Virtusa Corporation (NASDAQ:VRTU) Q3 2018 Earnings Conference Call February 8, 2018 8:00 AM ET
Executives
Will Maina – Investor Relations, ICR
Kris Canekeratne – Chairman and Chief Executive Officer
Ranjan Kalia – Executive Vice President and Chief Financial Officer
Keith Modder – Executive Vice President and Chief Operating Officer
Analysts
Bryan Bergin – Cowen
Joseph Foresi – Cantor Fitzgerald
Puneet Jain – JP Morgan
Maggie Nolan – William Blair
Mayank Tandon – Needham & Company
Frank Atkins – SunTrust
Vincent Colicchio – Barrington Research
Ariel Hughes – Wedbush
Operator
Good day, and welcome to the Virtusa Corporation Fiscal Third Quarter 2018 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Will Maina of ICR. Please go ahead.
Will Maina
Thank you, and welcome to Virtusa’s third quarter fiscal year 2018 earnings conference call, where we’ll be discussing our financial results for Virtusa’s fiscal third quarter ended December 31, 2017. On the call with me are Kris Canekeratne, Chairman and Chief Executive Officer; Ranjan Kalia, Executive Vice President and Chief Financial Officer; and Keith Modder, Executive Vice President and Chief Operating Officer.
Certain statements made on this call that are not based on historical information are forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
During this call, we may make, express or imply forward-looking statements relating to, among other things, Virtusa’s expectations and assumptions concerning management’s forecast of financial performance, the growth of Virtusa’s business, Virtusa’s ability to realize the intended benefits, revenues and other synergies of acquisitions; the ability of Virtusa’s clients to realize benefits from the use of Virtusa’s IT services; and management’s plans, objectives and strategies.
These statements are neither promises nor guarantees and are subject to a variety of risks and uncertainties, many of which are beyond Virtusa’s control, which could cause actual results to differ materially from those contemplated in these forward-looking statements. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Virtusa undertakes no obligation to update or revise the information disclosed during this call, whether as a result of new information, future events or circumstances or otherwise.
Other statements on this call also include certain non-GAAP financial information, as defined by the SEC. We present constant currency revenue to provide a framework for assessing how our revenue performed, excluding the effect of foreign currency rate fluctuations. We provide non-GAAP adjusted operating income, non-GAAP adjusted net income and non-GAAP earnings per share, which we believe provide insight into the operational performance of our business.
Reconciliations of non-GAAP to GAAP measures are included in today’s earnings press release and data sheet, which can be found on the Investor Relations page of our website. We also present a reconciliation of cash, cash equivalents, short-term and long-term investments that we believe provide insight into our total cash position and overall liquidity.
Please note that a supplemental data presentation to our fiscal third quarter results has also been posted on our Investor Relations website. For additional disclosures regarding these and other risks faced by Virtusa, see the disclosures contained in Virtusa’s public filings with the Securities and Exchange Commission and our earnings press release.
With that, I’d like to turn the call over to Kris.
Kris Canekeratne
Thanks, Will, and thank you everyone for joining us this morning on our fiscal third quarter 2018 earnings call. I’m pleased to share that Virtusa delivered another strong quarter. We generated revenue of $263.8 million, which was above our guidance range and represents 6.3% sequential and 21.5% year-over-year growth.
Our two largest industry group, Banking, Financial Services and Insurance and Communications and Technology, were strong contributors to our top line performance. We also continued to execute very well against rising operating leverage in the business. In Q3, we expanded our non-GAAP operating income margin by 190 basis points sequentially and 240 basis points year-over-year to 9.9%, which was at the high end of our expectation.
Finally, we delivered non-GAAP EPS of $0.47, which was up 34.3% from Q2 and 27% versus the prior year period. Our consistent, solid performance over the past three quarters of fiscal 2018 is evidence that our strategy and the investments we have made position us well above industry growth. As a result of the strong Q3 results and the continued momentum we are seeing in the business, we are once again raising our full fiscal year 2018 guidance ranges.
So, let me spend a moment on what’s driving our strong performance. In today’s world, just about every organization is facing the critical mandate of reducing the costs and risks associated with their legacy IT environment, while at the same time forging ahead into an increasingly digitally-centric world.
They must address the complexity of their legacy IT architecture built over decades in order to not just lower overall costs and increase agility, but also to establish a more effective foundation to support and enable transformative new forms of customer engagement, which are highly personalized, frictionless and omnichannel. All attributes that are now essential requisites to compete and grow a digitally-centric world.
The reality is an organization cannot fully realize the benefits of digital transformation without addressing their legacy IT architecture. This is precisely what Virtusa serves for its clients by employing our end-to-end digital strategy, consulting and engineering services to bridge our client’s journey across the digital divide. Through our engineering rigor and deep industry expertise, this simplifies our client’s IT assets through platform modernization, consolidation and rationalization.
At the same time, through our digital engineering services, we develop the end-to-end connective tissue between their internal IT systems and their customer-facing digital experiences. And finally, we help our clients reimagine their digital presence and customer engagement model by developing their digital omnichannel slope run.
We believe that our ability to help simplify our clients’ IT environment in order to enable them to fully leverage the digital opportunity to be a significant differentiator and competitive advantage for us in the market. And our business performance bears that out. We have further separated ourselves from the pack because of our unique approach to the legacy IT component of the task.
While the majority of our generation one competitors in this space focus on cost arbitrage as the primary means, Virtusa applies our tried and proven engineering arbitrage instead. Because of our deep engineering heritage, we are able to employ best practices to rationalize, consolidate, modernize, and eliminate technical depth of our clients’ legacy IT environment.
The ultimate benefit of engineering arbitrage is that the cost of – of costs reduced, but as important, the root causes of the excessive costs are eliminated, driving outcomes which have a materially positive impact on the short and long-term health of our clients’ businesses. This is in sharp contrast to cost arbitrage or the old-world model of just delivering cost savings by running the existing IT asset solace, which we have found often carries unintended consequences that, ironically, can result in long-term inefficiencies and undue expenses.
We believe this distinction is extremely important in today’s world that clients are increasingly seeking outcome-based ROI approaches that achieve clear targets of productivity and customer benefit gains. We believe that our strong fiscal 2018 year-to-date performance and expanding pipeline are proof positive that our strategy, capabilities, and value proposition are resonating with clients and enabling us to gain share.
To underscore both our unique position and capacity to grow across our entire portfolio of services, I want to give you a snapshot of a few client cases. For a Fortune 50 insurance company, we are modernizing their legacy IT platform to enable their digital journey and build business-ready digital products. This is a great example of Virtusa’s end-to-end digital capabilities underpinned by our engineering rigor and industry expertise.
We first help them reimagine and develop a new customer self-service portal optimized for the digital age. We then work to develop a microservicers middleware layer for our client, which seamlessly integrates our front-end application with their legacy system, enabling faster speed to market.
We were chosen by this client because of our deep banking financial services and insurance domain expertise and end-to-end digital capabilities, which have enabled our client to fast track their digital transformation, improving their customer experience and driving growth.
Virtusa also recently awarded a large contract for digital re-engineering around microservices and payments transformation. The client, a super-regional U.S. bank with over $2 trillion of daily international funds transfer volume, is currently using a legacy fund transfer system developed over three decades ago.
We are partnering with them to migrate that legacy system into a 21st century enterprise payment architecture that leverages microservices to integrate multiple systems and channels, effectively breaking down the silos often present in legacy structures. We expect this to result in 25% improvement in operational efficiencies and 15% gains in transaction processing time, thereby reducing operational risk.
While much of our work is in the financial services and insurance industries, this next client example underscores both the breadth of our appeal and our digital engineering abilities. As per rigorous and intense RFP process, Virtusa was recently awarded a large-scale program to build one of the largest disruptive Blockchain platforms ever to be undertaken in the media industry.
The platform will enable a consortium of media and entertainment of MSO companies to securely share customer consumption data with trust, while still retaining the ownership of their large data sets. Leveraging this Blockchain platform, each of the participating Fortune 100 companies can securely access information held by other partners through keychain management, microservicers, APIs and event streaming architectures to generate necessary insights of each of the consortium partners. This collaboration by and between traditional competitors will allow them to more effectively compete with market disruptors, especially digital market disruptors.
My last case example is our largest client and a perfect example of our unique ability to simplify and modernize legacy IT architectures through engineering arbitrage, resulting in both cost reduction and a stronger foundation to support a digitally-centric business application.
We immediately set ourselves apart from the generation one providers with this client because our value proposition clearly defines a roadmap to significantly reduce their business as usual IT costs, primarily by utilizing our software platforming and rationalization techniques, as well as intelligent automation to complex efforts, improve efficiencies and eliminate technical debt.
As a result, there is sustainable BAU cost savings in excess of 25%. And just as important, because of the material value we have delivered, they continue to reward Virtusa with more business resulting in third quarter annualized run rate of over $200 million of revenue.
While there are many more cases I could share, the collective story is one of Virtusa having established a unique position and value proposition in the technology services arena, enabled by deep industry knowledge and decades of experience designing, engineering and scaling systems that deliver material and long-lasting business value.
Our end-to-end capabilities stand creating innovative digital experiences for our clients, digital storefronts, developing the connective tissue that seamlessly integrates our clients’ customer-facing digital and back-office IT system and simplifying and modernizing these environments through engineering to fully leverage the digital opportunity.
These functions are inexplicably linked and can only differ by a company with deep software engineering and digital engineering capabilities. And that is Virtusa. With such fundamental capacity, coupled with the trust and track record we have established by executing digital transformation at scale, that is really the key to our performance and growth.
Finally, before closing, I would like to mention how pleased we are to be able to successfully close the Polaris delisting process. We believe this is a positive event for both Virtusa and Polaris’ shareholders. The delisting will provide us with additional operational flexibility and will be accretive to our non-GAAP earnings. Ranjan will take you through the details during his prepared remarks.
In sum, we delivered strong third quarter results and we are again raising our fiscal year 2018 guidance. The demand environment to IT services entering calendar year 2018 is early and Virtusa is well positioned to capitalize on the areas of increasing investment within our planned IT budget, setting the stage for continued above-industry growth.
Now, let me turn the call to Ranjan, who will provide more details on our results and our fourth quarter and fiscal year 2018 guidance. Ranjan?
Ranjan Kalia
Thanks, Kris, and good morning to everyone. Let me start by summarizing the results of our third quarter fiscal year 2018. I will then provide current guidance for both the fourth quarter and fiscal year ending March 31, 2018, before opening the call for questions.
Revenue for our fiscal third quarter was $263.8 million, which exceeded the high end of our guidance range, primarily due to better-than-expected performance in our banking and insurance segments. Third quarter revenue increased 6.3% sequentially in reported currency and 6.1% in constant currency, reflecting a strong contribution from our BFSI and C&T clients.
Additionally, both our top 10 and non-top 10 clients generated strong sequential growth. Year-over-year revenue increased 21.5% in reported currency and 19.9% in constant currency. Gross margin in the fiscal third quarter was 30.5%, which was above the high end of our expectation and represents 240 basis points sequential and 180 basis points year-over-year improvement. Gross margin in the quarter benefited from high utilization and better-realized pricing.
GAAP operating income for the third quarter was $13.7 million, up from $10.3 million in the prior quarter and $6.5 million in the year-ago period. GAAP operating income was at the midpoint of our expectation. Stronger revenue and gross profit was partially offset by increased variable compensation and stock-based compensation, reflecting strong performance.
Third quarter other income was $2.8 million, primarily comprised of $300,000 of net interest income and $2.6 million of net unrealized foreign exchange gain. The unrealized foreign exchange gain includes $5.5 million gain from the revaluation of our intercompany note offset by $2.9 million of transaction losses.
We recognized a GAAP tax expense of $24.4 million. This includes $19.8 million as a result of the Tax Act, comprised of repatriation tax expense of $14.6 million and a restatement of U.S. deferred tax asset of $5.2 million.
GAAP loss per diluted share, inclusive of minority interest of $2.1 million and convertible preferred dividends of $1.1 million, was $0.38 in the third quarter compared to net income per share of $0.12 in the prior quarter and $0.15 in the year-ago period. Our Q3 GAAP EPS includes $19.8 million charge or $0.68 per share impact from the Tax Act.
Turning to our non-GAAP results. Non-GAAP operating income was $26 million, an increase of 31.5% from the prior quarter and up 59.3% from the year-ago period. Third quarter non-GAAP operating margin was 9.9%, up 190 basis points from the prior quarter and up 240 basis points from the year-ago period.
Our Q3 non-GAAP operating margin was at the high end of our prior expectation. Non-GAAP diluted earnings per share were $0.47 in the third quarter of fiscal 2018. This is up from $0.35 in the prior quarter and $0.37 in the year-ago period. Our Q3 non-GAAP EPS was at the high end of our previous guidance range.
Turning to the balance sheet. Ending cash at December 31, 2017, was $303.9 million inclusive of cash and cash equivalents, short-term and long-term investments. Our Q3 ending cash balance includes a $25 million drawdown from our revolving credit facility to fund the Polaris delisting offer.
Excluding the $25 million revolver drawdown, our cash balance improved $24.9 million, compared to the second fiscal quarter. Cash flow from operating activities was $24.3 million in the third quarter, representing 9.2% of revenue reflecting a 4-day improvement in our DSO.
Now, I will turn to some additional quarterly financial and operational metrics beginning with those related to our third fiscal quarter revenue. Revenue across our industry groups was as follows: BFSI revenue increased 7.6% sequentially and 31.7% year-over-year, representing 69% of total revenue.
Our BFSI results in the third quarter were better-than-expected driven by growth at our banking and insurance clients. During the quarter, we experienced less-than-expected impact of year-end furloughs among our banking clients. This reflects the increasingly mission-critical nature of our work we are performing for our clients.
With respect to insurance, we experienced stronger-than-expected growth in Q3, driven by new project ramps, including the work we are doing with a Fortune 50 insurance firm, which Kris just mentioned in his remarks. Communication and Technology revenue increased 5% sequentially and 2.7% year-over-year, representing 22% of revenue.
C&T performance was driven by growth at our large telecom client, as well as our healthcare and U.S.-based technology clients. Revenue was flat on a sequential basis and up 6.3% year-over-year, representing the remaining 9% of revenue. M&I performance was better than our expectation.
During the December quarter, we commenced work with six new clients, including two each in BFSI, C&T, media information, and other. Global utilization, excluding trainees, was 83% in the third quarter, up from 82% in Q2.
Now, I will provide our current guidance for the fourth quarter and fiscal year ending March 31, 2018. Revenue in the fourth quarter of fiscal 2018 is expected to be in the range of $274 million to $280 million. Non-GAAP diluted earnings per share in the fourth quarter of fiscal 2018 is expected to be in the range of $0.51 to $0.57. Our Q4 fiscal 2018 non-GAAP earnings per share guidance anticipates an average share count of approximately 33.4 million.
For the fiscal year ending March 31, 2018, we expect revenue to be in the range of $1.013 billion to $1.019 billion. Non-GAAP diluted earnings per share for fiscal year 2018 is expected to be in the range of $1.59 to $1.65. Our guidance excludes $27.7 million of stock compensation expense, $10.7 million of acquisition-related charges and $1.3 million of restructuring charges, of which we have incurred approximately $1 million year-to-date.
Full fiscal year 2018 non-GAAP EPS anticipates an average share count of approximately 32.4 million. Our current GAAP and non-GAAP guidance is based on a set of assumptions that can be found in our data sheet located in the Investor Relations section of our website. Our pipeline continues to expand across our industry on a year-over-year basis and meantime to close is consistent with prior quarters.
While still early, preliminary indications point to calendar year 2018 client budgets to be consistent with the prior year. This reflects an increase in the spend on digital transformation programs and reduced spend on legacy IT outsourcing programs. For our BFS clients, we are seeing a consistent level of demand for digital and mobile offerings that improve our clients’ ability to reach millennial customers and help to preempt disruptive market forces of new FinTech entrants.
We also continue to see investments in operational efficiency initiatives that drive BAU cost savings. In particular, we are seeing added focus and investment [Technical Difficulty] Okay. Sorry, I will continue. In our insurance portfolio, we’re building on the momentum we experienced in the second quarter and continue to expect to have stronger second half growth versus the first.
We’re seeing good demand for our digital services at our meaningful client engagements. We continue to see demand for our clients for efficiency services such as technical debt [indiscernible] through our application portfolio rationalization and digital re-engineering services.
Furthermore, we see our insurance clients seeking to access their insured risk by continuing to develop their digital capabilities through variable technologies. Such digital solution sets will enable our clients to further enhance their pricing strategies.
In the healthcare segment, we’re seeing increased interest in digital transformation in automation as companies seek to expand their margins by increasing efficiencies through automation of repeatable processes. In life sciences, we are seeing greater interest in Big Data analytics as our clients seek to get more actionable insights into their existing data with the same cost structure.
In communication and media, we see our major clients’ focus on expanding their addressable market. As a result, they are turning to Big Data to gain insight into their customer behavior. Our telecom clients are also seeking to reduce cost by improving operational efficiencies through our automation services and process re-engineering offerings.
Our fiscal Q4 guidance reflects continued strong sequential revenue growth and year-over-year margin accretion. At the midpoint of our guidance, revenue is expected to grow 5% and non-GAAP operating margin is expected to be consistent with the third quarter.
For full fiscal year 2018, at the midpoint of our guidance range, we expect revenue growth of 18%, non-GAAP operating margin to expand 200 basis points and non-GAAP EPS growth of 30%. The midpoint of our full year non-GAAP EPS expectation is $0.06 better than the midpoint of our prior guidance.
Our non-GAAP effective tax rate is expected to be 27.4% for the fiscal year, compared to the prior guidance of 28.2%. With respect to the Tax Act, we have not fully determined the impact of the act on our tax rate and financial statements as we await further technical guidance that may impact our analysis. The current b-tax [ph] provision and interest deductibility limitations may have an impact on U.S. multinationals, like ourselves.
We are currently assessing a range of mitigation strategies that may be executed as further clarifications are issued and analyzed. Our current non-GAAP guidance anticipates minority interest of approximately $9.1 million versus prior guidance of $9.7 million.
Before closing, I would like to address the Polaris delisting process. As we discussed with you previously, Virtusa had launched the Polaris delisting offer on January 30. On February 5, we finalized the discovered price to delist Polaris through the reverse book building process. Upon settlement of the transaction, our ownership of Polaris will increase from approximately 74% to at least 93% of share capital of Polaris.
The aggregate purchase price of the shares tendered based on the discovered price is approximately $145 million, excluding transaction and closing costs. Upon closing and receipt of final approvals from the stock exchanges, the common shares of Polaris will be delisted from all public exchanges on which it is traded. The remaining Polaris shareholders, who did not tender, can offer their shares to Virtusa at the discovered price for a period of one-year following the date of delisting.
To fund the transaction, we will use approximately $25 million of existing cash on hand and $125 million from a new credit facility, inclusive of transaction and closing costs. As a result of the transaction and based on a mid-February closing date, in Q4, we anticipate approximately $700,000 reduction in minority interest net of incremental interest expense, resulting in $0.02 EPS accretion. As discussed previously, we expect this transaction will be accretive to our FY 2019 non-GAAP EPS.
In conclusion, we delivered strong third quarter revenue growth above our guidance range. We also executed well against our margin expansion goals, delivering strong sequential and year-over-year operating margin accretion. We are well positioned to continue to drive incremental annual margin accretion – expansion in the future. Finally, we generated solid operating cash flow in Q3, increasing our financial flexibility. We are again raising our FY 2018 guidance based on our strong Q3 and year-to-date results.
I will now turn the call over to the operator to begin Q&A. Thank you.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] We’ll go first to Bryan Bergin with Cowen.
Bryan Bergin
Hi, thank you. I wanted to ask on the strong client stratification metrics. You had changes across the $10 million, $25 million and $50 million buckets. Can you comment just on some of the relationships there on the projects that you have in that growth?
Ranjan Kalia
Yes. So, Bryan, let me kick it off and I think Kris can provide additional. So, if you actually look at it on our data sheet, I mean, all the client metrics have really moved in the right direction. On clients trailing 12-month, which did about $1 million in revenue and moved from 118 to 123. More than $10 million clients have moved from 16 to 18. Our $25 million clients have moved from 4 to 5. So, they’re all moving in the right direction and really continues to call the strategy that Virtusa has adopted. With that, I’m going to have Kris talk a little bit about the clients.
Kris Canekeratne
So, Bryan, as Ranjan said, we’ve seen very strong progress across pretty much all client stratifications that we can look at. Most of it is driven clearly by the – by how well positioned Virtusa is in terms of digital transformation and helping our clients reimagine their digital storefronts. As you are well aware, more and more IT investments are being sort of moved over into the digital area. And clients are forging forward with their digital programs. And we are extremely well positioned to help them and lead them through their transition.
Notwithstanding, we are seeing tremendous traction for our services, specifically services on which we apply our engineering arbitrage. And through engineering arbitrage, we basically go in and help our clients rationalize, consolidate, eliminate technical debt and greatly reduce their costs of maintaining, supporting and enhancing their legacy environment.
So, it’s the combination of the two and our ability to create what we call the connective tissue that essentially combines these systems or the IT systems with the requirement for digital storefronts and creating great digital experiences is driving significant growth for us, and as you know, 6.3% sequentially in our third quarter.
Bryan Bergin
Okay. And then, can you quantify just overall pipeline and digital pipeline as you enter 2018?
Kris Canekeratne
Yes. So clearly, our overall pipeline has grown considerably year-over-year and supports our above industry – or significantly above industry growth. Our digital and BPM pipeline has been a significant contributor. And the momentum continues to be very strong with strong growth in our digital and BPM pipeline as well.
Bryan Bergin
Thank you.
Operator
And we’ll go next to Joseph Foresi with Cantor Fitzgerald.
Joseph Foresi
Hi, good morning. So, I was wondering if you could talk about demand and financial services. It sounds like you’re seeing a pickup there. Maybe we could get an update on that large digital project that was ramping?
Kris Canekeratne
We’ve seen very strong momentum in Banking and Financial Services. And clearly, BFS as an industry segment has been a growth in the envelope for Virtusa. Much of that comes by way of how well positioned we are in Banking and Financial Services. Well, Joe, as you probably know are an early adopter of advanced technologies and also most of the Banking and Financial Services clients that we work with have significant IT budgets. A large percentage of those IT budgets now or an increasing percentage of those IT budgets being earmarked for digital initiatives.
So, across the BFS landscape, we have seen significant opportunities around digital transformation. We’ve seen significant opportunities around payment transformation. We’ve seen, once again, significant opportunities in the FinTech arena. And this includes technologies such as Blockchain, artificial intelligence and machine learning, as well as microservices architectures. So, across BFS, we have seen very strong progress, primarily because of how well positioned we’re on the one side enabling our clients to reimagine their digital storefronts. And on the other end, applying engineering arbitrage to reduce their overall cost.
Joseph Foresi
Okay. And then just my second question here. Can you help us understand the impact of the Polaris delisting? When it closes, I thought that the noncontrolling interest would essentially go to 0. Maybe I was incorrect about that, but maybe we can get sort of an update? I know you gave some color on the $0.02 impact, but I was just wondering for a little bit more. Thanks.
Ranjan Kalia
Sure. So, Joe, before we commenced the process, we had a 74% ownership on Polaris. So therefore, we had a noncontrolling minority interest of up to 26%. We believe by the time we close Polaris, we will have at least 93% ownership. It could be slightly higher, but we believe at least 93%. So, it would mean that we will still have 7% of the noncontrolling interest that will be left. With the 93% ownership, we have quantified that, therefore, our Q4 would have a $0.02 accretive impact for our Q4 quarter. And that for annualized for FY 2019 will also be accretive for FY 2019.
Joseph Foresi
Got it. Thank you.
Operator
And we’ll take our next question from Puneet Jain with JP Morgan.
Puneet Jain
Hi, thanks for taking my question. First, Ranjan, I think you mentioned, you’re seeing some price increases. Is pricing upside sustainable? And if that’s something that will continue to generate upside over the near-term?
Ranjan Kalia
Puneet, what I mentioned in my prepared remarks was actually realized price increases. And in terms of rate cut price increases, yes, we do see those. We have received that. But at a company level, I wouldn’t say that they have a material impact. At a company level, the material impact is more so coming from realized pricing, which is – it’s a factor of mix, it’s a factor of fixed pricing, it’s a factor of onshore/offshore ratio. So, there’re a lot of pieces that go into computing the realized pricing. But if you’re really referring just to the pricing – rate cut pricing, that doesn’t have a material impact at a company level even though we are continuing to some of that.
Puneet Jain
Understood. Now, thanks for clarifying that. And SG&A expense seems to have come in little higher than what we expected. Is there any change in your overall margin expansion pieces stemming from how gross margin has arrived from SG&A?
Ranjan Kalia
Puneet, the only reason why SG&A is higher is really only primarily due to the increase in variable compensation or really to align it with the strong performance of the company has been experiencing.
Puneet Jain
And that should be?
Ranjan Kalia
Other than that, when we roll forward our Q3 to Q4 SG&A, we believe it’s going to be relatively flat.
Puneet Jain
Got it. Thank you.
Ranjan Kalia
And provide leverage in Q4.
Puneet Jain
Understood. Thanks.
Operator
[Operator Instructions] And we’ll go next to Maggie Nolan with William Blair.
Maggie Nolan
Hi, guys. I’m wondering if you can break down for us what drove the increase in gross margins of 180 basis points year-over-year in a little bit more detail.
Ranjan Kalia
Sure. Maggie, the gross margin if you look at it – let me just give you first a walk, which is, we’ll go sequentially. It’s really largely – and even at that whole season for year-over-year, it’s really being driven mostly on utilization. If you look at it last year, our utilization was running at an average of about 77%. This year, we’ll probably run in average utilization for the whole year of about 82%. That’s going – in itself, really that 5 percentage points is really going to result in about 150 basis points of accretion just from utilization, which is really the biggest driver. And that continues to be – in the beginning of the year, we had called our strategy that utilization will increase and we’ve been executing against that strategy.
Maggie Nolan
And do you think that you’ve reached your optimal sustainable level of utilization? Or is that something that you’re looking to improve further as you work to expand margins?
Ranjan Kalia
Well, we believe that our utilization continues to drive further opportunity. And Virtusa has done utilization in the 84%, 85% range, granted that was at a smaller scale, but we have. With more automation at our technology centers, we see more opportunities to continue to drive utilization. So, I would expect that year-over-year utilization will tend to increase and provide a gross margin level for us.
Maggie Nolan
Thank you.
Operator
We’ll go next to Mayank Tandon with Needham & Company.
Mayank Tandon
Thank you. Good morning. Kris, as you compete for digital, how is the competitive landscape changed if at all? And then also maybe you could talk about your hiring policies as you tackle on more complex digital type work?
Kris Canekeratne
Hi Mayank. So, clearly, we are seeing a significant amount of opportunity in the industries that we work in, specifically with clients now not just embracing digital transformation, but those digital transformation programs becoming larger in size, scope and scale. As you probably know, Mayank, in the Banking and Financial Services industry, we’re extremely proud of the fact that platforms that have been engineered by Virtusa, today, are being used by approximately 25% of U.S. consumers that have digital mobile banking accounts.
And clearly, the experience that we have gained, the credibility that we have has enabled us to create a very strong position or a leadership position in terms of being able to provide digital transformational programs to our clients. This combined with the fact that for several years now, we’ve been investing in our xLabs, specifically in FinTech, InsurTech, and ComTech labs to basically bring to bear some of these cutting-edge technologies, whether they be Blockchain, artificial intelligence and machine learning and/or microservices. So, we can really help our clients envision how we can combine these technologies, advance digital user experiences inside IoT, et cetera to be able to create a much stronger, much more galvanizing end-consumer experience.
So, from a demand standpoint, we’re seeing great demand. From an execution and experience perspective, we are extremely well positioned. And then, when it comes to hiring, we believe that we have one of the most advanced digital execution platforms in our industry that attracts some of the best digital engineering talent, retains this talent. And essentially, by applying a gamified continuous integration, continuous deployment platform, the performance is greatly enhanced by each engineer in the system. And not only do we use this platform internally, but now we’re starting to see an increasing number of our clients embracing this platform even for their engineering needs. So, we believe, in summary, that we’re extremely well positioned to continue to provide outstanding industry-leading services as clients embrace the digital opportunity.
Mayank Tandon
Great. That’s helpful. And Ranjan, as a follow-up on margins, if I could just ask you about the expectation for 2019. I know you’re not giving guidance, but should we expect margins to moderate going forward from the 200-basis points improvement that you’re seeing in 2018, maybe more the 100 to 150 basis points you’ve seen historically. Or can we expect another year of outperformance just given the levers you have in place? Thank you.
Ranjan Kalia
So, Mayank, I would agree that our model continues to present a lot of levers in front of us. But we’re going to be returning more to our normalized margin accretion annual of 100 to 150 basis points. We always knew this year would be higher because we were coming from a low, but next year, we really plan to return back into the 100 to 150 basis points range.
Mayank Tandon
Thank you.
Operator
We’ll go next to Frank Atkins with SunTrust.
Frank Atkins
Thanks for taking my question. I wanted to ask a little bit about some of the areas of strength and weakness in the communications and tech vertical. Any color you could provide there would be great.
Kris Canekeratne
Actually, Frank, what we are seeing – we’ve started to see that the Communications and Technology – the communications vertical is now a growth enabler for the company. Sequential growth in the communications vertical was approximately 5% and only second to our BFSI industry, which grew 7.6% in the same period. Much of that is being driven by larger programs, by clients that actually will resume spend in terms of rationalization, consolidation and eliminating technical debt. All through our services around engineering arbitrage and also their interest and enthusiasm with moving forward to digital transformation programs. So, we’re seeing this across the board whether it be in our communications sector or in our technology sector and that’s the reason why we saw strong momentum and growth in Q3 specifically from Communications and Technology.
Frank Atkins
Okay, great. That’s helpful. And in your prepared remarks, you talked about you are still in the process of evaluating some of the impacts around tax, including the beat and the interest deductible. But can you give us just a broader sense directionally as we start to look at 2019 numbers. Do you think it will be a positive or negative in terms of the tax implications?
Ranjan Kalia
Frank, so we’ve always said that Virtusa – even before the Tax Act came into play, we always model our tax rate to be increasing annually because as the – various holidays, some set. So, from that perspective, always really, we think about tax rate increasing annually for Virtusa. Now in terms of the impacts from Tax Act, it’s a little bit early for really providing any directional impact to it. But like I said earlier, we do see that the beat and the undistributed earnings could have an impact on us, but we’re still in very early stages of assessing because all the technical guidance is not really even out yet.
Frank Atkins
Okay. Great. And last one from me. Attrition ticked down nicely this quarter, anything driving that? And is that a sustainable rate going forward?
Kris Canekeratne
We’ll have Keith Modder answer that for you.
Keith Modder
Hi, this is Keith. Yes, we added 610 net new hires in the quarter. And our trailing 12 months attrition was 19.4%, down from 21.2% in the prior quarter. Our focus on shifting left in training, in growing our team members from inside are beginning to put us back in alignment with our aspirations of the high teens that we goal ourselves on from an attrition standpoint.
Frank Atkins
Okay, great. Thank you very much.
Operator
And we’ll take our next question from Vincent Colicchio with Barrington Research.
Vincent Colicchio
Yes. Ranjan, I was wondering if you can give us some of your thoughts on wage inflation in the U.S. and offshore markets.
Ranjan Kalia
I think there is always – it’s always tough from a – finding good talent and that’s what Virtusa continues to do is to find and reach that good talent. Overall, wage structure, we think the inflation is probably flat to maybe marginally down, especially in our Asia locations last year versus this year. So, we’re actually going to be modeling more so on the flat – moving this year in comparison to last year, which was [indiscernible] in the high single digits at a company level.
Vincent Colicchio
And then could you give us a little more color on the strength in Europe and if we should expect that to continue?
Kris Canekeratne
Yes. So, Vince, we’ve continued to see some expansion within our existing client base, clients that have worked with us for many, many years. And then, beyond that, we have won some significant opportunities in the U.K. and in Europe. As you know, we won a very large U.K. bank engagement, thereby we have taken over application development, application maintenance and application rationalization for all of their market systems. Again, one of the reasons that Virtusa got selected for that large-scale markets opportunity was because of our ability to demonstrate the power of engineering arbitrage and our ability to rationalize, consolidate and eliminate technical debt for this client.
So, we’re starting to see very strong traction not just in our digital transformation portfolio and book of business, but we’re also seeing great traction in terms of enabling clients to reduce the complexity, simplify their IT systems and essentially create that connective tissue between their IT systems and the rapidly emerging need for digital and – great digital experiences.
Vincent Colicchio
Thanks guys, nice quarter.
Kris Canekeratne
Thank you.
Operator
And we’ll go next to Ariel Hughes with Wedbush.
Ariel Hughes
Hi, thanks for taking my question. Just one question on the financial services segment. Can you provide us with some color on just the nature of the work in that segment, you know, what’s accounting for the relative outperformance in this area? Thank you.
Kris Canekeratne
Yes. Great question. So just to summarize, we’ve had very strong progress in the financial services segment of our business. And we’ve seen a steady expansion of market share within Virtusa in terms of financial services. There are primarily two things that are driving this. The first is the work that we’re doing in and around transformative digital programs and essentially working with our clients to reimagine their digital storefront. Banks and Financial Services or the industry is investing heavily in, basically transforming towards digital environment. And essentially expanding their addressable market by providing very advanced, great user experiences for their consumers.
And that’s clearly an area that Virtusa is extremely well positioned at. And we continue to expand our market share in Banking and Financial Services in the digital transformation area. The second area that’s a tremendous growth driver for Virtusa in Banking and Financial Services once again is essentially going in and applying our engineering arbitrage to be able to rationalize, consolidate, modernize and eliminate technical debt of our clients’ IT systems.
As a matter of fact, in one example, for one of our clients, by applying engineering arbitrage, we’ve helped them reduce in one 12-month period, 28% of their spend, primarily and exclusively by eliminating 28% of the cord that was being used to support these systems. So, you can see the inherent power and capability of engineering arbitrage and they are starting to see this as a competitive differentiator and a competitive weapon against generation one providers.
Operator
This does conclude today’s question-and-answer session. At this time, I would like to turn the call back to Kris Canekeratne, CEO.
Kris Canekeratne
Operator, back to you.
Operator
All right. This does conclude today’s conference. We thank you for your participation. You may now disconnect.
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