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Edited Transcript of LXFT earnings conference call or presentation 11-Aug-17 12:00pm GMT

Thomson Reuters StreetEvents

Q1 2018 Luxoft Holding Inc Earnings Call

Zug Aug 16, 2017 (Thomson StreetEvents) -- Edited Transcript of Luxoft Holding Inc earnings conference call or presentation Friday, August 11, 2017 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alina V. Plaia

Luxoft Holding, Inc. - VP of Global Communications

* Dmitry A. Loshchinin

Luxoft Holding, Inc. - CEO, President & Director

* Evgeny Evgenyevich Fetisov

Luxoft Holding, Inc. - CFO

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Conference Call Participants

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* Alexander Vengranovich

Otkritie Capital International Limited, Research Division - Research Analyst

* Alexey Ilin

* Arvind Anil Ramnani

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Ashwin Vassant Shirvaikar

Citigroup Inc, Research Division - Director and U.S. Computer and Business Services Analyst

* Georgios Kertsos

Berenberg, Research Division - Analyst

* Joseph Dean Foresi

Cantor Fitzgerald & Co., Research Division - Analyst

* Maggie Nolan

* Moshe Katri

Wedbush Securities Inc., Research Division - MD and Senior Equity Research Analyst

* Steven Mark Milunovich

UBS Investment Bank, Research Division - MD and IT Hardware and EMS Analyst

* Vladimir Bespalov

VTB Capital, Research Division - Analyst of Industrials, Transportation, Infrastructure, and Chemicals

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Presentation

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Operator [1]

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Greetings, and welcome to the Luxoft Holdings, Inc. call to report results for the 3 months ended June 30, 2017. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Alina Plaia, Vice President and Investor Relations Officer. Thank you. You may now begin.

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Alina V. Plaia, Luxoft Holding, Inc. - VP of Global Communications [2]

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Thank you, Rob. Good morning, good afternoon to all. Welcome to our earnings call. We hope that you reviewed our earnings release filed last night. The updated materials including the press release and the company's fact sheet are on our website, luxoft.com, Investor Center.

Also please note that quarterly highlights slides are accessible during the webcast.

Our speakers today are Dmitry Loshchinin, the President and Chief Executive Officer; and Evgeny Fetisov, Chief Financial Officer.

As always, I have to notify you that some of the comments on the call today may be deemed as forward-looking. They include our business and financial outlook, any comments with respect to high potential account development, development of our Luxoft digital business, integration of our acquisitions and the answers to some of your questions. These statements are subject to risks and uncertainties as described in the company's earnings release and other filings with the SEC.

In reporting of our financial statements, we follow U.S. GAAP accounting rules. However, during our calls and in investor materials, we will also refer to certain non-GAAP financial measures that we consider relevant for the better understanding of our dynamic.

Now I would like to pass the line to Dmitry who will give you an overview of the first quarter performance, highlighting some headwinds, opportunities and achievements for the quarter. Then Evgeny will give more details on financials as well as in our guidance.

Dmitry, please go ahead.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [3]

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Hello, everyone. Welcome to Luxoft's earnings call for the first quarter of the fiscal year 2018.

This quarter, we delivered 2009 -- or $209 million in revenue, which represents growth of over 17.5% year-over-year. Revenues, in addition to seasonally weak pattern, were affected by the expected slowdown in the top 2 accounts with DB slowdown currently trending closer to the bottom of the guided range to 20%. Additionally, we see headwinds from the financial services vertical and slower business growth with the 2 large accounts acquired through M&A. There, softer growth versus our initial plan is due to the internal reorgs in those 2 accounts. At the same time, the rest of the business performed close to the plan.

Looking at today's snapshot, we can say that Luxoft business is structurally sound. Outside of top 2 accounts, the business is growing 55% year-over-year. We continued to rebalance the bulk of growth from entry accounts into HPAs and from Financial Services into Automotive, Digital Enterprise and Telecom.

Top themes of expected revenue growth for the remainder of the year are as follows: In Automotive, which should grow above 35%, revenue is driven by demand from most European OEMs and major Tier 2 suppliers for software development around autonomous driving and digital cockpit.

Luxoft Digital Enterprise is expecting growth above 20%, fueled by demand for talent to fulfill complex engagement. This usually require knowledge of (inaudible) disruptive technology and deep domain expertise that would allow the best application of these technologies in a given end market.

Telecom vertical is forecasted to grow above 40% as we continue to build on synergies from prior acquisition and expand our relationship as one of the top 10 Fortune customers, which is our fastest growing top 5 client.

In Financial Services, growth is expected to be driven primarily by engagements around digital transformation, regulatory and platform consolidation and capital markets and wealth management. I will give you more details on key business segments in a few minutes.

High potential account portfolio is a key driver for the underlying strong performance of all segments. For the first quarter, HPA delivered $77 million in revenue. Now they represent 37% of the total revenues versus $42 million in revenue and 24% concentration in the year ago quarter. This implies 82% year-over-year revenue growth for the HPA group as a whole. We believe HPAs will end fiscal year 2018 with over $340 million in combined annual revenue, representing around 50% year-over-year growth for the whole group. This is at least 35% contribution to the overall top line for the financial year 2018 versus 29% in 2017.

Incurring new high potential accounts and increase in concentration of the HPA portfolio supports an ongoing derisking of our business model and substantial reduction of concentration of top 1 and 2 customers. This quarter, each account delivers 17% of the total revenues, corresponding to about 10 percentage point concentration decline for DB and about 7 percentage point decline for UBS on year-over-year basis.

For the full 2018, top 1 account, which is UBS this year, is still forecasted to be flat, and top 2 account, which is now Deutsche Bank, is expected to decline close to 20%. We expect DB finishing this financial year being around 15% of total revenues and UBS to achieve that concentration shortly thereafter.

At the same time, we foresee the following headwinds for the next 3 quarters. First, current budget reduction in Deutsche Bank are taking place at the top level of the announced range, 20%. Second, we are revisiting -- we are revising annual forecast for some of the acquired accounts, one reason being a ramp-down of low margin legacy engagement to ensure efficient scalability for new value-creative opportunities that we are currently pursuing. This is analogous to the process we have done in Excelian after its acquisition in order to increase margins of the remaining accounts and projects. The other reason is internal restructuring within 2 large acquisition-related clients, which has been highlighted in the media, prompting less aggressive growth this year versus our initial plan. We expect these accounts to return to the planned pace of growth in several quarters. While this is affecting our top line, it will also be reducing earn-out numbers, thereby adjusting down the final price of the acquisitions. Lastly, now Financial Services vertical this year slower-than-expected decision-making on several key large aerospace, the latter is causing shift in ramp-up timing, this potential revenue coming in early next year instead of this year.

Gross margin dynamic. The primary reason for a temporary dip of gross margin to 35% level, which is 5% lower than in the first quarter of last year, is decline of our legacy accounts and growth of high potential accounts. Legacy accounts require relatively low investment to maintain and scale, and thus, have higher margins. On the other hand, our high potential accounts are still young on average and require more investments. At the same time, ramp-down of legacy account engagements, namely, from Deutsche Bank, created a bench. Despite effective redeployment into other opportunities, a big portion of bench engineers was not billable in the past quarter. Most of our acquisition that have initially lower margin profile continue weighing down on the margins. Over long term, we are bringing these margins back to the company levels by doing a restructuring. Further, we actually hedge in digital transformation capability through our traditional ADM services to mitigate the effect of margin pressure in ADM and to successfully compete with larger players in high-complexity end-to-end engagements. Our digital strategy is based on anchoring these clients at the earlier stages of their transformation-related buying cycles. This proof of concept require extensive initial blueprint conceptual consulting work, commitments of time and the best resources we make available against relatively small early stage budgets. This is why our HPA and [public-wide] investments into an account in the first 2, 3 years of its development in order to achieve target scale and margin consistent with the rest of the company. When we say we invest into an account, that means we decide to dedicate more resources to rigorous onboarding and training process and allow for a high percentage of more seasoned consultants. We also include a more extensive on-site presence and sometimes accumulate bench to reduce time-to-market for our clients.

Investing into HPAs and achieving maximum scale, critical wallet share in the shortest period of time is vital for our success to become a strategic vendor for these clients. Being a strategic vendor for many of our customers ensures recurrence of our revenues and ability to participate in all key RFP processes. Usually, HPAs start seeing benefits from economy of scale after 3 to 6 months, achieving gross margin north of 35%. Our current average age of the HPA in the portfolio is under 2 years, meaning at least another year of HPA-related investments is required to ramp up organic growth and start improving the margins for this client group. Therefore, for the remainder of this year, we expect margin improvement in the following quarters, but the overall company-wide gross margin profile remain at or above 37%. It is our goal to gradually improve gross margin over the following financial year.

Our investment into business transformation rebalancing. Last year, we started the transformation to diversify our customer base and verticals, expand our offering further into premium standard package and digital service consulting, beef up our sales force and expand services delivery footprint. Each of these initiatives represents substantial effort, and collectively, is a complicated exercise, requiring firm budgetary commitment and excellent execution by our key personnel. At the same time, our SG&A stayed at the same proportion to the top line for the past 6 quarters, around 27% of revenues. We believe we will be able to retain the same or better level of SG&A for the rest of this financial year, is coming down to 24%, 25% level in the financial year 2019. As a result of past investment of [$430 million], we were able to achieve a solid progress to date in expanding our HPA portfolio, launching in new verticals, expanding our offering including Digital in the new locations and integrating M&A. In the last 2 years, we have more than doubled our sales force to over 200 vertically focused specialists that now grow our key business segments. Thus, over the past 4 quarters, we added 59 new clients, 14 of which are HPAs. During the first quarter of this year, we added 23 new clients and 3 HPA accounts. We finished the quarter with 6 HPAs being in our top 10 accounts versus only 3 last year and these 15 HPAs are now top 20 accounts versus only 8 last year.

From the geographic delivery expansion standpoint, Luxoft has been increasingly growing its presence in APAC including the addition of own office in Bangalore, India, and together with derivIT, we are also aiding Luxoft presence in China. Luxoft will now have 37 delivery centers versus 28 delivery centers a year ago.

To preserve our unique culture, engineering excellence and to minimize time-to-market of new locations for our clients, we are moving our engineers from Eastern Europe locations to Bangalore. We are planning to start getting highly scaled consultant expertise from hiring in the local market later this year. A substantial portion of the new business in all key segments incorporates current and bleeding-edge digital technologies such as IT, AI, data enrichment, deployment of cloud, DevOps, et cetera. Part of our SG&A is channeled to support our owner in the efforts in these areas, forge strategic partnerships as well as support training, education and recruitment efforts.

The importance our clients place on the role of digital disruption today and the amount of opportunities we currently see on the market from the task to form Luxoft Digital Enterprise. This business unit was created by combining technology expertise we had in the COEs and innovation lab with deep domain knowledge we historically [forge] with our verticals. By the end of this financial year, it is expected to reach over $120 million in revenues.

Our primary goal is to deliver to our clients innovative solutions and to cross over Luxoft digital capabilities and advance the main focus of consulting. For example, currently we are implementing chatbot capable of the range of inquiries from the field technicians in the telecom and cable industry to streamline and bring down the cost of customer service. Recently, we won an engagement to develop Pepper robot receptionist for one of the banking institutions. We are working with one of the top Fortune 500 companies on implementing a blockchain technology to prevent fraud and security breaches in the health care system. One of the significant revenue contribution this year is expected to come from an existing account, our long-term oil and gas customer, that recently ramped up its spend on digital innovation and implementation of disruptive technologies, like IoT, to improve efficiency and quality of current and future output. Most recently, we have been recognized by ISG, which is a premier technology research and advisory firm, as a global leader capable to address all ADM needs across a majority of digital enabler-minded buyers.

M&A update. The core for our M&A strategy is based on gaining valuable domain expertise, engineering talent and complementary HP base to our existing platform. Every acquisition allow us to climb up the value chain by gaining more consulting and other premium services capabilities. This helps us not only to maintain our average prices to these customers, but also grow our average revenue per engineer, which increased once again by 0.5% this quarter on year-over-year basis.

Then days, we are closing a strategically important transaction, derivIT. This acquisition will be expanding Luxoft footprint in the APAC to service numerous high potential clients in the region.

Let's move to business updates. Financial Services. The vertical posted a low single-digit decline this quarter on year-over-year basis. The decline was due to a planned ramp-down in the top 2 accounts, as was discussed previously. Outside of top 2 account, the vertical grew 29%. Financial Services are now responsible for 54% of total revenues compared to nearly 69% a year ago. Because of the intensifying competition, increasing cost pressure and persistent regulatory burden, this year continuous to run interest in 2 areas. One, deployment of standard packages. This helps stay in compliance with regulatory requirements as well as reduce complexity and expenses of running numerous dispersed IT systems. Two, Digital Transformation. This benefits the cost of running the business through parts automation, implementation of cloud infrastructure as well as revenue generations through improved customer experience and through data monetization. This supports a strong demand across-the-board for our bundled end-to-end services offering for capital markets and wealth management that includes both digital transformation services and implementation of packaged solutions. The bundled package implementation is an entire system transformation and consolidation. When we compete for these deals, we do so based on quality of execution and business outcomes delivered to clients. Such deals, however, have longer sales cycles and longer cross-selling times, but they allow us to preserve our margin profiles and billing rates per engineer. While we are not expecting an immediate impact on the top line from sized deals this year, we believe that they will be moving the needle on their return in growth in later periods.

Automotive. Automotive vertical grew 38% year-over-year and 53% [year-over-year]. This vertical is responsible for 16 accounts on the HPA list versus 8 accounts last year. We have 7 direct contracts through the OEMs comparing to only 2 a year ago and the one 2 years ago. There are a lot of great multi-year opportunities that our company is working on both OEMs and Tier 1 suppliers, spanning across autonomous driving, digital cockpit and extended vehicle areas. Digital cockpit capabilities have traditionally been in high demand with our clients. The most sizable ramp-up in this area is with one of the German OEMs who is one of our top 10 clients. There, we helped with the integration of the next-generation infotainment system in all of its car classes. Because of our history of impeccable delivery and engineering excellence, they are allocating more strategic work to us in the upcoming year. Other type of work coming our way is developing autonomous driving features. It is rapidly evolving area where we had developed a strong expertise. Our offering in the autonomous driving has been supported by an aggressive ramp-up with a leading Tier 1 supplier. This account has already made it into our top 10 list, being just over a year old. For the past 2 quarters, we have been successful in growing engagements as one of the leaders in map compliance navigation for whom we are also becoming a long-term integration partner. Therefore, we are very pleased with the growth and prospects in the autonomous -- Automotive vertical. It is actively claiming its presence in our top customer list, and we'll finish this year with now 3 names among the current top 10.

Before I pass the call to Evgeny for more color on the financial side, let me summarize our results and the operational outlook for the year. We have posted a sub-20% top line growth for the quarter, tempered by a planned ramp-down of our top customers -- top 2 customers. For the rest of the year, we are also impacted by a temporary decision-making slowdown in the Financial Services vertical, as well as slower-than-expected growth from some of the businesses we acquired. This headwind affects not only our top line, but also the margin profile for the business. On the positive side, the rest of the business posted strong annual growth in excess of 55%. Outside of top 2 accounts, we expect year-over-year organic growth being over 30%. We are pleased to see success across a much broader client base, resulting in continued decrease of customer and vertical concentration and an ongoing increase in our revenue per billable employee.

Financial year 2018 is a pivotal year for our company. There's a lot of moving parts, some challenges, yet really exciting changes and business opportunities.

Before returning to high levels of revenue growth and better margins in the next financial year, for now, given today's snapshot of the business and forecast in the top line developments for the next 3 quarters, we choose to adjust our formal guidance to the market. We choose to be quite conservative in the new guidance figures that Evgeny will take you through now.

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [4]

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Thank you, Dmitry. Hello, everyone. Thank you for being on the call with us.

Let me go over some key numbers, give you an additional color for our operational and financial dynamic for the first 3 months of the fiscal year ending March 31, 2018, and go over our guidance.

In the first quarter, Luxoft delivered a healthy level of year-over-year and sequential growth. Revenue amounted to $209.2 million as compared $204.1 million in the fourth quarter of the previous year and to $178 million in the year ago quarter. That translates into an increase of 17.5% year-over-year and increase of 2.4 -- 2.5% sequentially. Sequential increase is impressive given the planned substantial reduction of revenues from each of the top 2 accounts. Growth outside of these 2 -- top 2 clients was 55.6%.

Nearly a year ago, our company committed to several key transformational initiatives focused on strengthening the sales organization as well as on expansion of our services and solutions capabilities Dmitry summarized a few minutes ago. As a result of our investments of over $30 million, we have achieved numerous structural improvements to our business, as reflected in decreased customer concentration, vertical concentration and developing dynamic of our high potential accounts. We will continue to diversify our business, investing to our sales and marketing efforts, a bulk of which is concentrated around establishment and development of Luxoft Digital Enterprise and Healthcare vertical, building our presence in the APAC and substantially scaling up our accounts in Automotive.

We estimate that our investments into sales channel and administrative initiative, discussed earlier on the call, will be approximately $25 million for the remainder of this year. These costs are to be distributed almost equally throughout the year with the SG&A remaining around 27% of our revenues, which has been the case for the past 6 quarters. We expect slower growth of SG&A in the following year.

As a result of our initiatives, we plan to have top 1 client around 15% of revenues, Financial Services vertical at 55% of total revenues and increase the share of Automotive vertical to 16% of the top line ahead of this financial year. We intend to continue growing our HPAs that fuel our current organic growth every year. We would like to see HPA portfolio to finish this year with around 50% annual growth and 35% concentration in the overall revenue.

To ensure success of our programs and a full alignment across our key management personnel with the company's strategic growth, we are maintaining the same range of SOP expenses, as previously communicated to the market, at or below 3.7% of the top line.

Those of you who follow Luxoft for a while are familiar with the seasonality patterns of our business with the second and third quarter being the strongest and the first and the fourth quarter being the weakest quarters of the year.

The overall pace of growth for the first quarter is in line with our usual trajectory while sub-20% top line growth is reflecting headwinds caused by the top 2 clients and also by slower than initially budgeted growth of the 2 M&A-related accounts.

Looking at the remainder of the year. As you are building your models, we expect a reduction of Deutsche Bank revenues to continue throughout this year and likely to be as high as 20%, which may affect the usual year-over-year and sequential path of growth. We see that in the first quarter already. We are also working on reducing the volume of low-margin accounts, which we got through the M&A activity as a part of our customer integration framework, so that is expected to add some headwind to the top line this year as well. Thus we are revisiting the forecast growth on the top line to be at least 17%. At the same time, we expect the pace of organic growth to improve outside of top 2 accounts to around 30% comparing to last year's number of 27% prompted by the development of 50 HPAs.

Furthermore, this growth coming predominantly from the development of high potential accounts put pressure on gross margin and operating margin. As a result, we anticipate margins to be lower with the adjusted EBITDA to be in the range of 15.5% to 16.5%. We expect to the end of the year -- to end the year with our GAAP EPS to be at least $1.53 and non-GAAP EPS to be at least $2.85.

Now let me give you highlights of the financial performance during the past quarter.

Revenue breakdown by vertical was as follows: Financial Services vertical amounted to 54.2% of total sales, that represents a decrease of 7.3% year-over-year in absolute dollar terms; Automotive and transport comprised 16.8% of total sales, an increase of 38% year-over-year; Digital Enterprise, 12.3% of the total revenue, an increase of 30% year-over-year; Telecom comprised 12.2% of the total revenue, an increase of 157.1% year-over-year.

We are pleased to report the development of our HPAs, both organically and through acquisitions, brought our client concentration substantially down. Our top 5 accounts, which have one new name versus last year's list, accounted -- amounted to 50.7% of sales, representing 20 -- 12.7 percentage point decrease year-over-year and 1 percentage point decrease sequentially. Our top 10 accounts amounted to 61.9% of sales, which represents 11.5 percentage points decrease on a year-over-year basis and 0.4 percentage point decrease sequentially.

Moving on to the profitability metrics.

For the quarter ended June 30, adjusted EBITDA was $26.4 million versus $29.6 million in the same quarter of the last financial year and $29.2 million in the previous quarter. This represents 10.9% decline year-over-year and 9.7% sequential decline, respectively. Our adjusted EBITDA margin was 12.6% versus 16.6% in the first quarter of last year and 14.3% in the last quarter.

Operating income margin in the first quarter on a U.S. GAAP basis was 2.9%, and on a non-GAAP basis, the margin was 8.6%.

Our GAAP net income in the first quarter was $6.3 million, net of a $2.2 million FX impact. And net income margin was 3% compared to 7.9% a year ago and 6.7% in the fourth quarter of last year.

Our non-GAAP net income for the quarter ended June 30 was $17.1 million versus $21 million in the first quarter a year ago and $21.5 million in the previous quarter ended March 31, 2017.

Our non-GAAP net income margin in the first quarter was 8.2% compared to 11.8% year-over-year and compared to 10.5% in the previous quarter.

Our effective tax rate for the quarter ended June 30 was 14% versus 15.1% in the first quarter last year.

Weighted average diluted share count for the past quarter was 34.5 million shares, up by 0.2 million shares from the previous quarter. Our diluted EPS amounted to $0.18 per share as compared to $0.40 per share in the previous quarter and $0.42 in the first quarter a year ago. On a non-GAAP basis, our diluted EPS was $0.50 per share compared to $0.63 per share in the last quarter of 2017 fiscal year and $0.62 per share in the first quarter of last year.

Let's move to the balance sheet. Luxoft finished the first quarter with $98.3 million in cash and cash equivalents on its accounts. The company continued to generate healthy cash flow. Operating activities generated $10.4 million or 5% of revenue. Financing activities used $14.8 million of cash. And net cash of $7.3 million was used in investing activities.

Our free cash flow-to-revenue ratio was 1.4%, and Luxoft is debt free.

Our CapEx remains at the same level quarter-over-quarter at approximately 3.5% to 4% of revenues.

As of June 30, our trade receivables including unbilled revenue were $174 million compared to $159.3 million as of March 31. Unbilled revenues were up from $14.5 million previous quarter to $29.1 million this quarter.

At the end of the first quarter, DSO, days sales outstanding, excluding unbilled deferred revenues stood at 63 days, down by 1 day from 64 days in the previous quarter. Full DSO including unbilled and deferred revenues stood at 70 days, same as last quarter.

We have finished quarter with 12,814 people, of which 10,884 were IT professionals. Attrition in the first quarter was 14.1%, up from 12.7% as of March 31, 2017. Our annualized saving per engineer is now $75,900, which represents 0.5% year-on-year increase.

Before I conclude, we would like to leave you with an updated outlook for the full financial year ending March 31, 2018. We expect to continue delivering solid revenue growth. However, we are revisiting our guidance for the top line to be at least $920 million for the year. Adjusted EBITDA margin expectation is now in the range between 15.5% and 16.5%. We expect to end the year with our GAAP EPS to be at least $1.53 and non-GAAP EPS to be at least $2.85. The EPS is based on the estimated weighted average of 35,051,297 diluted shares as of the end of the first quarter ending June 30, 2017.

With this, we are opening the lines and look forward to your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question today comes from the line of Steve Milunovich with UBS.

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Steven Mark Milunovich, UBS Investment Bank, Research Division - MD and IT Hardware and EMS Analyst [2]

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Dmitry, regarding the gross margin and operating expenses, did you say the gross margin will improve as we go through this year, average about 37%? And then would you expect next year, we would get back to 40%? And similarly, on operating expenses, should we continue to see roughly a 20% growth rate through this year and then perhaps see some operating leverage next year?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [3]

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Yes, that's exactly right. So we had some margin impacts on our margin during the first quarter for several reasons: about 1% was related to the ForEx, another 1% came from -- drop came from M&A so the M&A dragging us down about 1% and we are working on improvement and another 3% reduction came from the bench, which we're absorbing right now, but over the first quarter, we significantly improved. And most of the clients are balancing. So you're going to see margin improvement already starting next quarter and throughout the rest of the year as well as our target for fiscal '19 to bring it closer to 40%.

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Steven Mark Milunovich, UBS Investment Bank, Research Division - MD and IT Hardware and EMS Analyst [4]

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Okay. And regarding some of the revenue issues. To what do you attribute the delay in decisions in the financial sector? And regarding some of the acquisitions like IntroPro and INSYS, what's going on there in terms of the disappointing revenue relative to what you expected when you acquired them?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [5]

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Some news came just as a surprise to us, so there were several large-scale deals, which were postponed. And we see that there's a probably trend in financial services that the clients they moved slower than expected, especially on large multi-year deals, so we just got a couple deals pushed towards the end of this fiscal. We expect them to start in the first quarter. And as for the acquisition, the actually 2 accounts, pretty large and very sizable. There were some probably over optimists from the management or owners of the companies we acquired on one hand; on the other hand, both accounts are experiencing massive reorg. So those 2 factors just made less aggressive growth. So if you were to look at the growth pattern this year that we anticipate that roughly 15-plus percent organic, and currently, we are looking at somewhat around 13% organic. And so we are talking about 2.5%, 3% drop in organic growth. This is equally contributed by financial services and acquisitions, so roughly 1%, 1.5% came from -- drop of growth came from both of them.

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Operator [6]

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Our next question is from the line of Joseph Foresi with Cantor Fitzgerald.

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [7]

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First, on DB. How do you think about the growth trajectory of the top 2 accounts next year?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [8]

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So DB and the way we see DB now is we are nearly at the bottom. We're going to see some modest growth over the next few quarters, so kind of reach the bottom and it will stabilize a little bit. So we still would be quite conservative for the next year in terms of the growth potential, but we are quite confident there will be no more drop because we are definitely at the level that DB cannot squeeze it more and there are quite a number of projects and deals they have simply postponed. For UBS, as we've said, this year is flat. There are some ups and downs, but overall, again, we are seeing some modest growth opportunities. So looking at the DB -- the UBS next year, we should see a single-digit growth.

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [9]

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Okay. And then can you give us some color around utilization rates? With DB down 20%, what did the utilization rate drop to? And how does that improve throughout the year? And what was it running at? I'm just trying to get a sense of how you're handling staffing and resourcing.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [10]

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So we don't report utilization. But overall, we believe that now our standard utilization or usual was close to 80%, so 79% to 80% that in the past quarter, we are around about 75%, so a 5% utilization drop. That was primarily caused by DB ramp-down and redistribution of the skills. So it will continue throughout the second quarter, but half of the exercise has been done. And again, as I said, that most of the ramp-down has been -- already has taken place, so we shouldn't see the bench to increase. It will decrease and it should eventually, during our third quarter, get back to our normal.

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [11]

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Got it, okay. And then the last one, I think I might have heard you say that you were looking at an acquisition or it was a large one, I'm not quite sure if I caught all the commentary around the acquisition side of things. But how do you think about potential acquisitions at this point? What is in the pipeline? And is there something that could be done in the short term that -- are you willing to do something in the short term with the rest of the business sort of having some positives and some negatives?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [12]

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Yes. So the one which we reported is already reported acquisition of derivIT, which took a little bit longer to get all of the approvals from the regulators. We are at the very final stage, so that should come within days. So we can close the deal (inaudible) and maybe close quite some time ago. There is a smaller deal, which is in the pipeline with likelihood to be completed by February. On one hand, it's a strategic acquisition, but number-wise it's not very significant. We are looking at several opportunity in the health care space. Again, we have some leads in the pipeline. It's unlikely they will materialize within the first half of the year. We may see some -- something happen in the second half, but as you understand, this is a process, which may turn -- the result may take long.

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Operator [13]

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Our next question comes from the line of Moshe Katri with Wedbush Securities.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD and Senior Equity Research Analyst [14]

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Dmitry, with Deutsche Bank down about 20% for the quarter, was there also an impact on pricing? I mean, at this point, should we assume that they're operating close to their minimums based on the near reset contract? And then what gives us the confidence that, that changes for the next few quarters, which is kind of what we're expecting? That's my first question.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [15]

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Moshe, so during our last call, we said that we see the drop in revenue in DB at 15% to 20%. It went a bit more accelerated during first quarter, so that pretty much what you see right now. There is no commercial renegotiation or anything, it's all based on existing MSAs. So commercials are the same as before. It's just a matter of kind of starting some project and ramping down. We are pretty confident that this 20% decline should be the maximum decline that can come from DB. Again, most of the budgets are confirmed, so we have pretty good visibility for the rest of the year.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD and Senior Equity Research Analyst [16]

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Okay. And then the commentary around the acquisition where revenues came in below expectation. Do you feel at this point that was an issue with due diligence when you kind of looked at it? It's kind of odd that you're -- that we're getting these post the transaction itself. What do you think went wrong there? And will you be changing your due diligence kind of processes down the road because of that?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [17]

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Well, there is nothing wrong about due diligence and the process. As we said on the call, the revenues of those companies will be less than projected initially during due diligence. And you cannot really control and estimate everything there because some of that is a company business, some of that is client decisions. In these 2 particular cases, there was some over optimism on the management side, but at the same time, objectively, 2 large accounts are going through really massive reorg, which we cannot control. But as we said, our SPA is structured the way that if their numbers are not fulfilled, then the goals are not achieved, that we are paying less. So we're going to pay significantly less for those acquisitions, which we believe is very right for that issue.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD and Senior Equity Research Analyst [18]

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Understood. And then these 2 clients specifically, which verticals do they belong to?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [19]

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One Healthcare, one Telco.

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Operator [20]

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The next question comes from the line of Anil Doradla with William Blair.

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Maggie Nolan, [21]

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This is Maggie Nolan in for Anil. I was wondering about your visibility into the investment levels for the HPAs in order to keep those growing strong. Do you think that, that's baked into your guidance at this point? Or could we expect to see some additional investments and some additional downside surprise?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [22]

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No, there's nothing new coming from the investment there. We planned before, so that comes pretty much in line with our initial thoughts. As we said, it takes about 3 years to bring HPAs to the company -- standard company margins, and on average, we are somewhat close to 2 years in the HPA group. So I believe another year is required to work on the margin improvement as well as we see some of the postacquisition clients, their clients which we acquired that came with low margins onboard, but again that was initially anticipated. So that we continue -- are continuously improving margins there. So again, nothing new here, that all planned. All of the surprises you see are related to those 2 major factors, some slow performance in financial services and slow performance of post-M&A accounts.

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [23]

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Just jumping in here. I'm sorry, just on the -- this is Evgeny. I have mentioned in my part that we have -- we are planning to invest additional $25 million through SG&A, which is already planned. So this is for the sales team and the development efforts.

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Maggie Nolan, [24]

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Okay, great. And then for the top line guidance, it seems like the reset comes from both organic and inorganic expectations. Can you break out the new mix of organic and inorganic in the context of your new guidance?

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [25]

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Organic, as we've said, it's around 13% and then 4% will come -- are nonorganic.

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Operator [26]

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Our next question comes from the line of Alexey Ilin with Templeton Asset.

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Alexey Ilin, [27]

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Can you please elaborate on equity-based compensation? Based on your guidance, you are projected to issue like 1.5 million shares and probably to recover more than 50% of adjusted EBITDA for this year. So basically, are shareholders in the same board with management or not? Can you please tell a few words about it?

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [28]

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We have -- yes, this is Evgeny Fetisov. So the way we look at this when we think about stock options problem, we benchmark it as a percentage share of revenues. So we have been saying that we will be keeping the door for 4% of the revenues. And currently we're making it more specific, we're saying we will stay below 3.7% for this year, which we think is a reasonable level. We think, and the company believes, that using stock options program is necessary to align interest of shareholders and the management and to actually make them longer term -- align them longer term. Plus, we use stock options program to incentivize management of the acquired companies to stay onboard.

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Alexey Ilin, [29]

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Yes. But sorry, just if I remember, actually there were like also like targets -- like revenue targets and market cap targets, right? So probably you are not fulfilling them. So maybe we should expect some adjustments on the bonus program as well?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [30]

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And it is adjust as the percentage is not growing. So revenue is low, then the overall volume is low. But if you look at our competitors, they even have more aggressive numbers, so I don't think it's unusual for the industry.

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Alexey Ilin, [31]

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Okay. But speaking about number of shares for year-end, should we really expect like 1.5 million shares because last year, the amount was much smaller?

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [32]

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I think we have given the number in the guidance. This is what we have foreseen right now. So we are budgeting to a less than $30 million spend on the stock options program, so that should be coming to 3.7%.

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Operator [33]

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Our next question is from the line of Ashwin Shirvaikar with Citibank.

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Ashwin Vassant Shirvaikar, Citigroup Inc, Research Division - Director and U.S. Computer and Business Services Analyst [34]

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So my question was is it safe to assume that the people coming off the top 2 relationships, if those relationships were operating at a favorable price point from a client's perspective, will those employees be redeployed at new clients at a higher price point? And a related question is, is this a very different skill set because I was a little surprised that if you have 55% growth elsewhere, your employees coming off are not immediately redeployed.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [35]

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Thanks for the questions. So first, rates, of course, not directly the same at all clients. There are some cases they are higher, sometimes it's lower. So it's hard to respond. HPAs usually have lower margin because some extra efforts and some, I would say, different factors, so for instance, whenever we grow HPA, the bench and utilization is lower there, then we put more seniors onboard. And then we reach certain size, we push more juniors that would rebalance and you have better margins on juniors and regulars than on seniors. So that's the way it works. So when we have people coming off some of the accounts, we deploy. Redeployment is, on one hand, yes, there is a growth. Growth is not always in the same area. So as you can see, DB is an enterprise type of skill set. It offers financial services and the growth today happen in Automotive and in Telco, so they each have predominantly embedded skill set, this number one. Number two, not always people that are free are at same locations where we grow. So we apply relocations or if we see some good engineer is free, we would relocate and offer relocation for him and the family. It takes some lead time and then we may see some of the opportunities come in later this year for this skill set, haven't started yet, but in this case, we would just keep them on the bench. So it's a complex matter, but I don't think you can do it somehow different.

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Operator [36]

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Our next question is from the line of Georgios Kertsos with Berenberg.

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Georgios Kertsos, Berenberg, Research Division - Analyst [37]

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I have 2 actually, if I may. First of all, on Harman. I was interested in getting your thoughts. I mean do you guys have any color on what Harman's, I guess, operating model is likely to look like going forward following the recent acquisition? And any sort of expectations you might have on what that might mean for the business that you have with Harman? And the second question is on the margin level. Are you effectively saying that you are relaxing the 17% to 19% non-GAAP EBITDA margin range for the following year and beyond, i.e., if the 15.5% to 16.5% sort of EBITDA margin that you're guiding for this year is a new level that you expect the company to be -- to operate within for the following couple of years? Those are the 2 questions.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [38]

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Okay. So I'll answer the first question and Evgeny will answer second. So first one was about Harman. Yes, Harman post acquisition of Samsung, there has been some reorg and restructure happen, and as you can imagine, overall business is pretty solid and they're actually getting much stronger in the automotive space with a pretty massive integration efforts from Samsung. But all in all, the account looks quite promising, though this year is not the best place for the growth, again due to all of these internal factors, some new managers are coming onboard. Still, we see that as one of the key accounts for the next 3, 5 years in Automotive.

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [39]

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Georgios, with your second question on margins. As we have mentioned, we have a pressure coming from GM this year that's why we are lowering our guidance for this year to 15.5% to 16.5%. Next year, as we expect GM to go north of, say, 38%, 39%, we will be aiming to get back to the 17% to 19% adjusted EBITDA margin guidance.

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Operator [40]

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Our next question is from the line of Arvind Ramnani with KeyBanc Capital Markets.

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Arvind Anil Ramnani, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [41]

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I just had a question on your -- we have met in late May and you had sounded pretty optimistic. And I just wanted to get a sense, did things deteriorate in the month of June?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [42]

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Yes. Well, things were coming our way, just we didn't see them all because you have some delays in closure and some decision-making process. So when we met in May, we still saw an adjust -- early quarter results, but most of the things happened during -- which we report here during May and June, right?

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Arvind Anil Ramnani, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [43]

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Great. And just a quick follow-up. These top 2 accounts, are you able to pass on some of the costs that are pretty dramatic to your top 2 clients? Or that's not how the contract is written up?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [44]

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That's not the way the contract is structured.

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Operator [45]

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Our next question is from the line of Vladimir Bespalov with VTB.

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Vladimir Bespalov, VTB Capital, Research Division - Analyst of Industrials, Transportation, Infrastructure, and Chemicals [46]

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I have just several things to clarify probably. On derivIT, is the integration of this company built into your current guidance? Or there is some further upside might come once you integrate? And what could be the contribution of this asset to Luxoft? And the second question is like do you still see some downside risks to the guidance on margins that you provide for the next 3 quarters or maybe there is some upside? And are the deals which you anticipate your M&A pipeline in the guidance or not yet?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [47]

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So yes, so derivIT is in. In all respect, it's a bit -- it has taken us longer than we initially anticipate in terms of the final closure due to all these regulatory process, but that -- we'll probably finalize everything next week or week after. But we know their numbers. It's in, as we said, about 4% of the growth will be nonorganic, that's where derivIT sits. In terms of the margin pattern, there, it's also all in, so shouldn't be expecting any surprises. As for the guidance, this time we do it quite conservatively so we don't expect that to be lower.

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Vladimir Bespalov, VTB Capital, Research Division - Analyst of Industrials, Transportation, Infrastructure, and Chemicals [48]

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Okay. But you don't build any M&A potential dues into this guidance, right?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [49]

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No.

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Operator [50]

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The next question is from the line of Alexander Vengranovich with Otkritie Capital.

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Alexander Vengranovich, Otkritie Capital International Limited, Research Division - Research Analyst [51]

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A couple of questions, also sort of clarifications. First one on the difference between your planned GAAP EPS and non-GAAP EPS, actually it was $1.46 per share. Last quarter, it becomes like just $1.32. So it's not a big difference. And as far I understand, the major part of that difference actually comes from share-based compensation expense, so you are saying that you are kind of reducing net expense, but it's -- looking at the guidance, the difference is pretty much the same, so I don't see any decrease here. Or maybe you expect some other parts of the adjustments to increase, which will compensate that reduction. And a second question is on UBS and other financial service accounts. Did I get it right that the delays in some engagements are not connected to UBS and these are connected to the other accounts and the outlook for UBS remains the same?

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Evgeny Evgenyevich Fetisov, Luxoft Holding, Inc. - CFO [52]

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Yes, Alexander, this is Evgeny. I'm not sure I can answer your question in great detail on the fly. What I can tell you that the SOP forecast didn't change much. So for the stock option program, we're staying at roughly the same level as we planned, maybe slight changes. So if you need to go into the more detailed reconciliation, we will need to take this off-line.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [53]

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Yes. And on the second, yes, you are right. It's not related to UBS. There were several large-scale deals with existing clients, but really HPA clients which we were quite confident or positive that they should have started already, but they were postponed till later this year.

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Alexander Vengranovich, Otkritie Capital International Limited, Research Division - Research Analyst [54]

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Okay. Then if we look at the performance of top 2 accounts, so they both came down by 19%, right, in the first quarter. That means that actually, yes, I understand previously the saying that Deutsche Bank may go down by 15%, 20% and the outlook for UBS is kind of flat. So it's just the seasonality effect that UBS is kind of weak in the first quarter, right?

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [55]

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Yes and no. I mean, Deutsche came down 23%, UBS close to 15%. Our first quarter last year for UBS was very, very strong and things, kind of cuts, in UBS started on the second quarter. So we shouldn't compare that. So we had very strong quarter with UBS in Q1 '17 and relatively weak in '18. Going forward, we don't expect a reduction in UBS. Actually, there will be some growth. And last year, we had reductions throughout the year, so that's why you see this drop. And Deutsche is just, as I said, it dipped to the bottom and it will slowly grow.

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Operator [56]

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We have now reached the end of our question-and-answer session for today. I will turn the floor back to management for closing remarks.

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Dmitry A. Loshchinin, Luxoft Holding, Inc. - CEO, President & Director [57]

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Thanks so much for joining our earnings call, and have a great rest of the summer. And we look forward to see you in the upcoming conferences.

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Operator [58]

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Thank you. Today's conference has concluded. Thank you for your participation. You may now disconnect your lines at this time.