Nagarro SE (NA9) Earnings Call Transcript & Summary

Good afternoon to everyone. Welcome to Nagarro SE's H1 2023 Earnings Call. You should have received a copy of the earnings release for Nagarro's second quarter 2023 results. If you have not received a press release, a copy of the release as well as this presentation is available on nagarro.com in the Investor Relations section. Representing Nagarro on today's call are Manas Human, Co-founder and Custodian of Entrepreneurship in the organization; and Gagan Bakshi, Custodian of Strategic Finance. Before I pass you over to Manas Human, 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 or the notice on reported results that are non-GAAP measures. [Operator Instructions] With that, it is my pleasure to hand you over to Manas Human.

Thank you, Dan, and hello, everyone, and welcome to this earnings call. First, a short word about Nagarro, to those of you who are new to Nagarro. We are a leader in digital transformations for blue chip clients. We listed in 2020 with a revenue of around EUR 430 million that year . And we have grown rapidly in the meantime, and have new guidance out for EUR 915 million in 2023. Now in our first Capital Markets Day in 2020, we presented this slide. And I'm sharing it now because I think it helps to understand our current context as well as our future opportunity. In this slide, we showed Nagarro as a company with a digital engineering DNA. But somewhat different from the other excellent companies in this group in that we do have great engineering, but we have aspirations beyond that. We really wanted to think enterprise, to build deep enterprise knowledge, to build deep industry knowledge, to be involved in a large number of industry-specific topics and in fact, to invest substantially and deliberately to diversify ourselves across many industries, across many geographies with the ultimate goal of one day being one of the world's great companies -- great global companies and with an additional goal of derisking that journey. And as we said on the right, we engage each client with a distinct, superior, Nagarro way of working with a lot of intimacy and an agile mindset and a lean, small team culture. And I'm saying all this, and I'm sort of showing this old slide from 2020 because I think this long-term lens of who we are and where we are coming from historically helps explain Nagarro's current context. For example, this differentiation helps explain some of Nagarro's resilience and strength right now in the face of the environment confronting our digital engineering peer group, and some of the challenges do apply to us, but we also have some extra resilience and strength. Also, it helps explain Nagarro's unique opportunity in the future around AI-led transformation and data-driven transformation, which I'm sure you all have a lot of questions about. With all the interest around AI on one hand and Nagarro's intrinsic strengths on the other, which are listed here, these are very well suited to AI interventions. This gives us a great opportunity to get even more strategic for our clients with AI and move up to the next level with our clients to get to a better client engagement, move up the value chain. In fact, as many of you who have studied the company for some years may know, many of our flagship projects over the years have been around decision optimization and decision support with math and data. For example, factory scheduling and inventory optimization for pharma or supply chain optimization for fashion retail, which is very dynamic or vehicle routing optimization for logistics or ticket pricing optimization for airlines or process informatics for jet engine manufacturing and so on. And these case studies, they reflect the backgrounds and interests of some of the early Nagarrians, including myself, my own academic and experiential background is in these areas. And they also reflect some of the latent capabilities in the company. Even internally, our business operating system called Ginger, that we talk a lot about, is around data-driven transformation, data-driven decision optimization, using data science, using AI and in fact, it's now getting traction at clients as they start to think about what AI can do for them. So we have a lot of experience from the past that we are now finding is very relevant for decision AI with how the odd dynamics of the client should be orchestrated, how the change management should be run, how data should be handled, how the UX should work and so on. Also for many years, and again, some of you may know this, we have been investing to build a great AI and big data team, led by Anurag Sahay, who some of you may have heard, he is a total Rockstar and we have invested in many client projects to build serious technical capabilities and serious consulting capabilities around these topics. And then on top of that, we have our thinking breakthrough innovation framework that we launched several years ago, which by now almost all our accounts are using in some form or the other, which is easily extensible to the subjects of decision AI and generative AI. So today, the news is that we are bringing all this together. And we have launched a systematic program to take charge of the AI-related conversations at the CXO level at all our top clients. We are calling this the "Fluidic Enterprise AI" initiative. With the Fluidic standing for agile, adaptive, experience-led and personalized. And I won't talk very much about it here, but I just wanted to give you a quick taste of that. For our clients, this transformation to embrace AI is, we believe, not a 3-month journey, not a 30-year journey, but perhaps a 3- or 4-year journey. And we want to be with them all the way and ideally lead the way with them, show the way for them, right? And just like I've shown you this slide from 2020 today in 2023, I hope in 2026, I can show you the same slide and just explain how we have achieved what we set out to achieve, how consistent we have been and how this has been able to transform not just our clients, but also Nagarro's place in the industry and how Nagarro is perceived in this world of technology services. So that was the background and context setting. Now let us get to the here and now. Let's talk about the highlights of quarter 2. We believe that it was Nagarro's diversification that allowed it to continue to grow. It grew 10.7% year-on-year in constant currency, of which 8.7% was organic. Most accounts developed well and we continue to score new wins and the accounts generating over EUR 1 million in revenue over the trailing 12 months were up at 168 at the end of June from just 131 a year ago. Our Net Promoter Score was high at 63, which means the client satisfaction was excellent. By the way, this client satisfaction also comes out in every client conversation that we have been having even when clients have had to pull back on some projects, which has happened for some reason or the other, especially in horizontal tech and banking. The client relationships have stayed strong. We expect that we will be able to bounce back at most of these clients once demand returns. Just as in 2020 and with COVID, we were forced to offer our clients at that time some pricing cuts and some concessions on payment terms but things bounced back in 2021. Still, that said, the bounce hasn't happened yet, and our revenue expectations for 2023 have changed. Foreign exchange is also -- rates have also had an impact. So we have revised our revenue guidance downwards last week. The changed revenue expectations, along with a sudden sharp drop in attrition, which is now less than 5% have left us with more excess capacity, excess production capacity than we had expected. Now we have taken a long-term view on this. And being a growth-oriented company, we have really put a lot of emphasis on protecting our employer brand. And also watching out for a potential resurgence in demand. So we have avoided dramatic layoffs. Instead, we have taken many small steps to rationalize cost and head count to where they need to be. The benefits of this cost rationalization will mostly accrue in Q3 and Q4 because there's a little bit of a lag. And then, of course, they will carry through -- carryover into 2024. To share one important example of cost rationalization, we actually renegotiated the contracts for nearly 14,000 employees to insert an EBITDA-linked organization bonus into their existing compensation structure, which will give us considerably more flex in future years. The idea is to never waste a good crisis and to emerge systematically improved. Now we could have cut deeper if we had made a temporary cut, but we decided instead to make a shallower cut and make it a forever thing, a flexibility asset for the future. Now on this slide, we have spoken about the fluidic enterprise AI initiative already, so I won't go into that again. Let me talk a little bit about ESG. On ESG, we improved our efforts across multiple areas. Professor Vishal Gaur, was ported on to our Supervisory Board. Vishal is the Dean of Cornell University's S.C. Johnson School of Business and a professor of topics very relevant to [ the cover ] today, especially when it comes to creating solutions around data and AI for clients. For those of you who do not know the Cornell Business School, it was ranked by the Financial Times, the FT, as one of the top 10 business schools in the world and Vishal is a Dean there. The Supervisory Board now has 4 members and 3 of the 4 are independent. Also on ESG, we have been stepping up our engagement with ESG rating agencies, such as CDP, EcoVadis and ISG and also with industry initiatives such as supplier assurance for the automotive industry. We have just recently announced that EcoVadis has upgraded Nagarro to Bronze Medal status, and we expect other agencies to also reevaluate us in due course. Now moving to the quantitative view of the quarter. Revenue for Q2 2023 was EUR 227 million. Gross margin was 25.3%, accounting for the excess capacity in the bench and in the business units. Adjusted EBITDA was EUR 28.9 million. In general, we felt that, the more traditional industries did better. The rest of Europe grew fastest year-on-year on a small base, while North America was affected by its exposure to Horizontal Tech. Our top 5 clients accounted for just 14% of revenues. We ended the quarter with a cash balance of EUR 99 million. Last week, we put out a revised guidance for 2023 of EUR 915 million revenue, 26% gross margin; and 13% adjusted EBITDA margin, and we will come back to this later. The best-performing industries on a year-on-year basis were Energy, Utilities and Building Automation followed by Automotive, Manufacturing & Industrial and Life Sciences & Health Care. The weakness in Horizontal Tech, we have already spoken about. Now you may notice some changes in Public, Non-Profit and Education, but these are mainly due in our opinion to some lumpy demand timing kind of thing and should not be systemic. We remained low in terms of client concentration, as always. Our list of top clients from a year ago is more or less the list of top clients now, barring the one special client situation that we have described in the H1 report. In this top clients list, there has been very little movement. There's been some movement up and down. But all these relationships are very good and very strong. So if you think about it, we keep adding more clients at one end of the funnel, but the existing ones also keep growing and the churn is very low. You can see that the development of the different client regions has, for us, been more or less driven by the dynamics of the industry, the verticals. North America has lost its place because of its exposure to Horizontal Tech. And also, as I said, because of some demand timing in the Public sector and accounted for just 35% of revenue in Q1. But we all know that business in North America bounces back rather quickly. We are waiting for the bounce. In terms of people, we have had almost 0 net hiring because we already have significantly excess production capacity. And the increase in head count in this quarter is almost totally due to acquisitions. Now over to Gagan to say a few words on the balance sheet and cash.

Thank you, Manas. Hello, everyone. Let's first review the balance sheet. In the left-hand chart, you can see the balance sheet position on June 30, 2023. We reported financial liabilities of EUR 273.6 million, which consists of our syndicated credit, [Audio Gap] bank loans and liabilities [ to banks ]. [Audio Gap] lease liabilities stood at EUR 52.2 million. And with a positive cash balance of EUR 99.3 million, our net leverage was EUR 226.4 million. Given our LTM EBITDA of EUR 139.7 million, our net leverage ratio came out at 1.6x at June 30. The company's liquidity position at the end of June was comfortable with a working capital of EUR 167.1 million. Now on to our cash flows, which are shown in the right-hand chart. For the 6 month period ended June 2023, our total cash flow was negative EUR 16.2 million as against negative EUR 26 million for the comparable period last year. Let's break it down further. Our operating cash flow for the 6-month period ended June was EUR 15.4 million as against EUR 15 million for the comparable period last year. There was a reduction in net cash flow from factoring of EUR 11.5 million and an increase in trade receivables and contract assets of EUR 7.8 million relating to new acquisitions. Days of sales outstanding, which are calculated based on the quarterly revenue and include both contract assets and trade receivables were at 79 days at the end of June. Cash flow from investing activities for the 6-month period ended June were EUR 51.2 million, and this outflow was mainly due to payment obligations for new and old acquisitions. The outflow of cash in the comparable period last year was EUR 39.2 million. We also reported a CapEx of approximately EUR 2.5 million for the 6-month period. which is only about 0.5% of our 6-month revenues. And finally, our cash inflow from financing activities for the 6-month period ended June was EUR 19.6 million, as against a cash outflow of EUR 1.8 million in the comparable period last year. Major items of cash inflow were net proceeds from bank loans of EUR 52.7 million which were offset by cash outflow of EUR 12.2 million for lease payments, EUR 5.2 million for interest payments, and EUR 16.4 million for share buybacks. A quick update on our ongoing share buyback program, under which we have approval to purchase up to 350,000 shares in 3 tranches of EUR 10 million each, and subject to a EUR 30 million limit overall. We're glad to announce that 2 tranches of the buyback have been completed, and the third tranche is well underway. Also, as mentioned earlier in the presentation, we're happy to report that the accounts for the 3 latest acquisitions Infocore, MBIS and APSL were consolidated in Q2. With this, I hand over back to Manas. Thank you all.

Thank you, Gagan. So now this is our guidance again, and we have already referred to it. And I expect there will be a fair number of questions around it. This is a slow year for sure, but we remain very bullish for the medium term, and we would like to reiterate our expectation that this company can grow at 20% organic revenue growth in a typical year in the medium term. And we reiterate our commitment to push towards 18% adjusted EBITDA in 2026. So now this guidance slide, I think, sets us up very well for the Q&A, which I expect you all will be waiting for. So let me hand these things back to the moderator to run the Q&A. Over to you, Dan.

[Operator Instructions] I will introduce or read out the first question. Okay. Our first question is from [ Retoras Jovan ], who is an individual investor. Hi, Manas and the team. I was wondering if you are considering any new potential acquisition target during the second half of the year.

Thank you for the question. Yes, we continue to look at interesting companies that can add value to Nagarro's growth story. And we don't have any concrete plans, but we do have several companies in the pipeline that we are evaluating.

The next question is again from Retoras Jovan. In the press release, you said that you will defer salary increments from August to the end of the year. How do you expect this to impact your ability to remain attractive in order to keep and recruit new talented people?

I think there won't be a significant impact. The labor market is a little bit more employer-friendly than it has been. As we said, attrition is at an all-time low almost with just below 4% actually. So we do think that we will retain the ability to attract talent. And people will understand that we are in a tight position as an industry and the -- we are also sharing the pain in some way.

The next question is a phone question. It's from Andreas at Warburg Research.

Thank you. Congratulations on achieving growth in a difficult environment. My question is regard the visibility for the remainder of the year. So I would assume that given the fact that we are already in August, visibility should be pretty good, and clients should have committed to the projects that they would like to carry out with Nagarro. That's my first question. The second is on the type of discussions that you've had over the last couple [Audio Gap] economic headwinds? Or is it mainly large clients being more cautious. If I look [Audio Gap]

Andreas, I think you will have to repeat the second question because your voice was fading in and out. If you can just repeat the second question, please.

[Audio Gap] that you're having with your clients. Is it -- does it mean the bigger clients cutting back the IT spending, if I look at your 1 to 10 biggest clients, it seems like it's mainly the big clients who are cutting back. And then in general, on the EBITDA link that you have now implemented [Audio Gap]

Dan I think we will have to maybe wait for Andreas to call back in. In the meantime, maybe I can answer the questions that he has raised -- that I think he has raised that I could fully grasp. So the first question was around visibility for the remainder of the year. And we think we have good visibility through the remainder of the year, but there is, of course, the uncertainty around how the project staffing levels will run. So I would say we have fair visibility. I would not emphasize this too much that we have superb visibility, but it's fair. And in terms of our -- which clients are cutting back, as I mentioned in the first slide in our H1 report, there is a very specific case of an inherited Build-Operate-Transfer clause with one of our clients, one of our big clients that came to us through an M&A. And we don't typically do such clauses, but we had this one with this particular client. And this client had also a particular situation, a pre-IPO situation where they wanted to pull in their team. So this has impacted us in a way that is not actually -- there's no other client in our portfolio that has that. But in general, what we are seeing is it's more of a vertical thing, it's more a Horizontal tech thing or a banking thing typically, but not so much a large client versus small client. So I think that pattern is not so easy to discern. Andreas, sorry, I think I got your questions. I'm not totally sure I got them all right, but Dan maybe we can move to the next question.

The next question is from Nicolas David. He actually has 2 questions. The first question is, could you please comment SE sequential evolution of the demand in Q3 versus Q2, generally speaking, and more specifically in the tech sector? The second question is, should we expect some exceptional changes -- charges, linked to the measures taken in order to reduce the production overcapacity.

So as a policy, we are trying to minimize adjustments to our EBITDA. And where we just have a 2-month notice period that will -- we will not -- we don't plan at the moment to take exceptional charges for that. But where it involves further restructuring, more deeper restructuring, we might take those charges. But at the moment, we have not factored any of those in. In terms of the evolution of demand from Q3 -- Q2 to Q3, this is typically quite consistent, and there are no significant trends. What is more important is the number of working days in each month and things like that. But we don't see any particular trend from Q2 to Q3 that is worth highlighting here. Thanks, Nicolas.

The next questions are from Martyn Jones at Liontrust PLC. So can you please give some additional color on the particular geographies and sectors where you are seeing weakness? Given your past experience, could you see these areas recovering? The second question is on capital allocation, can you reiterate your thoughts on future debt reduction versus further share repurchases?