Exlservice Holdings Inc (EXLS) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Second Quarter 2007 ExlService Holdings Inc. Earnings Conference Call. My name is Tawanda and I will be your coordinator for today. At this time all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of the conference.

(OPERATOR INSTRUCTIONS)

As a reminder this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Jarrod Yahes, Head of Investor Relations.

Please proceed, sir.

Thank you, operator, and thanks everyone for joining us today on our second quarter 2007 earnings announcement. Joining us from India are Vikram Talwar, our Vice Chairman and Chief Executive Officer, Rohit Kapoor, our President and Chief Operating Officer and Matt Appel, EXL's Chief Financial Officer. We hope you've had an opportunity to review the news release we issued last evening after the market close, as well as the PowerPoint presentation that's available for review on EXL's website on the investor relations section.

Let me very quickly outline the agenda for today's call. Vikram will first begin with an overview of our growth during the second quarter, including specifics on some of our new client wins. Rohit will talk about the operational highlights of the quarter and Matt will then take you through the financial details and also provide you an outlook for the year 2007 and then close the presentation before we take questions.

As you know, some of the matters we'll discuss in this call are forward-looking, and you should keep in mind that these forward-looking statements are subject to known and unknown risks and uncertainties that could cause EXL's actual results to differ materially from those expressed or implied by such statements.

Such risks and uncertainties include, but are not limited to, general economic conditions and those factors set forth in today's press release, discussed in the Company's periodic reports and other documents filed with the SEC from time to time.

EXL assumes no obligation to update the information presented on this conference call. During our call today, we may reference certain non-GAAP financial measures, which we believe provide useful information to investors and you can find reconciliations to those measures to U.S. GAAP on the press release. So let me now turn the call over to Vikram.

Vikram, please.

Thank you, Jarrod, and good morning to everyone. We are very pleased to report that the second quarter of 2007 was a very solid quarter for EXL. We delivered revenues of $43 million, which exceeded our expectations for the quarter. The continuation of our rapid revenue growth was driven by very strong momentum in BPO and advisory services.

The BPO business grew 8% sequentially and 58% year-over-year. The advisory business line again experienced record quarterly revenues of $3.4 million and grew 17% sequentially and 55% year-over-year.

As expected, our research and analytics business line experienced flat revenues on a sequential basis of $4.3 million. While we are excited about our current growth and the momentum in our business, we continue to focus on building a longer-term base for growth.

In this regard, we had a particularly strong quarter in terms of new client wins, which totaled 11, two in BPO, five in advisory services and four in research and analytics.

In the BPO business, we won a key finance and accounting engagement with a Fortune 500 transportation company. This win is exciting because of the profile of the client, the complexity of the processes and the entry into a new industry vertical domain for EXL.

In addition to the strategic BPO client win, we started BPO work this quarter for a digital media provider. Because of the normal lead times in the BPO business between contract signing and process migration, we would expect this new strategic client to have a more significant impact on our business in 2008.

We are also pleased to report that the pipeline of opportunities in the insurance vertical continues to look strong. With respect to the mortgage industry, I would also note that our risk of client downturn or failure is relatively low.

We have one client in the subprime segment that appears to have been negatively impacted, and this client accounts for approximately 2% of this quarter's revenue. And our core domain of insurance clients are also taking an increasingly strategic perspective on their relationship with EXL, and as a result we are experiencing a strong level of interest from C-level executives to further their outsourcing and offshore programs.

This quarter we migrated an additional 13 processes for our clients, nine of which are insurance related for clients in both P&C and life insurance. In the advisory services business line, as you may recall, we have committed investment to develop a suite of value-added services focused on the CFO.

I am pleased to report that these investments are beginning to earn us the desired traction in this business. This quarter, we won a transformational financial outsourcing engagement for a global investment bank in their capital markets area. This is noteworthy because it demonstrates our ability to penetrate the capital markets space, as well as rapidly scale our new offerings.

We believe we have a unique service offering in this area that is unparalleled by any of our competitors. We also won four other deals during the second quarter in the advisory services business line.

During the quarter, we continued to add management strength needed to leverage longer-term growth in this service line. While this had a slight impact on the quarter's profitability, we believe the investments will rapidly lead to growth and increased operating leverage.

As we reflected in our guidance last quarter, the research and analytics business line experienced a soft quarter from a revenue perspective. In terms of new [local] wins, the research and analytics business line won four new clients during the quarter. One is the wealth management division of a Fortune 50 U.S. bank. Another is a FTSE 100 global bank and another is a top 20 P&C carrier in the United States.

We believe that as we deliver client satisfaction and high quality to our research and analytic clients, they will serve as excellent points of entry for our BPO and advisory services businesses. We have also experienced continued success in cross-selling research and analytics services to EXL's BPO clients.

On a longer-term basis, we are encouraged by our ability to attract research and analytics business that is contracted and long-term in nature, as compared to traditional project-based work. While this shift will take some time, it will enable this business to grow and scale along with BPO business over the longer term. We believe that the second quarter was the low point for this business and we expect this business to begin to recover in the second half of the year.

During the second quarter, we continued to aggressively build up our front-end sales and marketing capabilities. We recently announced the hiring of Krishna Nacha as Vice President and Chief Sales and Marketing Officer. Krishna joins us from iGate, where he was a Vice President and member of the executive leadership team.

Prior to iGate, Krishna was at Infosys, where he was the Group Sales Manager in Insurance and Healthcare. We welcome Krishna to the team and look forward to his strong contributions to EXL.

In addition, we hired four additional salespersons during the quarter, as we continue to execute on our plan of continued investment in this area. As EXL continues to expand its vertical focus, we also continue to align our sales force to pursue opportunities within these verticals.

To augment the strong organic growth we are experiencing, we continue to look critically at strategic acquisitions to gain industry vertical and process competencies and to diversify the geographic base of our service delivery infrastructure.

In closing, during the second quarter, we continued to aggressively grow our business in this exciting marketplace. We believe that our strategy of providing a competitive edge to our clients by transforming and outsourcing their business processes is winning in the marketplace, and we will continue to focus on executing on the large opportunity set we have in front of us.

Now let me pass it over to Rohit to comment on our operations for the quarter.

Thanks, Vikram. To follow-up on the comments Vikram made, regarding our investments in the front end during the quarter, we continue to believe that EXL has a significant opportunity to deliver additional value to our existing client base. In order to better address this opportunity, we established this quarter a strategic account management function that will be led by Kal Bittianda in North America and Kulpreet Singh in the UK and Europe.

This group will focus on ensuring customer responsiveness and intimacy for existing business and identify and fulfill opportunities to bring additional value in the form of diverse service offerings within EXL to our strategic clients. The establishment of this group is an important milestone in the maturation of our business as we invest to better service our client base and grow our business over the longer term.

On the people front, our attrition has come down slightly from the last quarter, from 44% to 42%. While we certainly view this as a positive, we are more focused on the longer-term management of attrition through various organizational initiatives. As such, we will be investing in a new recruiting and training and development center in Noida, which is an important commitment to the development of management and leadership talent within the Company.

Strategically, we believe that retaining our talented human capital by providing learning and development opportunities will have a meaningful impact over the longer term. While we have significantly increased our focus and investments in the area of management development and training, our focus to date has been primarily on development of middle management and business leadership.

This focus will be expanded to include the agent population, with the expectation of enhanced employee engagement, as well as retention. During the second quarter, we added approximately 300 new professionals to our business. EXL has now reached approximately 9,300 employees. Please note that there will be volatility in the quarterly headcount additions associated with our business, based on the specific plans of our clients to scale specific processes, depending upon their business requirements.

From a customer satisfaction standpoint, our clients continue to express the view that our service delivery, communication, partnership model and responsiveness consistently meets or exceeds their expectations. This is a hallmark delivery capability of EXL, and we continue to make great progress on this dimension.

Now let me pass it over to Matt, who will provide more detail on our financial performance and guidance.

Thanks, Rohit. EXL's revenue for the second quarter ended June 30, 2007, increased to $43 million, up 71% from $25.2 million for the quarter ended June 30, 2006, and also exceeded our expectations for the quarter.

As compared with the first quarter of 2007, revenue for the second quarter of 2007 increased 3.1 million, or 8%, reflecting increases of $2.6 million, or 8%, in BPO, and $0.5 million, or 17% in advisory services. Within EXL's business lines, BPO accounted for $35.3 million, or 82% of total revenue in the second quarter.

Analytics contributed $4.3 million, or approximately 10% of total revenue, and advisory contributed $3.4 million, or approximately 8% of total revenue.

From a qualitative standpoint, BPO continues to benefit from both the growth in work performed for existing customers, as well as work for new customers. Advisory continues to benefit from strong demand for their legacy product set and their new value-added services offerings. And, as expected, research and analytics experienced a flat quarter from a revenue perspective.

Gross margin for the quarter ended June 30, 2007, was 33.1%, compared to 36.8% in the quarter ended June 30, 2006. In the first quarter of 2007, our gross margin was 38.6%. The decline experienced in the second quarter of 5.5% is primarily attributable to two factors, depreciation of the Indian rupee, accounting for 3%, and the impact of the annual salary increments that went into effect as of April 1st, 2007, which accounts for 2%.

From a gross margin perspective, we will continue to be at risk with respect to further appreciation of the rupee. While we have an active hedging program that delivered substantial cash flow during the second quarter, these gains don't help us, as you know, from a gross margin perspective and are not sustainable over the longer term.

Adjusted operating margin, excluding the impact of stock compensation expense and the amortization of intangibles, was 10% for the quarter ended June 30, 2007, compared to 13% for the quarter ended June 30, 2006, and 15.9% for the quarter ended March 31, 2007. The decrease in adjusted operating margin of 5.9% sequentially is primarily attributable to the 7% appreciation in the rupee, accounting for 3.5%, experienced during the quarter, and the impact of the annual salary increments for both direct and support personnel, accounting for 2.5%.

While we did not experience a significant increase in sales and marketing expense during the second quarter, several investments made in staffing in both sales and marketing, as well as strategic account management function this quarter will impact our sales and marketing expense as a percentage of sales in the third quarter. And this is reflected in our updated guidance.

As mentioned previously, the rupee appreciated 7% against the U.S. dollar during the second quarter. The flip side of this impact to our operating income is the results of our hedging program. During the second quarter, this program provided us with gains of approximately $2.3 million. On average, we hedged the majority of our exposure to the rupee and pound 18 months forward.

So therefore, to the extent the rupee stays at current levels of approximately 40.5 to the dollar, we would expect to see similar gains from our hedging program over the next two to three quarters, thereby protecting our net margins.

To complement our hedging program, we are redoubling our focus on expense management and the leverage of our existing infrastructure. We will continue to focus on maximizing seat utilization and improving productivity within the BPO business, as well as billable utilization within our project-driven businesses.

Secondly, we continue to seek equitable price increases from our customers in response to the cost pressures faced in India. On a longer-term basis, we will diversify our operating footprint from a geographic standpoint into other offshore and near-shore locations to better manage our cost and serve our customers

Now, with respect to our effective tax rate for the second quarter of 2007, the first thing I'd like to point out to everyone is that our second quarter is the first quarter of the India tax year. So, accordingly, this modification that we've made to our effective tax rate is made at the beginning of the India tax year, and it represents a change or a modification to the internal transfer pricing agreement between our India and U.S. entities to exclude the impact of the unusually high unrealized foreign exchange gains from the transfer pricing computation.

This change resulted in the reduction of our effective tax rate to approximately 5% for the quarter ended June 30, 2007, as compared to 17% in the previous quarter. We should receive some benefit from this change during the rest of the year, as long as the rupee-dollar exchange rate is maintained at approximately current levels.

From a balance sheet perspective, I'd like to mention that our cash balances have returned to more normal levels from first quarter levels due to a focus on collections. In addition, this positive impact on cash flow has helped to fund the $5 million we've spent year-to-date on our capital expenditure program. We expect that capital expenditures for the full year will fall between $11 million and $15 million as we accelerate spending in the second half for the new center that Vikram and Rohit spoke about. Before opening the floor for questions, I'd like to conclude by providing guidance for the full year of 2007.

Based on the strong revenue performance we've experienced so far this year, we are increasing our revenue guidance to between $168 million and $172 million, from $160 million to $170 million previously.

In addition, we are reconfirming our adjusted operating margin before stock compensation expense and amortization of intangibles at 12% of revenues for the full year. This guidance is predicated on the rupee-dollar exchange rate remaining at approximately current levels throughout the remainder of the year.

And with respect to our effective tax rate, we are providing guidance of between 10% and 15% for the remainder of the year. And, finally, we are providing EPS guidance for the full year of between $0.74 and $0.78 per share. We'd now like to open the floor for your questions.

(OPERATOR INSTRUCTIONS)

Your first question comes from the line of Dave Koning, with Baird.

Please proceed.

Yes, good morning, guys, and congrats on really nice results. I had a question I guess first of all on currency, just to be clear. It sounds like currency gains offset the quarterly drag. I just want to make sure that I'm understanding that clearly that it's not that the gain reflects your full 18 months' hedging all reflected at once. It sounds like those gains are recurring based on kind of the year-over-year rupee change. Is that a fair way to look at it?

Thanks for the question. The gains that we're reporting in the quarter reflect certainly not the 18-month program. They represent the impact of hedge contracts that closed during the second quarter. And those gains of $2.3 million are slightly higher than the drag, as you put it, that the rupee had on our operating margins for the quarter. That drag was about $1.5 million, so they're slightly in excess of that because the rates at which we hedged that for the contracts that matured in the quarter, those contracts taken a year-plus ago, are somewhat higher than the previous rates in the first quarter and earlier this year.

So our expectation, as I've suggested, is that those hedge gains, if rates continue, would continue at approximately these levels for the rest of the year.

Great. That's very helpful. So basically what we're seeing here is operating income is actually much better than you would have expected, given the currency moves and so because that's better, it ends up coming in line still and you're still getting the currency benefit on the other side.

That's a very fair and accurate characterization.

Okay, great. And then, finally, it looks like sequential BPO revs up 8% this quarter. The last several quarters, they were up 11% to 17%. I'm wondering if there's true deceleration in demand here, or if it's more just the way you're setting up your seats in more of a calculated move in terms of the timing of contracts coming on, et cetera.

Dave, this is Rohit. Let me address that. The 8% growth rate for the quarter and the 17% earlier, it all depends upon when we sign up strategic clients within the BPO business and when the ramp-ups take place. As you are aware, it normally takes us a long lead time to secure new clients within the BPO business and then the ramp ups will depend upon the customers' business requirements and the business environment.

So it's difficult to predict on a quarter-on-quarter basis. However, that being said, we do not really see any kind of slowdown for the growth rate of the BPO business and the better metric, as we have tried to articulate in the past, is to really take a look at the rolling last 12 months progression. And that progression will show you a consistent move up in the growth rate of the revenues from the BPO business.

Great. Thanks, and congrats again.

Thank you.

Your next question comes from the line of Ashwin Shirvaikar, with Citigroup.

Please proceed.

Hey, guys, congratulations on the nice quarter. The question I have is with regards to the new Noida center that opened I guess in late March or early April, you did not mention any tangible impact from that. Can you talk about that, how is the progression of filling up those seats proceeding?

Hi, Ashwin. This is Vikram here. The center itself is fairly full already. Part of the reason is that we did make a shift from one of our centers to the center to consolidate a client in that center because of the increased operations that we were seeing within that particular client.

The growth of business continues to fill our seats even in the center that has since been vacated -- or part of the center that's since been vacated. So to answer your question more specifically, the center that we have opened up has in fact fully been filled up and only a part of the existing center is left vacant. So we continue to require additional requirements within our seat availability. This is one of the reasons why we are in the process of building out a new center, which Rohit alluded to in his comments, partly for our training and development and partly to relieve us of space in our existing centers for greater growth from our existing and new clients.

And, Ashwin, this is Matt. To the extent that there is some excess capacity caused by what Vikram just explained, the financial impact really isn't all that significant, which is why we hadn't mentioned it.

Okay, and with regards to the salary impact, 200 basis points, that you mentioned, over the next I guess three quarters, that impact gets absorbed almost ratably. Is that a fair assessment?

That's a sustained impact over the remaining quarters and is reflected in the guidance and outlook that we've provided.

Okay, and a clarification on your hedging program. Are you continuing to roll forward the 18-month program, or is that -- because your comments sort of left unclear about what the impact might be headed into next year, assuming that the rupee stays where it is.

Yes, Ashwin, we look out 18 months kind of on a rolling basis, so we continue to place contracts at least 18 months out, to the extent that the rates, after reflecting the premiums, are attractive.

And so obviously we're not as hedged 18 months out as we are, say, three and six months out. But we look out on a rolling 18-month window. So I'm sorry to have misled you slightly with those comments.

No, no, no. And, again, congratulations on this great quarter. Let me ask a last question. That's on a non-India center. If you could comment what your plans, timeline and any competitive impact with regards to where you might want to set it up, Philippines or Eastern Europe and so on.

Hi, Ashwin, this is Rohit. We continue to make progress on that front and we've spent a fair amount of management time doing diligence in the various locations and the two locations that you mentioned are the ones which are in the front end of our radar screen. Philippines will be the first area that we'd be looking at establishing a presence and we think we are now close enough that we should be in a position to establish that within the next six to 12-month period.

Eastern Europe is slightly behind, as far as the timing of that is concerned but is a high priority for us as well. And we continue to make efforts to look at expansion in that geographic direction as well.

Great. Thank you. Congratulations again.

Thank you.

Your next question comes from the line of David Grossman with Thomas Weisel Partners.

Please proceed.

Thank you. I guess, Vikram, you talked pretty positively about the pipeline and the new client adds. And I'm wondering if you can help reconcile your backlog and your pipeline with the addition of new capacity, including both I guess the new center that Rohit talked about in terms of how should we expect that to ramp and what kind of visibility you have on I guess full capacity utilization not only of the new center you started or opened in March or in the June quarter, but also the new one that's planned. Thanks.

Sure, David. The new capacity that we continue to build, we always build out about six months in advance, as you know. Obviously, this cannot be a just-in-time situation. Also, the new pipeline, or the pipeline and the new opportunities I alluded to, is a combination of both new clients, as well as our existing clients. And the ramps in existing clients, as you will obviously believe the logical conclusion is that they ramp much more consistently and with a predictable pattern where we know precisely when these are going to happen because of an existing relationship.

And that area obviously gives us a fairly good indication of where we need to be with regard to our capacity and capacity utilization. New clients as they come onto the pipeline are slower to grow for obvious reasons and we project those further out into the year or even into next year. So the capacity utilization that I was talking about really takes into account both of those, and we believe that by building out the new center we will be very well positioned for our requirements, both into the rest of this year as well as into the early part of next year.

So is it fair to say that you, based on the current building plans for new capacity that you already have pretty good visibility vis-a-vis the backlog on utilizing that capacity?

We have a decent understanding of that. Obviously some of this is forecasts that we had built with our clients, particularly our existing clients and our expectations of how that will go out in the next six to 12 months.

David, I'd just like to add to that. One thing which you should be mindful of is this new capacity that we are adding on is again in an STPI location and it is our strategic intent to build out much larger blocks of capacity in a special economic zone and in an SEZ, and therefore for the next few months, until the time we are able to secure the correct strategic option on a special economic zone, we will be building incremental capacity such that we will expect our capacity utilization to run pretty high and be pretty close to the actual infrastructure that we have.

I see, so when is it that you expect that you could start construction in an SEZ zone?

That's a very difficult question to answer, David, and we are looking at several different alternatives in terms of being able to lease space in a special economic zone, in terms of owning space in a special economic zone and multiple options in multiple cities which are being pursued simultaneously. And, unfortunately, given the lack of availability, as well as lack of clarity of the government policies, we are unsure as to what the timing of that might be.

Okay, so the facility you just referenced then, that you're working on now, is in an STPI?

Yes.

I see.

We, however, do have applications out for SEZ, so it's actively being pursued, David.

I see. Actually, just while we're on that, is kind of the impact on the tax rate. Obviously your tax rate's coming down for other reasons near term. Matt, how should we think about the tax rate on a more secular basis kind of beyond '07? Should we go back to that 17%? Is that a fair characterization of a fully taxed number?

David, I think you can think in terms of the 10% to 15% number. So the guidance that we've given for the second half as a new level set in terms of 2008 taxation. Beyond that, 2009, if the tax holiday expires, we're in a different world, as you well understand. But I think 10% to 15% for the next six quarters is a fair view.

Okay, and just getting back to your commentary on the rupee, so as I understood your comment was that the FX gains of $2.3 million were about $800,000 higher than your estimated impact of the rupee on operating income. Did I understand that correctly?

You did. That's correct.

David, just to elaborate on that, that $1.5 million of adverse gain is really from Q1 to Q2. And the gain of $2.3 million on the FX is based upon the hedges that were taken up to 12 months prior to Q2.

But that matured during Q2.

Right.

But your guess of the net impact from both of them would be an $800,000 positive on the bottom line, right?

On a comparative basis.

On a pretax basis, I'm sorry.

But you really need to take into account the $600,000, if you're going to do a full comparison, so what the gains were in the first quarter, to be fair, as Rohit's suggesting. So our gains are $1.7 million higher than they were in the first quarter, so they just about offset dollar for dollar the $1.5 million that we were referring to.

I see, I see. And how should we look at the second half of the year? I think you said that gains would stay in this kind of $2 million to $2.5 million range in the second half of the year. Is kind of the math similar, kind of if you look at a rupee at about 40.25?

Yes, if the rupee stays at 40.5, I would expect something closer to $2 million per quarter, not $2.5 million. I think that's a very fair assumption, $2 million a quarter. Should it change, then we'll have the flip-flop, if you will, between operating and the hedge gains.

Okay, and in terms of the R&A business. I'm not sure if it was Rohit or Vikram said you thought that it had bottomed. Is that based on kind of the pipeline and the backlog of new business, that you actually have visibility on kind of a return to sequential revenue growth in that business?

It is some visibility, but bear in mind our objective is to transition to more annualized and annuity-based type of revenue and move away from the project-based revenue that we've been dependent on, and which is one of the reasons we are facing the situation we are on the lower revenues, with one of the major clients having more or less reduced their spend on this kind of business.

So, yes, we believe that it will start to build up, though not very rapidly, and we may see somewhat the same levels going forward over the next couple of quarters. But, yes, we believe we probably have bottomed out in terms of absolute numbers.

Okay, great. Well, congratulations again. Thank you.

Thank you.

Your next question comes from the line of Julio Quinteros with Goldman Sachs.

Please proceed.

Sure. Real quickly, just to go back to a couple of key metrics here, can you just give us the operating cash flow for the quarter, and I think I caught the CapEx number, but if you can just give us the free cash flow number for the quarter. And then just the last two items, ESO, stock compensation expense assumption for the rest of the year and your amortization of intangibles as well, please?

Sure. Let me start with the stock comp and the amortization of intangibles, if I might. Those numbers, we expect, will be relatively constant to the second quarter. Stock comp for the year will be approximately $4.5 million, and the amortization of intangibles will be $1.6 million. The intangible amortization diminishes slightly in the second half, so I think it's $1.4 million per quarter in the second half, so slightly lower than this quarter.

I'm sorry, the $4.5 million for the stock comp, that's for the full year?

That's correct, and $1.6 million for amortization of intangibles.

For the full year?

Absolutely, yes.

Got it.

So this impacts will be just slightly below in quarters three and four what we're seeing in quarter two, because some of our intangibles are fully amortized at this time, so there will be about 100,000 (inaudible).

Got it. And then on the cash flow?

Yes, from a cash flow standpoint, our cash from operations is effectively flat for the quarter. We did a great job of driving our collections, but with some buildups in working capital attributable to our revenue growth and our receivables, offset by the acceleration in our capital expenditures, cash is effectively flat on a free cash flow basis.

Okay, great, and then just maybe going back to a couple of quick things. And in terms of the front-end investments comments that you made and the whole focus on strategic accounts, can you just give us a sense right now on how many accounts you guys actually consider to be sort of strategic accounts, what your level of penetration is with those and what the sort of ramp opportunity is?

Sure. Julio, this is Rohit. In aggregate, we have approximately 58 client relationships. Of those 58 client relationships, we would categorize close to 20 accounts as being strategic accounts.

And the definition for strategic is what? I'm sorry.

The definition of a strategic account is an account which can build up to a potential annualized revenue of $5 million per annum. The function, as we are building it out right now, is still in its nascent stages, and therefore as we embark upon it in Q3 and Q4, we will not be able to cover all the 20 accounts. But our intent is by the end of the year, we would have dedicated account managers and account directors in the U.S., UK and Europe that will cover all of these 20 account relationships.

The level of penetration within these accounts varies quite significantly between the U.S. and UK. In the U.S., we believe that the penetration rate for the strategic accounts represents less than 2% to 3% of the addressable offshorable opportunity for EXL, and our clients within the UK are much more significant clients, such as Norwich Union and British Gas, and there the penetration rates are much higher. So we continue to see growth in those accounts, as well.

Okay, great. Thank you.

Your next question comes from the line of Cynthia Houlton with RBC Capital Markets.

Please proceed.

Hi. In your prepared comments, you had mentioned initiatives that you wanted to make to improve the gross margin, and then you also talked about initiatives to improve the attrition of your workforce. Obviously, that also has an impact on margins. Can you provide just a little bit more detail on kind of some of the tangible items that you think can help the gross margin line over kind of the next 12 to 18 months and kind of what's the most important initiatives, or which initiatives are most important to delivering the better gross margin.

Hi, Cynthia. This is Rohit, and I'll take that. So our gross margin for the second quarter was 33.1%, and if you take a look at the breakup of each of the three business lines, you'll notice that the gross margin for the R&A business was extremely low. For the advisory services business, is still lower than the average, and the BPO business has a gross margin of approximately 35% to 36%, even in the second quarter.

So number one focus is going to be to bring up the gross margins of all the lines of businesses and that will help us improve the overall gross margin for the Company. Number two is going to be to be able to improve the capacity utilization, the shift utilization and to be able to get operational efficiency in terms of service delivery capability.

Number three is going to be to decrease the attrition levels that we currently experience and to be able to reduce the cost of attrition and recruitment and training and development as we work on customer processes. So we see that there are significant areas of opportunity for us to work on, and we will be making adjustments to our cost structure, given that.

The other element that we would also be focusing on is on pricing, and as far as pricing with our customers is concerned, we are seeing much better acceptance with our clients, which are agreeing to annual price increments and now with the rupee volatility, we are also seeing a softening of their stance in terms of allowing us to structure bands of exchange rates within which the pricing is fixed. And we are seeing most of our new customer contracts being signed and negotiated on terms that will give us protection on the foreign exchange rate currency movement, as well.

So we think as we make progress on the pricing dimension, as well as on our cost structure, we'd be able to improve our gross margins.

Great. And then just a quick follow-up on just where seat count ended up, or where we are with seat count, and then kind of what we should assume in the second half in terms of additions and what that will do to the margin?

Cynthia, the seat count at the end of the second quarter was 6,800. And, I'm sorry, your follow-up question to that was?

I'm sorry, just plans for the remainder of the year.

Well, as we said, that we are building out a new training and development center, along with the ability to free up some incremental operational capacity, and that's going to give us an increased capacity of approximately 300 seats incremental. And the way in which we are going to be building up incremental capacity, at least until the time we get clarity on the SEZs, is going to be in small, incremental stages of between 300 or so each time that we create additional infrastructure.

Great, thank you.

(OPERATOR INSTRUCTIONS)

Your next question comes from the line of Mitali Ghosh with Merrill Lynch. Please proceed.

Mr. Ghosh, your line is open.

Hello?

Yes, hi, Mitali. Go ahead, please.

Yes, hi, thanks. On the comments that you just made on the gross margin, can you just take us through what is the kind of further scope there is to improve gross margins from the utilization lever and therefore some color in terms of where we are on shift utilization and capacity utilization?

So, Mitali, from a shift utilization perspective, we continue to operate at a shift utilization of approximately 1.3, and as we've stated previously, with our more mature clients, we end up working with a shift utilization of about 1.8, and therefore the upside for us is really to progress our business from a shift utilization of 1.3 to 1.8.

One of the other elements which we are seeing as far as our clients are concerned is that they are allowing us to do more daytime work and they are giving us the flexibility to be able to use and share the seats and the infrastructure with other clients. And as that progression takes place of customer acceptance of allowing the infrastructure to be shared, we think there is an opportunity for us to improve the shift utilization and improve margins thereof.

From a capacity utilization standpoint, the new incremental capacity of 1,200 seats became operational in the second quarter, and that will get absorbed before the end of this year. And, as we said, we will be building out new capacity in small, incremental steps. And that's why we would expect to have fairly high capacity utilization going into Q4 of this year.

Thanks. And, secondly, just on the sales and marketing side, which you have built out this quarter as well, just wanted to understand where we are on that buildout plan, how much more you plan to expand it by. And, also, are there any other key management positions that you're looking to fill?

As I mentioned in my comments, Mitali, this is Vikram, hi.

Hi.

We have added at least four people at the moment in our sales force and we continue to look at additional people, both in the sales force, as well as in our strategic account management function that Rohit alluded to in his comments. We believe we will continue to add several more people here over the next six months, people both in terms of sales as well as domain experts. And our strategy there is to add high-quality, highly experienced individuals with extensive domain expertise in our strategic account management area, particularly in insurance, as well as in the mortgage area, two areas of focus for us with our domain expertise.

What we expect to get from these domain experts is the ability to deepen our relationships, create the necessary credibility of knowledge with our clients, particularly in the area of outsourcing and transformation and that resource will be critical in our development of our strategic accounts.

So this exercise will continue to go on, not only during the course of this year, but we will continue to add people in the first half of next year.

Just on that, what is the total size of the team you have now? The sales and marketing and the domain experts?

We have about 20 people at the moment. Some are in the transition of being added. We have a domain expert coming on board literally next week, so it's volatile, and we hope to have that person really add substantial knowledge to us in the insurance field. So it's around 20 at the moment.

Thank you. And, finally, if I may, just one last question, you did mention in your opening remarks that you have only one client who operates in the subprime mortgage market. But just given the current worries that investors have in terms of possible impact for the entire banking and financial services sector, any thoughts on in what ways that could really impact business from your existing client base on your new wins, maybe how much of your business is transaction pricing linked? Any color on that would be extremely helpful.

The one client we do have in the subprime area that I talked about provides us only 2%. It is not transactional-based. It is based on FTEs. We are in constant touch with our client, as things develop. We have not seen any major issues arise at this point in time.

However, this is a very volatile market, as you know. With regard to our pipeline, we are obviously very cautious about this particular area and will take adequate safeguards as we get into new relationships with clients, particularly in this space, because of the current environment that the industry is facing.

Right. And how much of your total business is transaction pricing?

Our transaction pricing business is relatively small. We basically are focused more on -- as you know, our primary business relationships are with Aviva and with British Gas. Both of those are either FTE based or headcount based on a cost-plus basis.

I would roughly estimate somewhere in the region of between 15% to 17% may be transaction based, so it's relatively small.

Sure. Thank you very much.

Your next question is a follow-up from the line of Ashwin Shirvaikar of Citigroup.

Please proceed.

Thank you for taking the question. I just wanted to completely clarify, because many questions have been asked about your earnings power here, which seems to be quite impressive. But just to summarize, without the currency move in May, you could have had an adjusted operating margin of roughly 14%?

That's correct. Yes, that's correct, Ashwin. You understood correctly.

Okay, and then a follow-up question on the SEZs. You said you have a couple of applications out. I would just like to try to possibly compute the tax impact headed into 2009, which is difficult, but let me take a shot at this. For how many seats do you have the SEZ applications out, and then the related question is as you invest, for example, in the Philippines, you will also avail there of the local tax holiday, right?

Yes, Ashwin, that's correct. The applications that we have out for an SEZ is actually to acquire the minimum amount of land which is required for an SEZ, which is 25 acres. And so if we were to acquire an SEZ of our own, it will allow us the opportunity to build up capacity gradually over a period of time, and that's going to be fairly substantial and significant capacity that we can build up.

The requirement by the government is to build it up over a period of three to five years and therefore there is adequate room to be able to invest in the real estate and then build up the infrastructure over that time period.

Okay, and last question, in your advisory business, if you could break it out into the risk versus the process part of it and comment on the recent Sarbanes-Oxley changes versus the demand you are seeing in process advisory, which I believe is strong.

So on the advisory business, the reliance on the SOX part of the business continues to come down and in the past it used to be as high as 80%. Right now, it is somewhere south of 60% and in terms of the advisory business, the other element which is happening is there is a shift towards handling this business out of India, which is much more recurring, and much more of an annuity work stream.

The breakup between the process advisory and the risk advisory is not something which we have regularly, but just as an indication, the process advisory business would represent perhaps close to about 15% or so of the revenues.

Thank you very much.

Your next question is a follow-up from the line of Dave Koning with Baird. Please proceed.

Yes, thanks, guys. Just a couple of follow-ups. First, if we just take Q2 revenues and flat line them for the rest of the year, we get pretty near to the midpoint of your new updated guidance range, and that just seems to be reasonably conservative, given kind of demand trends.

I'm wondering if what you're seeing from a demand perspective would imply that that revenue should go up sequentially kind of the rest of the year, or if there's something that would lead them to be kind of flattish.

Dave, the way we've kind of arrived at that guidance is that we have taken into consideration the existing customer contracts that we have in hand, the new customer wins and the pipeline that we can see. And we have also factored into it the kind of risk and the possible downtrends that might take place with some of our client relationships. And it's basically after factoring in all of these assumptions that we've come up with an assessment that a realistic level for the Company to achieve in terms of its revenue guidance is between $168 million to $172 million.

Dave, I would add that we've also factored in the risk in terms of exchange, since, as you know, half of our revenue is denominated in pounds. So we have some risk in terms of movement of the pound there.

Okay, great. That's very helpful. And then, secondly, I know it's far too early to perfectly forecast '08, but a couple of things. Just to kind of reinforce, one is you still would expect Aviva 10% to 12% or so of [res] to kind of go away in Q1 and then, secondly, just I guess on -- I'm sorry, on the currency impacts to '08, if we just flat line currency at 40 to 41 for the rupee, we'd expect probably margins to stay maybe somewhere around where they are now. But by Q2 of next year, you don't get the currency benefit through the exchange line anymore.

So I'm just wondering how to think about currency. Is that a pretty big headwind in '08, or is there any context you can give there?

The currency headwind will start to come into -- will start to -- it will get stronger toward the middle of next year, so your characterization of that is correct. Given the extent of our hedging program and the rates at which we're hedged, that net margin hedge would start to fall away in the middle of next year.

What I would add to that, David, is that the opportunity for us really is that once the R&A business gets back to steady state revenues and profitability, that actually will give us a headwind in terms of building up our margins back to normal levels.

Tailwind.

Yes, tailwind, sorry. I'm sorry.

Great, thank you.

Your next question is a follow-up from the line of Julio Quinteros with Goldman Sachs.

Please proceed.

Real quickly, just to follow-up on two questions. First, on the STP, the percentage of revenue that comes from STPs today?

It's 100%, Julio.

Okay, that's what I thought. And then when we look at the R&A and the risk advisory business, what percentage of that work, if you could break that up, is from the BFSI vertical today?

The majority would come from -- I would say at least 80% would. Correct me if I'm wrong, but I would say 80% comes from the -- if you take them both together.

Okay, good. Thank you.

And at this time there are no further questions in the queue. I would now like to turn the call over to Mr. Vikram Talwar for the closing remarks.

I'd like to thank all of the participants for the excellent questions, and appreciate your time. Thank you very much and look forward to seeing you next quarter.

Thank you.

Thanks, everyone.

Ladies and gentlemen. That concludes your presentation. You may now disconnect, and have a great day.