top levels. In fact, remote working has become a way of life for us, and we are now doubling down on this digital-first work-from-anywhere Nagarrian experience in a variety of ways. One more important development in this quarter was the work towards the rollover of minority interests from the Nagarro holding level to the Nagarro C level. A lot of work has been done and the stage has been set, and the next steps will be taken in the coming weeks and months with the AGM and beyond. This should also insert some more liquidity into the share. So that's the summary for the quarter. Now we get into a look at the quarter by the numbers. The revenue that we did in quarter 2 was EUR 127 million. We talked already about our revenue growth. The quarter-on-quarter revenue growth was 10%. The gross margin was 29.9%, which includes some forward investment in hiring people fresh out of college, which impacts your gross margin negatively in the short term, but in the long term, it's positive for gross margin. We had adjusted EBITDA of EUR 19 million, with the largest adjustments being related to the one-off cost for the rollover and stock option expenses. In terms of the industries, we had the maximum growth for the automotive, manufacturing and industrial -- industry vertical, followed very closely behind by retail and CPG, as might be expected. The worst performing industry was telecom, media and entertainment. We think not because of any structural reasons but because of more individual client-related reasons. In terms of segments, we continue to grow fastest in the rest of the world and slowest in Central Europe, which is also recovering from certain industries being more impacted by COVID. Our client concentration remained roughly what it used to be. Cash balance was EUR 102 million at the end of the quarter. And our customer satisfaction score is almost constant at a very high 95%. We retain our guidance for the year, and we will touch on this later in the presentation. Coming to the revenue by industry, we already spoke about the 2 verticals that have done exceedingly well. But close behind them are the Public, Non-profit and Education vertical, particularly the U.S. public sector, the Horizontal Tech vertical and the Energy, Utilities and Building Automation vertical, which has bounced back. So these all -- the 3 verticals that I just mentioned have roughly 30% growth from Q1 2020. If you look on the right at the revenue by customer, as I said, more or less, the revenue concentration has remained unchanged. So growth has been largely broad-based, although some verticals are growing a little faster than others. If we go to revenue by client region, again, we -- the rest of the world is the fastest-growing segment. And we have growth in every segment overall. We have -- in terms of personnel, as I mentioned, we added over 1,150 personnel this quarter, net of attrition. I might just point out that some of these new hires in this quarter are fresh graduates who will be trained further and are not likely to be immediately deployed on client projects. So they're more of an investment for the future. This is another view of our revenues and gross margin by segment. The gross margins for Q2 2020 are not very reliable comparison for comparison purposes. Because if you remember, last year, we had salary cuts to prepare for the effect of the pandemic. So rather than looking at them as comparison numbers, I think it's better to just look at the gross margins for Q2 2021 independently. So you can see that we have been growing across all segments, but the rest of the world has been growing the fastest. North America also has healthy growth. The slowest growth has been Central Europe, partly because, as I said, of the industries in which -- to which Central Europe was exposed. Some of them have been more impacted by COVID. Coming next to -- I spoke a bit about last year not being a very good comp. The same is true for cash flows. And before I hand over to Gagan, maybe I'll just speak for a little bit on the operating cash flow, in particular. So as I mentioned, the H1 2020 -- and here, we are talking about half year numbers. H1 2020 was affected by salary cuts. It also had almost no growth. And we also went into an emergency cash conservation mode to prepare for the pandemic. On the other hand, in H1 2021, what you have is a fairly high EUR 8-plus million payout of spin-off and listing costs. So still carrying some of that impact on the cash side, our spin-off and listing costs. Plus a lot of working capital tied up in the rapid growth that we are seeing. So overall, the conversion of EBITDA to net cash, once you adjust for these effects, is fairly normal. So maybe, Gagan, you can speak a bit about the balance sheet and the rest of the cash flows.

Okay. On the left-hand chart, we can see the liabilities position at year-end 2019 and year-end 2020 and also at June 30, 2021, which is the right most part. Now in that bar, the purple segment shows financial liabilities of EUR 180.1 million, which are essentially syndicated credit facility, working capital facilities, et cetera. The green segment shows lease liabilities of EUR 56.1 million. And the gray segment represents the cash which is EUR 101.9 million. So liabilities adjusted for cash gives the company a net debt of EUR 134.3 million. And given the adjusted EBITDA for a 12-month period ending June 2020 of approximately EUR 78 million, the net leverage ratio remains 1.7x. As a headline, the company's liquidity position at the end of H1 2021 was comfortable, with current assets of EUR 220 million and current liabilities of EUR 107.7 million. The right-hand side chart shows the cash flows for H1. Since Manas has already discussed the operating cash flows, let's focus on the remaining 2 parts of the cash flow statement. The cash flow from investing activities is an outflow of EUR 6 million. The 2 main components are an outflow of EUR 1.8 million from CapEx and an outflow of EUR 4.1 million to meet contractual obligations of previous acquisitions. Cash flow from financing activities is an outflow of EUR 6.3 million. This was primarily due to outflows from a lease payment of EUR 9 million, interest payment of EUR 2.7 million and repayment of bank loans of EUR 2 million. These outflows are offset by inflows of EUR 3.1 million for proceeds from shareholders of Nagarro or our stock options and inflows of EUR 2.9 million for funds received from noncontrolling shareholders.

All right. Thanks, Gagan. Just a few words now on our outlook. As I mentioned right at the beginning, we are fully steady to our revenue and EBITDA outlook for the year, but we are revising our gross margin outlook downwards conservatively. This is, again, in keeping with our view that the impact of the remedial measures that we are taking, like price increases, will lag the wage increases by several months. Many of the price increases that we are already in the process of negotiating will come into force from early 2022, typically in January. Despite the drop in margin, potential drop in margin, we still feel we have the levers to shoot for an adjusted EBITDA target of 15%. Some of you may feel that our revenue target is now looking somewhat conservative, and that is true. But we are not revising it given the uncertainty around subsequent ways of the COVID-19 pandemic. We do continue to believe that in the medium term, we can grow organically at around 20% and keep an adjusted EBITDA of 15%. And we're not just talking about wild times like this one, but even in a more stable markets, we continue to believe that we can grow at 20%. Finally, when we presented ourselves to the investment world in our first Capital Markets Day back in September 2020, it seems like a lifetime ago. We said that we had these trends. We said that we had a unique positioning. We said we had very good clients, a great client base. We were an agile organization that could morph and change with the times. We felt that we had good financials, robust financials and the ability to grow both organically and through acquisitions. And I'm happy to say that despite all sorts of upheavals that we have had in recent months, we remain on track. We are building on these trends. And as the Nagarro brand gets better and better known globally and as we continue to work on strengthening our core internal processes as well, we feel more and more confident about our goal to be approved global scale digital services players in the coming months and years. So that's it for the presentation. And now I will hand it over to Beatrice, and we can take some questions.

[Operator Instructions] And first up is Mike Junghans from Commerzbank.

Mike Junghans from Commerzbank. The first is on your demand environment. So as we are now in the middle of Q3, have you noticed any significant change in the good sales momentum in Q2, as you mentioned, announcing uncertainties due to COVID-19. And furthermore, in the risk section, you mentioned factors that could affect your ability to service the customer demand. So could you elaborate on these risk factors in greater depth? And the second set of question related to the labor supply constraints. So could you all elaborate on the situation here on the labor supply constraints and have these risks further intensified going into Q3? And last question for the moment is on pricing actions. So could you explain the measures you have taken to compensate for this higher wage inflation. And will these package of measures be sufficient enough to fully offset the mounting headwinds that we are seeing on the gross profit margin side? And how many months will it take until we see the first positive effect?

Thanks, Martin, for all these questions, very pertinent questions. So let me take these one by one. On the demand side, we see steadily strong demand. And as before, we have thousands of positions open for hiring and our -- there's just so much work to do and high-quality work. And we really have the chance to move the needle for our clients. More and more clients are picking up this digital transformation as a CEO priority. And being relatively well-known now or at least better known company in this space, we are getting a lot of inbound interest. And both from existing clients and from new clients. And our biggest concern right now is how to do right by clients in terms of servicing them with the resources that we have. So the demand side remains pretty strong, and there's an emerging consensus in the industry that this is likely to stay this way for several quarters and it's not going to go away very soon. So that's one part of the picture, the demand side. When we talk of risk factors, right? I mean, there is always a risk that -- I mean, the macroeconomic risks to hyperinflation or whatever, right? I think that you probably understand as well or better than I do. But I think that in our industry, the biggest risk is from the supply side. And this is in 2 parts, right? I think there's, of course, the risk that there are subsequent waves of the pandemic that will lead to our engineers not being well or having to take care of their family. Or hopefully, this will not hit us as badly this time as it did last time. We are trying our best to get people vaccinated and families vaccinated. And hopefully, this will not affect us. And I think also, at least in India where we had the worst of the second wave, the government is also probably wiser and the conditions are maybe a little bit better than they were for the second wave. So that's one part of it, right? But we do keep that option or that possibility at the back of our minds. The second more likely progression of supply side challenges is on the talent availability side. Now this is an interesting problem because depending on the type of talent we're talking about, the challenge is different. So for more traditional technologies, talent is still available. And in fact, there isn't that much of a scramble for this talent. But at the high end, for the digital technologies where we typically work, there is, of course, a huge scramble for talent. And this doesn't show any signs of abating. I would say perhaps it stopped spiraling. And it will probably also be helped by the fact that gradually, our offices will start to open. And while we are going to stay in a work from anywhere more, we do expect at least 1/3 of our people or half our people to occasionally come into our offices. And that helps bring back some of the bonding that keeps people together in the company. And also we do expect that the rapid job changing will not -- will slow down. I see on my message that -- am I audible?

Yes, yes. You're audible. Sure.

I'm sorry. I saw some fellow moderator say that they could not hear me so that thinking. Anyway, so yes, we do see this continuing to be a challenge, but maybe not spiraling out of control. On the other hand, on our side, we have made a lot of different attempts to address this, both on the hiring side, on the Nagarrian experience that I briefly mentioned, in the initial slide, we are now preparing ourselves to think of the company as a digital-first company. And let me expand a bit on that. The idea being that just like when you are on Netflix or when you are on Amazon, the company is trying to do the most it can with you and through that little window it has into your time. In the same way, from a conventional way of thinking about a company and its relationship with its employees, we always want a little bit, I would say, more done in this area. But you want to take it to an extreme now in thinking of a digital-first employee experience that is absolutely the best in the world, right, or among the best in the world. So there's a lot of effort that we are putting in, which will pay off in the next month. But with that, we expect to be able to tackle this aspect even when people are work from anywhere sort of mode. Coming to pricing, which you also touched upon, I think the pricing -- the work that we're doing on pricing can be broadly classified into 2 or 3 areas. One is, of course, you want to now choose new work, more based on pricing than you had done in the past. So you want to prioritize work that is actually paying better, and there's plenty of that. You also want to go back to your clients and inform them about what's happening in the job markets. Luckily for us, every client is more or less aware because most plan for themselves facing these challenges. And so that work is ongoing, and a number of clients have already agreed to price increases. Now in terms of how does this offset fully the wage increases and how long will it take? I think we say positive that across the different measures we are taking, we will offset these -- And when I say it may take a few months, I'm basically trying to see through to the end of the year. And there may be months or quarters, a quarter in between where it's not really offset. But overall, across the freshers that we are hiring out of colleges, across the efforts that we are making to -- in utilization and the efforts we're making in price increases, we do not see any major we -- do not foresee any major disruptions in our ability to deliver 15% adjusted EBITDA.

Okay. Understood. So follow up on pricing actions. That means if I put the things together, we would have to assume that gross profit margins would not become better before Q4 of this year, right?

Yes. The gross margin may not become better before Q4 of the year, right? Yes. And we're also being a bit conservative. I may also just add, there's also some conservatism. But it is what we have put down, and we would rather err on the side of conservatism on that.

Now coming to the next questioner. It is Martin Comtesse from Jefferies.

Yes, Manas and Gagan. I would like to just get some more understanding around your hiring at the moment because I think that's really the scent of the debate. You were hiring 1,150 people net in the second quarter, which is an absolute number is a bit higher than Q1. But in relative terms, it's actually a sequential step down, a small one from 12% in Q1 to -- from 13% in Q1 to 12% in Q2. Can you just give us a feeling for what would your ideal number of people be if you have the possibilities to hire people, would you hire 2,000 people? Or -- because many of your competitors guide for sort of a desired number of hires. Any color around that would be appreciated. And then also, can you also give us the share of fresh graduates in these people, just approximate? And then I would follow up with another question, if you let me.

Sure. So I think in terms of how many we would like to hire, we would like to hire several thousands, a few thousands at least. I mean, so as I said, we have a few thousand positions open constantly. And I don't have the exact number, but my guess is upwards of 3,000. So we definitely can do with a lot more people, right, so -- and deploy them almost immediately. So this is really supply constrained. And when I say supply constrained, I mean, absolutely choking for people. The only escalations we're getting are about the availability of engineers, right? So that's the biggest challenge. In terms of the breakup of people from colleges versus people hired laterally, I think it's a little bit complicated, of course, because there's also some attrition and the attrition rates are different and so on. But just roughly speaking, maybe about half and half, right, just maybe around half and half. Maybe a little bit more lateral, but roughly about half and half, if you would just take a bigger number. So yes, I think hiring has really stepped up. But this is a challenging environment to hire in. And we continue to look for ways to take it to the next level. And yes, we will keep coming back to this group with updates as and when we get there.

Perfect. That was very clear. My second question would be on the gross margin, and that ties into my first question, actually. You were basically referring to, a, an inflation in wages, which I think is understood. And the other part of higher cost is your not utilized staff, right? So the graduates that are currently sitting on the bench. You had a drop of around 400 basis points on gross margin year-over-year. Could you try to quantify sort of what share comes from higher wages and what share comes from an underutilization? Or maybe just give some color around the staff utilization at the current point in time?

Yes, I can give you some color. I think the -- it's -- I think it's not a good idea to compare it with last year. As I said, last year had a different dynamic altogether. We had, I think, 2 months in the quarter with salary cuts and significant salary cuts. So it's not probably a good comparison. But I would estimate that roughly 1% of margin is going towards these youngster maintaining these youngsters in training. On the other hand, there are -- just to be very transparent, we are also not running a typical bench, right? And so there's a number of different factors that are at play in the sort of very unusual environment. And we are trying to find the right balance, right? So it's a balancing act. We've always said that we shoot for 15% EBITDA, and we try to grow as fast as we can until we reach that, right? So that's kind of the way we are looking at it. We are not trying to maximize EBITDA. We are trying to just grow as fast as we can while keeping the 15% adjusted EBITDA.

Okay. And a last follow-up on this. You also mentioned COVID-19 disruptions on the gross margin. Can you specify what you mean by that?

Yes. So the numbers for the quarter were definitely impacted by the fact that maybe between EUR 1 million or EUR 2 million. And I'm just approximately speaking, of billing was lost because people were away in COVID situations personally or with their families. So there's some of that impact in there as well, right? So we are not quantifying it precisely, but there is that impact. On the other hand, there are some other effects like people not taking leave in a typical way that -- because they have nothing to do because of the lockdowns and they'd rather be working. So there are a number of factors that are working in different directions. But overall, we do feel that the net effect in Q2 was also -- there was a depressive effect on margin because of COVID-19, the second wave in particular. Thanks, Martin.

Next up is Andreas Wolf from Warburg Research.

I have a few. So one, Manas and Gagan, is relating to growth. Could you specify which fields are driving growth in particular, in terms of technology? Is it cloud? Is it more custom software development? Maybe you could provide some insight here. I guess it's across all fields that you are providing to the clients, but some additional insights would be helpful. The second is on price negotiations with the clients. I assume that you have observed similar behavior among competitors is this right? And then the third question is relating to the P&L items that you expect to compensate for the gross margin impact that you've seen coming from wage inflation and underutilization. Is it basically some cushion that you had in the guidance? Or is it lower travel and expense costs? I saw that vehicle costs and rent and building costs have declined in a year-on-year comparison. Maybe you could shed some light on the positive factors supporting the adjusted EBITDA margin guidance. And then it's probably kind of related to the targeted number of people that you have, but maybe you could provide some insight into the order book situation that you have. How has that developed year-on-year? Or what's the book-to-bill ratio if you have a figure comparable to that, if there is something that you track that you could share with us? That would be helpful.