Virtusa Corp  (NASDAQ: VRTU) Q4 2020 Earnings Call Transcript

Virtusa Corp  (VRTU) Q4 2020 earnings call dated May 13, 2020

Corporate Participants:

William Maina — Investor Relations

Kris Canekeratne — Chairman and Chief Executive Officer

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Analysts:

Mayank Tandon — Needham & Company — Analyst

Puneet Jain — J.P. Morgan — Analyst

Bryan Bergin — Cowen & Co. — Analyst

Maggie Nolan — William Blair — Analyst

Vincent Colicchio — Barrington Research — Analyst

Presentation:

Operator

Good day and welcome to the Virtusa Fourth Quarter and Fiscal Year End 2020 Conference Call. [Operator Instructions] Please be reminded that this meeting is being recorded.

I would now like to turn the conference over to William Maina, Investor Relations. Please go ahead.

William Maina — Investor Relations

Thank you, Shawn and welcome to Virtusa’s fourth quarter and full fiscal year 2020 earnings conference call where we’ll be discussing our financial results for Virtusa’s fourth quarter and full fiscal year ended March 31, 2020. On the call with me are Kris Canekeratne, Chairman and Chief Executive Officer; and Ranjan Kalia, Executive Vice President and Chief Financial 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 implied 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, the ability of Virtusa’s clients to realize benefits from the use of Virtusa’s IT services, the impact on our operations during the COVID-19 pandemic 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, 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.

Reconciliation 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 provides insight into the total cash position and overall liquidity. Please note that a supplemental data presentation to our fourth quarter and full year results has also been posted to our Investor Relations website. For additional disclosure regarding these and other risks faced by Virtusa, see the disclosures contained in Virtusa’s public filings with the SEC and in our earnings press release.

With that, I’ll turn the call over to Kris. Kris?

Kris Canekeratne — Chairman and Chief Executive Officer

Thank you, Bill. Good evening, everyone, and thank you for joining us today. Let me begin by saying that I hope all of you and your families are safe and healthy. These past few months have posed unprecedented challenges around the world. And on behalf of Virtusa, our hearts go out to all those affected by the COVID-19 pandemic. Virtusa’s top priority remains protecting the health and safety of our global team members and their families and continuing to serve our plan in a fair and sustainable manner. We moved rapidly on both of these fronts early in the crisis and today 98% of our global delivery team members have the ability to work from home. Our secure internal, cloud-based digital infrastructure has proven to be a tremendous asset in our ability to service our clients uninterrupted during these challenging times.

I’m incredibly proud of all our global team members for quickly adapting to this evolving situation moving swiftly to maintain business continuity and going above and beyond to ensure we continue to serve as an agile and trusted partner that our clients can rely on to address their most critical technology needs at any time and under any circumstance. In terms of our results, total revenue for the fourth quarter was $329.7 million representing a decline of 1.6% sequentially and 0.6% growth year-over-year. Our Q4 non-GAAP EPS was $0.41. For full year fiscal 2020 we generated $1.31 billion of revenue, up 5.2% and posted non-GAAP EPS of $2.14. As we previously announced in late March, our fourth quarter results reflect the impact of the COVID-19 pandemic, including business interruptions and project delays as well as elongated client decision-making cycles.

Now, I would like to provide you with some color and context around what we are seeing in the market today. It is clear that the COVID-19 pandemic is impacting clients’ spend across industries and geographies at varying levels. Some clients are reducing budgets, some have taken a more aggressive look at offshoring, while others are sitting on the sidelines until they have more visibility. Although we expect short-term secular headwinds, we see the current environment creating opportunities for us. As corporations are moving to reduce short-term cost and cut discretionary spend, they are concurrently seeking to increase investments in longer-term revenue-generating and efficiency improvement areas including digital transformation, cloud transformation, and Remoting or remote workforce support. These trends play into Virtusa’s strength.

Digital is the central revenue driver in our business and we are committed to delivering value to our clients through our digital initiatives in the short- and long-term. The definition of digital and how our clients and the industry view the overall digital marketplace has evolved in recent years. The other term was previously used to describe largely consumer-facing applications, digital now represents a broader set of technologies and interfaces critical to delivering end-to-end digital experiences. More and more companies are realizing that achieving a truly immersive and efficient end-to-end experience requires integrating front-end seamless consumer interfaces with their back-end system where digital middleware and cloud technology often referred to as deep digital. That is the expanded task and view of today’s digital and what is driving the demand.

With that view in mind, when we align Virtusa’s definition of digital with our clients and industry and after specifically excluding non-digital technologies, our proportion of digital revenue increases to 58% of total revenue in fiscal year ’20. Moving forward, we will use our updated definition of digital to report our digital revenue percentage. Additionally, our overall pipeline has expanded 78% year-on-year in the fourth quarter. And the mix of our digital pipeline to overall pipeline is consistent with our revised digital revenue mix. As digital transformation demand continues to grow, we are also seeing increased interest in cloud transformation and the two are inextricably linked. The cost reduction, flexibility and operating efficiencies cloud represents are significant and essential. We believe that the current pandemic and the recessionary environment we operate in will accelerate demand for our cloud offering, a Virtusa’s strength and competitive advantage.

We are encouraged by the early signs we have already seen and are well-positioned to help our clients. And finally, the call for help with setting up remote workforces have been steady and growing. As of today, it is estimated that tens of millions of global workers are now working from home. Employers were not ready for this transition and many have reached out to Virtusa for our unique technical ability around Remoting and virtual execution including, our Hyper Distributed Agile Solution and Services. Alongside these essential service areas, we are seeing more discrete interest in cost optimization opportunities that play to our strength, including Vendor Consolidation, Agile Squads, and Release Assurance all proven approaches to driving overall costs down and performance up.

In addition, we are seeing demand for regulatory compliance projects, particularly with our banking and financial services plans focused on either complying with new mandates created as a result of COVID-19 or advance income plans with existing requirements with timelines that were not impacted by the current health crisis. Now, I would like to focus a little closer on a few of these discrete areas which play into Virtusa’s strength and provide some specific details on how Virtusa is helping our clients address these challenges today and over the long term. We are seeing several of our larger clients, enterprises broach the need for strategic vendor consolidation planning. We believe Virtusa is exceptionally well-positioned to respond. In addition to our extreme agility to quickly enable 98% of our delivery team members to work from home providing virtually uninterrupted service to our clients we are among a minority of preferred end-to-end vendor that has the ability to provide our clients with actionable thought leadership and full stack WFH agile teams.

As a result, we are seeing some clients that want us to take on additional work from other providers who do not have the level of agility and flexibility that Virtusa has been able to demonstrate. In other cases, we are seeing clients that had already started their vendor consolidation process accelerate their planning, choosing Virtusa as their lead partner. Our success and proven track record in this regard is highlighted by an increasing number of clients across the globe who have awarded us preferred vendor status, which is an honor and represents a tremendous opportunity. As cost optimization initiatives intensify, we are also seeing more clients exhibit significantly higher comfort levels with fully offshore delivery team. As clients seek flexible, agile resources across a wide variety of projects and technologies, our Remote Agile Squad model of operation has been experiencing an increase in demand.

Our Agile Squad model utilizes 35 agile scrum teams virtually deployed to provide scale and capacity to set up a remote-ready SDLC platform to ensure distributed teams operate efficiently and critical deadline are not missed. Lastly, I also mentioned the increased client demand for regulatory compliance program necessary to comply with new mandates resulting from COVID-19. Our deep domain expertise has been a cornerstone of our regulatory compliance capabilities for many years. Virtusa was recently selected by a leading U.S. bank to create the digital infrastructure necessary to support the loan booking and servicing operations related to the aid package recently passed by Congress. In this engagement we are helping our client accelerate the loan disbursement process for the U.S. Small Business Administration Paycheck Protection Program loan as part of the COVID-19 stimulus package.

Given the critical role that banks are playing in executing the government loan program, Virtusa sees strong potential to support multiple clients in these efforts going forward. I think it is important to highlight again the demand for digital transformation and cloud transformation remains universal and is showing encouraging signs. Clients want to partner with a firm that provides true end-to-end digital solutions to help them address the public health and economic challenges of COVID-19, better digitally engage with their customers and consumers and deliver the cost efficiency benefits inherent to true end-to-end digital and cloud transformation. These directives not only fit well with who Virtusa is and what we do but most importantly, they fit well with what Virtusa does best.

As an example, with our U.S. healthcare and life sciences client base, we see a growing demand for our collaborative cloud native AI-driven platform vLife as clients rapidly pivot to focus on COVID-19 treatment and vaccination research. The vLife platform is designed to expedite research and development efforts in healthcare and life sciences by providing deeper insight into data pattern than conventional data intelligence platforms. vLife is comprised of a HIPAA-compliant data lake with multiple data sources, pre-build APIs and AI ML models. The platform offers pre-build ML models, data visualization, simulated U.S. population data, device simulated, therapy analysis and many other features. Our solution is helping to empower medical researchers working day and night to resolve the present global health crisis.

At a leading telecom client, we recently won strategic cloud program to execute data migration, data analytics, and security solutions. And finally, for a leading UK bank, we recently won a major cloud transformation initiative within their commercial origination unit. The work involves upgrading legacy infrastructure and migrating to the public cloud. We won these engagements against strong competition, including a well-known incumbent in the final round. With this significant win, we have penetrated five new buying centers at this client. And now as a preferred Strategic Partner across this client’s entire IT estate, we have access to a large addressable market and significant upside potential. Turning now to fiscal year 2021 and beyond, like our peers, the COVID-19 pandemic has created certain near-term challenges to our business.

However, along with the challenges, it has revealed unique opportunities, especially as it relates to our three pillar strategy, which has been in place with respect to growth, diversification and margin improvement. Specifically we believe that furthering our plans and incorporating COVID-19 related changes will enable us to navigate the pandemic’s near-term economic impacts and strengthen our overall market, financial and operational positioning going forward. In fact, the pandemic may serve as a positive accelerant to some of the initiatives we already had in place. Building on our fiscal year ’20 plan, the fiscal year ’21 plan consists of three fundamental pillars. First, profitable revenue growth; second, revenue diversification, which can be categorized by geography, industry and client; and third, increasing gross and net margin.

We have concrete strategies, tactics and timetables in place to deliver in each of these areas. With respect to the first pillar, profitable revenue growth, it is clear that the Global 2000 buying behaviors are changing in today’s environment. For the foreseeable future, clients will be predominantly focused on cost reduction and/or strategic projects that involve critically important workloads. These are essential versus discretionary projects and generally longer term and recurring in nature, which provides us with the ability to better manage and improve margin. Our track record with work like this, our digital strengths, combined with our size, scale, and agility positions us well to win significant share. It’s a belief borne out by the recent positive response to several go-to-market campaigns we launched targeting Global 2000 and their strategic development needs. Turning to our diversification efforts, the second pillar; our efforts to increase our geographical diversification was strengthened in fiscal year 2020 during which time we separated out the Americas and EMEA P&Ls.

We aligned senior executives to oversee our efforts in each region and have made key local leadership hires including a Managing Director focused on Europe and the Middle East. We expect these changes will expand our client base, enable closer client relationships, strengthen our position regionally, and drive revenue diversification and growth, particularly in EMEA. In terms of group diversification, our increased sales and marketing investments in attractive verticals over the past year-and-a-half, as well as strategic M&A have resulted in 46% year-over-year growth in our healthcare client revenue and 25% growth in our C&T industry group in fiscal year ’20. Our Communications and Technology Industry Group represented 34% of our revenue in fiscal year ’20, up 500 basis points from fiscal year ’19 while BFSI dropped by 400 basis points over the same period.

Additionally, our healthcare clients represented approximately 15% of our revenue in fiscal year ’20. Given the increasing importance of healthcare to our business from a growth, scale, and margin perspective, we are evaluating whether to break out healthcare into a separate industry group on subsequent calls. Lastly, we continue to accompany our geographic and industry diversification efforts with greater diversification of growth at the client level. We believe it is critically important over the long term to reduce concentration in our largest accounts and capture increasing organic growth opportunities across the remainder of our account base. To do so, we plan to focus on high potential accounts by increasing sales and marketing spend in these areas.

We have seen this strategy work very successfully at our strategic accounts and our plan is to apply these same techniques to grow high potential accounts to accelerate account diversification. It is important to note here as well that all of our diversification efforts should inherently drive revenue expansion and organic margin accretion over time. Coming to our third pillar, our fiscal year ’21 plan also include several strategies under way to reduce costs and improve both gross and net margins from Q1 2020 levels. We have initiated programs to improve labor pyramid efficiencies, utilization and the direct cost versus build spread. The initiatives are focused on the core profit drivers of our business, people supply chain, mobility, project profitability and G&A cost reduction.

And we have initiated programs to reduce our use of subcontractors while also optimizing our staffing pyramid. We believe these actions and the fiscal year ’21 plan as a whole are the right course based on what we are seeing with increasing pipeline momentum, our models beyond the immediate negative impacts of COVID-19 and preliminary results. We believe this plan forms the basis for revenue growth and margin accretion to improve from Q1 levels over the course of fiscal year ’21 and fiscal year ’22 and then return to strong above-industry revenue growth and earnings growth faster than top line as we emerge from the pandemic and the recessionary headwind it has generated.

I will close by saying that for all the turmoil in the world right now, we are confident in the plan we have laid out. Virtusa remains well-positioned to deliver value to our clients, especially in these uncertain times. Although the short-term environment will have its challenges we have the right tools, teams and three-pillar strategy in place to come out stronger and better positioned on the other side. I’m incredibly proud of all our global team members and their unwavering commitment to Virtusa and to the clients we serve. Thank you for your time. Now, I’d like to turn the call over Ranjan who will provide more details on our fourth quarter and full year results and will provide some detail with respect to our outlook for the remainder of fiscal year ’21. Ranjan?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Thanks, Kris, and good evening to everyone. Let me start by summarizing the results of our fiscal fourth quarter and full year 2020. Revenue for the fiscal fourth quarter was $329.7 million, representing a 1.6% sequential decline in reported currency and 1.5% decline in constant currency. Year-over-year, our fourth quarter revenue increased 0.6% in reported currency and 0.9% in constant currency. Our fourth quarter revenue was consistent with our revised March 26 expectations. Gross margins for the fiscal fourth quarter was 24.3% compared with 29.4% in the prior quarter and 29.7% in the year ago period, primarily reflecting the impact of lower revenue on our utilization, higher subcontractor costs, seasonal increase of employee benefits and pre-scheduled compensation increases. GAAP operating income for the fourth quarter was $17.1 million compared with $30.4 million in the prior quarter and $23 million in the year ago period.

Fourth quarter other expense was $14.5 million. This includes $10.7 million of net foreign exchange loss and $3.8 million of net interest and other expense. Net interest and other expense includes $4.6 million of interest expense and $800,000 of interest and other income. GAAP diluted earnings per share was $0.66 in the fourth quarter. This compares to $0.38 in the prior quarter and $0.24 in the year ago period. Our fiscal fourth quarter GAAP EPS includes a tax benefit of $11 million or $0.33 per share related to the merger of our Indian entities.

Now turning to our non-GAAP results; non-GAAP operating income was $19.7 million in the fourth quarter compared to $40.5 million in the prior quarter and $34 million in the year ago period. Fourth quarter non-GAAP operating margins was 6% reflecting lower sequential gross margins.

Non-GAAP earnings per share was $0.41 in the fourth quarter. This is compared to $0.78 in the prior quarter and $0.46 in the year ago period. Turning to the balance sheet, ending cash at March 31, 2020 was $300.6 million inclusive of cash and cash equivalents, short-term and long-term investments. Cash increased by approximately $63 million sequentially. We made payments of $32.3 million in Q4 related to tuck-in acquisitions. These acquisitions include vendor consolidations at our large clients and an India-based digital transformation company. Our cash flow from operations was $5.4 million for fiscal fourth quarter and $79.9 million for fiscal year 2020. Our DSO for the fourth quarter was 78 days, a 9 day increase sequentially. Our Q4 cash flow from operations was below our expectations due to higher DSO, but in line with historical fourth quarter trends.

In March, we drew down approximately $84 million from our credit facility as a proactive measure in light of uncertain COVID-19 situation. Additionally, in April we moved $25 million of cash from our India entity to U.S. without tax implications to support our U.S. legal entity liquidity needs. We believe our approximately $300 million cash balance is adequate to cover our cash needs. That being said, we have designed additional strategies to boost liquidity if needed.

Now, I will turn to a more detailed discussion of our fiscal fourth quarter revenue performance. The $27.7 million underperformance compared to the midpoint of our February guidance was primarily due to 60% from a reduction in backlog due to the reduced scope and cancellation of certain projects, 35% from the impact of our pipeline from elongated client decisions making cycle and 5% from unfavorable foreign exchange fluctuations, predominantly the British pound versus the U.S. dollar.

In terms of our performance by industry group, BFSI decreased 2.7% sequentially and declined 8.3% year-over-year, representing 55% of revenue versus 61% in the year ago period. Our year-over-year performance in BFSI reflects the impact of the previously discussed reductions at our large UK banking client and impacts of COVID-19 on client spend. Communications and technology revenue decreased 2% sequentially and increased 13.3% year-over-year. Our year-over-year growth in C&T was supported by growth at our healthcare and telco clients. C&T represented 36% of revenue in Q4, up from 31% in the year ago period, as we continue to drive further industry diversification. Media information and other revenue increased 6.6% sequentially and 18.7% year-over-year, representing the remaining 9% of revenue.

We continue to see good momentum for our digital and cloud transformation services at our media clients. Turning to our geographical performance, North America revenue decreased 2.8% sequentially and grew 5.2% year-over-year. Europe grew 1% sequentially and declined 20.2% year-over-year. Finally, rest of world revenue grew 3.9% sequentially and 15.6% year-over-year. I would now like to briefly summarize our financial results for the full fiscal year 2020 as compared to fiscal year 2019. Revenue was $1.3 billion, an increase of 5.2% year-over-year. On a constant currency basis, revenue increased 5.6% year-over-year. Our performance reflects growth within our C&T industry group of approximately 25% year-over-year. C&T performance was driven by growth at our large telco client, at our large high-tech client, and across our healthcare client portfolio.

GAAP diluted earnings per share was $1.42 compared to $0.38 for fiscal year 2019. And non-GAAP diluted EPS was $2.14 compared to $2.12 in fiscal 2019.

Turning to our outlook. Given the market volatility and economic uncertainties associated with COVID-19, we have temporarily suspended our financial guidance for fiscal year 2021. While our pipeline continues to grow, we have limited visibility on when some of these deals will close and therefore do not believe it would be prudent to provide formal guidance at this time. We will continue to monitor the COVID-19 situation and plan to resume guidance once visibility improves. While we will not give you our typical financial guidance ranges, I will provide you with incremental color on demand trends, financial impact, as well as some opportunities.

Despite the COVID-19 overhang, we continue to see demand across our client base. We do realize that client budgets may be under pressure and thus certain programs and projects may not be actioned. Some work may be put on hold and longer decision-making cycles may affect pipeline closure. In the current environment, we believe some new spending patterns are emerging, while other areas are gaining more focus. First, increased focus on cost saving and efficiency program; these include spending on cloud transformation, intelligent automation, offshore development and vendor consolidation of smaller providers.

Second, enhancing the remote workforce model. This will include spending on collaboration and productivity monitoring tools, work for efficiency solutions and accelerated data and application migration to the cloud. Third, we believe the current environment will provide more opportunities for outcome-based pricing. And lastly, additional regulatory compliance work to address new requirements from COVID-19 related legislation. Global GDP remains under pressure impacting our clients’ budgets. While we have seen an increase in our pipeline, we believe decision-making cycles will remain elongated impacting start dates and initial deal sizes. Therefore, on a preliminary basis, we expect our fiscal first quarter revenue to decline approximately 10% year-over-year. While we remain optimistic about our growth in the second half of this fiscal year, our first quarter results and continued uncertainty in the market will most likely result in our FY21 revenue declining versus our FY20 results.

We caution that another significant COVID-19 outbreak could further impact the market and our performance. We are using this current environment as a time for continued improvement in order to exit this period even stronger. Some of the actions we have taken include a realignment of our revenue forecasting methodology to increase the percentage of backlog in our financial model. And a comprehensive cost reduction and efficiency plan, which encompasses improving pyramid efficiencies, reducing use of subcontractors, increasing utilization, enhancing project profitability and G&A leverage. In conclusion, the COVID-19 pandemic impacted our fourth quarter results and we expect fiscal 2021 will reflect continued demand side challenges.

We will continue to closely monitor the impacts of COVID-19 on the economy and our client budgets. We remain prudent and are planning preparing for a wide range of economic scenarios for Virtusa. During this period, we are prioritizing the health and well-being of our global team members and their families and serving our clients. At the same time, we have increased our focus on reducing our costs and strengthening our financial flexibility without sacrificing investments in those areas that will enable Virtusa to grow over the long-term. Once the current economic uncertainty subside, we believe we can grow revenue faster than the market, deliver annual margin expansion and generate EPS growth faster than revenue growth. Operator, you may now begin the Q&A session.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question will come from Mayank Tandon with Needham. Please go ahead.

Mayank Tandon — Needham & Company — Analyst

Thank you. Good evening Kris and Ranjan. Thank you for sharing some of that perspective. So just from a guidance standpoint, you’re not giving formal guidance, but you talked about the 1Q downtick in revenue. Could you talk about trends so far that you’ve seen in April and through early May? And what that might suggest to you in terms of could 1Q be the bottom? Is that signaling a trough or do you think that’s going to linger into 2Q as well before we see some kind of bottoming based on what you’re seeing today?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Sure. Mike, let me start then Kris will add. So Mike, like we talked, right, we believe the year-over-year decline on Q1. But what we’ve done for ourselves is we are really carrying Q1 with a lot higher backlog than we’ve done in prior times. So that’s one piece that we’ve done to our revenue forecasting model. Behind that if you really look at it, like Kris talked, the pipeline continues to increase. And even with lower close rates that they might be, we believe that the Q1 reflects around a 10% decline year-over-year. Now from there, we believe we will start to really grow similar patterns like we’ve done in prior years and even if we grow similar patterns like prior years and probably the latter part of the year, slightly slower than prior years, we do believe this will still be a year-over-year decline, but the year-over-year decline should be less than the decline that we are facing in Q1 year-over-year.

Mayank Tandon — Needham & Company — Analyst

Okay, that’s helpful color. And then I wanted to shift gears to the digital piece. In terms of, just looking at the digital numbers coming out of many of your peers, they’re growing a lot faster even in the midst of this pandemic at least through their last quarter. You noted a 2% growth rate. Could you just point to what might be weighing that growth rate down? Is it a function of the way you define it versus your peers or is something systemic to that piece of business that is impacting it versus what we’re seeing from a lot of your peers in terms of the growth profile there on the digital side?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Yeah, so Mike, I want to just correct the 2% growth rate that you mentioned. So if you look at the new digital definition that Kris talked about and he’ll embellish more on that, but I just want to talk about the growth rate, the digital growth rate that we have on the new definition is slightly higher than the company average. Now last year, if we look at it, it wasn’t the best growth rate year for Virtusa. You’ve known about the reasons being we had a significant shortfall in a very large UK based client, so that impacted the growth for the company. But the digital growth for the segment that Kris talked about is slightly higher than the company average.

Kris Canekeratne — Chairman and Chief Executive Officer

Mike, just to build on what Ranjan just said, so it’s very clear to us that digital has evolved in recent years and our definition of digital lag behind what clients think of as digital today. So where the term digital was previously used to describe largely user experience, consumer facing applications and technology, digital now represents a much broader set of technologies and interfaces that are really critical to delivering an end-to-end and immersive digital experience. So as an example, when any of our clients think of digital today, in addition to the end user interface they include the middleware layer, microservices, data lakes, AI/ML, cloud infrastructures so that it can provide an end-to-end experience. Much of this is also referred to as deep digital. So when we align Virtusa’s definition of digital with how our clients view digital transformation and after specifically excluding non-digital technologies, our proportion of digital revenue is 58%. From now on we will report digital in line with how our clients and many in our industry calculate digital. And we’re also very pleased with the pipeline momentum that we have in digital. As you know, our pipeline has consistently grown very rapidly with digital.

Mayank Tandon — Needham & Company — Analyst

Okay, that’s helpful. And just finally Ranjan, I didn’t catch this if you did note it, please remind — if you can provide some more color on margins. Do we see another step down in margins in 1Q before we start to build back up? Maybe any kind of framework on that would be very helpful from a modeling perspective. Thank you.

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Yeah. No, fair question, Mike. As you know, our Q4 exit was less than our previous expectations. Our previous expectation for Q4 used to be a low-double digits and our performance for Q4 was shorter than that. But coming into Q1 we are seeing another revenue step down sequentially as you will notice, and then over — which means that the billable utilization gets impacted. Over and above that, you have some new expenses that have come in and also we have the whole productivity discount that we’ve talked about with our large client that really starts to impact our Q1. So, yes, Q1 margins will be lower than the Q4 margins because of those two reasons. We plan to really grow the margins coming out of Q1 once again consistent with our prior performance and full year we are expecting margins to be flat year-over-year.

Mayank Tandon — Needham & Company — Analyst

Thank you.

Operator

And the next question will come from Puneet Jain with J.P. Morgan. Please go ahead.

Puneet Jain — J.P. Morgan — Analyst

Hi, thanks for taking my question and good to know that you all are safe and healthy. So Kris, you talked about how COVID-19 can result in increased spending on cloud and digital over the long term. Should we also expect to see inflection in offshore adoption as clients get more comfortable with virtual model of delivery?

Kris Canekeratne — Chairman and Chief Executive Officer

Great question, Puneet, and the short answer is yes. It’s very clear to us as we’ve looked at our pipeline and the significant increase that we’ve had in our pipeline that much of that increase is represented in what we would call Hyper Distributed Agile, which basically means that agile teams can work virtually from anywhere using our gamified tools and platform without any loss in productivity to execute the work. As you know, post-COVID and in this recessionary environment all of our clients have constricted budgets but they still have to get critical strategic workloads done. And we believe that the fact that Virtusa has already demonstrated the ability to execute from — through work from home using our tools and our platform have had no interruptions or disruptions in terms of service delivery.

And the fact that client budgets are declining, we believe that that will tend to increase offshore service execution as the quarters progress. And this is also reflected in our pipeline. So I can spend a moment on the pipeline, Puneet, just to build on your question. So our pipeline, as I mentioned earlier, is up 78% over the same period last year. But I think there’s a little color behind that. So shortly before COVID-19 was deemed a pandemic, we moved our teams very quickly to work from home and initiated to setup targeted campaigns to take specific offerings to both new and existing clients.

These offerings included of a Hyper Distributed Agile offering, enabling Virtusa’s scrum teams and squads to collaborate remotely without any loss of productivity, digital offerings and solutions targeted regulatory changes and on programs such as PPP and SMB loans, large scale workload consolidation through Remoting, offshoring and demonstrating compelling productivity metrics, and overall, and since early March, our overall pipeline have expanded significantly to over $4 billion. While much of the newly injected pipeline is in early stages, we are cautiously optimistic about its contribution in the second half and beyond.

Puneet Jain — J.P. Morgan — Analyst

Got it. A quick follow-up on that Kris. So we view your pipeline as existing work and new work in areas that you talked about, for example, Remoting and all. Is it going to result in reprioritization of client spending towards new area, meaning that some of the old work may not get executed or do you think that some — the old work will also get executed and it’s just being deferred right now?

Kris Canekeratne — Chairman and Chief Executive Officer

We believe that old work that comprised of digital transformation or end-to-end digital transformation to be able to reach a broader consumer and customer market. Cloud transformation, I think there is a heightened awareness of the importance of cloud, especially in terms of enabling work from home or servicing consumers that would most likely avail of services from anywhere. We believe that those programs are continuing to be funded; new programs with respect to on Virtual Remoting. In the past there was a strong desire, especially in agile teams to have everyone work in a open space environment all together, collaborating on solutions and we have been able to demonstrate very effectively, that we can execute that work remotely. We are seeing significant traction in that area. So those are the types of programs that we believe will continue to get funded. Critical strategic programs to expand our clients’ addressable market, regulatory compliance issues and Remoting obviously, in a cost-constrained environment we believe that a larger percentage of it would get executed through offshore.

Puneet Jain — J.P. Morgan — Analyst

Got it. Thank you. And Ranjan quickly, thanks for providing breakdown of $27 million or so impact on Q4. Was pricing also a component of it given like the magnitude of impact in such short duration? Was there any pricing impact and should we expect that to continue into Q1, Q2?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Yeah, fair question Puneet. If you look at it, was there any pricing concession discussions that you were really having while there was a revenue shortfall, probably not a significant amount that is there. But yes, when we look at what we’ve all talked about the realized pricing as a metric, that realized pricing as a metric was lower than our Q4 expectation, but that’s largely really due to the revenue shortfall that we were facing. Now moving this discussion forward, I think we do believe that our realized pricing rate or the industry sometimes terms as PDR will have an impact in 2021 largely due to the productivity, efficiency discounts that we provided to our large client and some of the FX issues that we’re having. But that a lot of it does get offset by a mix change of our revenue because we’re having some higher growth accounts that are expected to really grow or I should say higher margin accounts that are expected to grow. So overall, we would see an impact at the company level, but underneath some of the higher margin accounts are growing and would impact and offset some of the headwinds that we would be facing.

Puneet Jain — J.P. Morgan — Analyst

Got it. Thank you.

Operator

And the next question will come from Bryan Bergin with Cowen. Please go ahead.

Bryan Bergin — Cowen & Co. — Analyst

Hi guys. Good evening. Hope you’re all doing okay. Just wanted to follow up on the outlook. So based on what you’re seeing here and Ranjan within that initial 10% contraction expectation for the June quarter, can you just help us parse how much of that might be driven by the top client and some of the other top 10 clients versus whether you’re seeing that more broad-based across the portfolio?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Yeah. So we do see an impact at our top clients in Q1. Most of the performance, I would say that sequentially — there is an impact sequentially at our top 10 portfolio as well as at our non-top 10 portfolio from Q4 into Q1 levels. So we do see that impact. And there are few onesie, twosie clients that are keeping the large clients that are keeping their performance flat. But kind of in this current environment that’s a little bit expected. It could be demand but there’s also logistic disruption that is still happening, right. We still know that there’s — even though there is work from home abilities that we have but the lock-downs and the length of the lock-downs does impact sometimes the revenue performance because it does impact the new supply chain that’s really needed for the revenue.

So that’s not a huge surprise to us in the current environment that — that portfolio is showing a sequential decline both the top 10 and the non-top 10. But we do expect based on the pipeline and based on –like we talked, the high backlog percentage that we are carrying into the year and even in Q1 that those portfolios will grow for the remainder of the year, especially the top 10 one. Because the non-top 10 in the current environment — non-top 10 is going to have, still have more challenges. So we have top 10 portfolio. Well, if you have strong financial wherewithal to last through this period, that’s a more important portfolio and we do see that continues to go after Q1.

Bryan Bergin — Cowen & Co. — Analyst

Okay. And then just on the pipeline commentary. Can you help us translate some of the metrics you’re citing around pipeline with ultimately potentially revenue growth now? When we think about pipeline, how much is qualified or mature? How many of that has changed? Anything around close rates or just backlog as that has trended? Anything you can help us out with there.

Kris Canekeratne — Chairman and Chief Executive Officer

Sure, Bryan. So it’s — we are obviously very pleased with the growth in the pipeline. I think the campaigns that we took out were very topical. They resonated particularly well. We’ve even seen some opportunities move very quickly through the pipeline. But having said that, it’s important for me to stress and underscore that much of that very significant pipeline growth is in early stage and much of that will move over the next several months and quarters. And from an expectation standpoint, we expect that this pipeline growth will actually only translate into tangible revenue in the second half and beyond. Now, in terms of your question with respect to deal sizes and close rates; close rates have been consistent, hasn’t changed quarter-over-quarter or quarter-over-year. And from a size perspective, the overall pipeline has actually expanded with average deal sizes growing about 66% year-over-year.

Bryan Bergin — Cowen & Co. — Analyst

Okay. That was helpful. Thanks. If I could squeeze one more and Ranjan did you mentioned the — I thought I heard the inorganic contributions from a consolidation and another deal. Was that material?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

That was probably the inorganic, well, it’s probably in the 2.5% for the quarter for Q4. Yes, I mean, we did have — so one of the things that Virtusa has really benefited like Kris talked earlier on in these larger enterprises where we continue to gain preferred vendor status, we are also being getting opportunities of vendor consolidation, especially for the smaller vendors. That seems like is an inbound flow that continues to come to Virtusa because of the strength, the delivery excellence strength that we got and the domain expertise that we got. So the inorganic tuck-in acquisitions that I talked about were benefited by that and then we also acquired a very small tuck-in company — India based, which was a digital transformation company. And I would say, think of the eTouch of India, like we did a couple of years back, the West Coast company, which was all digital transformation but eTouch was all onshore oriented. This is still digital transformation but all offshore oriented. So we are very excited about some of these opportunities that we’ll be able to close.

Bryan Bergin — Cowen & Co. — Analyst

Thank you very much.

Operator

And our next question will come from Maggie Nolan with William Blair. Please go ahead.

Maggie Nolan — William Blair — Analyst

Thank you. Can you clarify for me — so kind of $27 million that you previously referenced when you withdrew the guidance, and that’s about kind of where you shook out? How much of that are you characterizing as truly COVID driven? And then of the COVID impacts, do you have a sense for how much the affected portfolio at that time was kind of having a knee-jerk reaction versus those that were already seeing financial distress related to COVID at that point in time?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Sure. Maggie, let me start and then Kris will add. Maggie, we believe most of it that impact of $27 million was really COVID impact, right? We believe we were going to meet the midpoint of our guidance. We did see shrinkage in our backlog, which usually, as you know, in our business doesn’t happen to a significant amount. You may sometimes come across a slight shrinkage in backlog, but it’s not a significant change in the backlog. In this case, we did see a significant change in the backlog over a very short period of time. We saw significant change in the deal closures. And also, we believe that was COVID-related. Some of it was disruption. Some of it was people really trying to manage that expenses and some of that decision-making, we believe also landed in our DSO in terms of getting the paperwork signed because those processes were really not articulated really well, somebody is working at home, the workflow systems are really not working. So all those pieces that happened because of COVID really impacted the revenue cycle we believe.

Maggie Nolan — William Blair — Analyst

Okay, thank you. And then with respect to the goal of growing high potential accounts to diversify the revenue base, how are you reconciling that with the likely widespread downturn in demand that we’ll see in the coming months and quarters? Is there a difference in how you have to define high potential or growth accounts in the near-term versus the medium or the long-term?

Kris Canekeratne — Chairman and Chief Executive Officer

So Maggie, obviously we have a three pillar strategy that we’ve been — that we deployed starting last year and we are continuing to move forward with our three pillar strategy. A key element of that is diversification and we are — we’ve seen and we’ve had very strong, a very strong track record of working with our clients and scaling them pretty significantly whether they were our own clients that we had organically brought in or whether they’re some of the clients that we actually acquired through what Polaris and our eTouch.

Now clearly, as we go into fiscal year ’21, they’re going to take some of those playbooks, and they are going to replay those playbooks in high potential accounts outside of some of the accounts that have already scaled significantly and are somewhat concentrated. Now, the good news is that we have an increasing number of accounts that we have been selected as a strategic preferred partner. So it gives us a very large addressable market. And we believe that from a sales and marketing spend perspective, etc., that we will focus a higher percentage of investments in those accounts that present high potential, have not — are not a concentration — have not reached that level of concentration but still present very significant potential for growth.

Maggie Nolan — William Blair — Analyst

So it’s not necessarily an expectation that you drive growth in fiscal ’21 at these accounts but you kind of build the foundation for it?

Kris Canekeratne — Chairman and Chief Executive Officer

Correct. I mean, obviously, our plan is to continue to drive our diversification strategy to obviously execute that by virtue of how we allocate sales and marketing investments. And as we do that, we will continue to push forward on our three pillar strategy and obviously build a strong platform as we continue both in the second half of this year and going into fiscal year ’22 to make sure that we are moving in the direction that we had set up in terms of diversification and reducing concentration.

Ranjan Kalia — Executive Vice President & Chief Financial Officer

So Maggie, just like to say, there will be growth in these high potential accounts this year itself. I mean, we’re just not expecting Q1 and probably some part of Q2 is going to get impacted but if things stay as it is and yes, there are some unknowns that could be, there will be a second wave of COVID-19, but that’s not necessarily what we’ve really planned for but without that, we do believe some of this growth will show up in the current year because we are expecting back half growth and some of the growth even in Q2.

Maggie Nolan — William Blair — Analyst

Okay, thank you.

Operator

[Operator Instructions] Our next question will come from Vincent Colicchio with Barrington. Please go ahead.

Vincent Colicchio — Barrington Research — Analyst

Hey Ranjan, could you break down the attribution of the decline in margins in the quarter, gross margins between low revenue subcontractor costs, etc.?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Vinnie, we’re not really providing that level of break but let me give you another perspective. If you really look at it, the change in utilization that we have from Q4 levels, if you look at it, our billable utilization is probably running at about 80% in Q4 and in Q1, right now, we’re expecting that utilization will probably be in the 74% to 75%. So if you look at our historical metrics around sensitivity of utilization, which has been about 40 basis points. So you’re really talking 240 basis points, 250 basis points just coming from the utilization factor in themselves. You overlay on top of that, the productivity discount that we talked about with our large customer, even though we believe some of that productivity discount will really come — still come from productivity efficiencies, but some of it will impact revenue. So therefore, those two pieces impact Q1 bringing Q1 down from 6% margin that we had in Q4 further down into Q1.

Vincent Colicchio — Barrington Research — Analyst

And then, Kris, you talked to a number of times about the increase in preferred provider relationships. Do you track that data? Do you have numbers behind that, like the number that it increased from year-over-year or anything like that?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

Yes, we do. I can tell you, Vince we’ve had a significant increase year-over-year in strategic preferred partnerships. We have not disclosed that number, but it represents a very significant drop of accounts that have reached a certain level of minimum scale that provides us with the opportunity to basically replay the same playbooks that we have used to grow accounts from 5 million to 20 million, 20 million to 50 million, 50 million to 100 million, and even a 100 million to 200 million. So, we’re very excited about that and we will keep you posted on subsequent calls in terms of how we are doing against our diversification pillar of our three pillar strategy.

Vincent Colicchio — Barrington Research — Analyst

And then last question, should we be concerned about any of your top 10 clients? Are any of them financially leveraged, anything of that nature?

Ranjan Kalia — Executive Vice President & Chief Financial Officer

I think Vinnie, that’s a tough one. We believe all our top 10 clients — these are Global 1,000 or Global 2000 clients. We believe they are all in a good financial position. It’s going to be a little bit of a sector discussion, right? We do have a concentration on banking clients. So if that sector get impacted. The positives are we don’t have exposures to hospitality. But we do carry some — a large portion of the banking clients. We believe these are marquee banking clients so should not really be a risk, but you always need to watch for those things. But we continue to believe, I mean the size and scale of business that we do with these larger clients. Trust me the market opportunity is huge inside them.

Vincent Colicchio — Barrington Research — Analyst

Okay. Thanks for answering my questions.

Operator

This will conclude our question and answer session. And I would like to turn the conference back over to Kris Canekeratne for any closing remarks.

Kris Canekeratne — Chairman and Chief Executive Officer

Thank you. Thank you all for joining us on our Q4 and full year fiscal ’20 earnings call. I would like to take this opportunity to thank our global team members for their dedication to our clients in these challenging times. Thank you once again for joining and stay well everybody.

Operator

[Operator Closing Remarks]