Any company that increases revenue every year, including 2008 and 2009, gets my attention.
That’s what companies in the Business Process Outsourcing (BPO) industry offer. A BPO company is different from a workforce outsourcing company like Manpower (NYSE:MAN) or Kelly Services (NASDAQ:KELYA). Instead of hiring a contractor to fill a headcount for a client, a BPO company takes on the entire responsibilities of a client.
The Business Process Outsourcing Industry
Think call centers.
A company like Dell gets a lot of calls about its products. In order to stick to its core competency, it will outsource call handling and other simple bulk processes. Saves time and money over trying to set up its own call center and processes. Other examples include billing, data entry, repetitive IT tasks and customer support.
The players in this industry do well because it saves money for the clients in the Global 1000 list. To hire a person for data entry in the U.S. costs about $10 per hour. In India or the Philippines, the comparable rate is $3 to $5 an hour.
When you look at the macro picture, in a downturn, temps from places like Manpower are fired, permanent employees are laid off and simple tasks are outsourced. When the economy recovers, businesses don’t want to be strapped with excess resources again. They want to preserve cash. They don’t rehire like before. Outsourcing is scaled up instead.
It works because a BPO company is able to take on an entire department’s responsibility.
No need for companies to lease buildings, hire new employees, buy new equipment and provide training. A BPO organization takes care of all that itself. For the client, it frees up capital resources and provides flexibility.
Outsourcing to an established company is a win-win for all.
A Moat in Fragmented Industries
For any fragmented industries, moats are hard to come by. Most companies stay the same size forever.
The only moat that can exist is high switching cost.
I have a couple of programmers that help me with old school value. Although there are thousands of programmers out there, I can’t switch. They know my system, I trust them and saving a few bucks isn’t worth the trouble, the cost of a potential error and the time to switch.
That’s a valuable moat.
But the added benefit with outsourcing is that it helps companies grow faster. If I were to have designed and created my website myself, it would look nothing like it does now.
Outsourcing allows the client to grow faster. At the same time, the BPO company grows along with the client. That’s because contracts are long term. A contract is anywhere from 3-8 years.
The downside is that it poses risk to the client.
Depend too much on a BPO company, and that limits your flexibility and how business is run. There is also possible security issues as data flows to an external company. Then there is quality control. It’s one of the reasons why Rackspace (NYSE:RAX) prides itself on fanatical support.
The other cause of concern is that the Global 1000 companies make several BPO companies compete against each other for price. Instead of awarding an entire contract to a single company, 2 to 3 companies are contracted and the responsibilities are split.
It’s a way to manage risk by not being reliant on a single company.
On a higher level, there is political risk. Instability in the local country is going to cause issues with operations. Currency fluctuations has an effect.
Oh, and there is Obama risk too.
He hates outsourcing jobs to other countries and there are proposed state and federal legislation for companies to reduce offshore outsourcing. But overall, it’s a great industry to be in. You’ll see why with these two stocks.
ExlService Holdings (NASDAQ:EXLS)
A BPO company with the majority of assets and and operations coming out of India followed closely by the Philippines.
- Revenue CAGR is 25.06% from 2005 to 2012
- Book value CAGR is a staggering 35.18% over the same period
- FCF CAGR is 29.34%
In addition to a great first impression, the balance sheet is fundamentally solid.
- Cash makes up 26% of assets
- No inventory to carry
- Low working capital
- Fixed assets is less than 10% of total assets
- Negligible debt
The only bad point is the increase in goodwill. ExlService is starting to acquire businesses to obtain “new” contracts and continue growth.
Margins are great but there has been a drop, which the company blames on lower utilization of their IT business, a drop in the Indian rupee vs the U.S. dollar and high costs due to a buyout.
Quality is great. No warning signs of accounting shenanigans.
The next set of numbers show you that ExlServices was never extraordinarily cheap.
Even 2008 wasn’t that cheap compared to other stocks at that time. At the moment, the cash adjusted PE is still 19 with an EV/EBITDA of 10.
P/FCF is 17 whereas I prefer to buy when a company sells for less than 10. A P/FCF of 15 is borderline for me.
ROE and ROIC is solid and CROIC is in the elite status. This is a profitable business.
But wait, there is consistent share dilution.
In a span of 7 years from 2006 to 2012, diluted shares outstanding has gone from 23m to 33.2m. A lot of options exercised by insiders and they are paid handsomely with minimal insider ownership at 3%.
Overall, here’s my take on ExlService.
EXLS Intrinsic Value
Cognizant Technology Solutions (NASDAQ:CTSH)
Cognizant is a large-cap idea. Displays the same characteristics as ExlService but as a business, it is involved in more industries and operates at higher efficiencies.
The following numbers sum it up well.
High margins, consistent growth, money making machine and high returns on investment is how I describe Cognizant.
Cognizant and ExlService have many of the same characteristics.
- Top line growth every year
- Fast FCF growth
- Very strong balance sheet
- No quality issues
The valuation ratios look eerily similar to ExlService but Cognizant is trading at a higher premium.
Insider ownership is a measly 0.2% with 93.4% owned by institutions. Insiders are very well paid and they have no interest in paying for stocks with their own cash. Also, I prefer to buy stocks with lower institutional ownership as I want to be buying something that the big boys don’t know about.
CTSH Insider Transactions | Source: Morningstar
Here’s a quick look at the business summary and intrinsic value range.
CTSH Business Summary and Intrinsic Value Range
If I had to choose between the two, I’d go with Cognizant. Size and scale helps considerably with this sort of business. However the current price does not offer a big enough margin of safety to jump in.
For such strong fundamentals, I am willing to take Charlie Munger’s advie and pay a fair price for a good compounding machine. But the valuation is too rich for me. These two will have to wait.
Side by side, here’s what they look like.
Disclosure: No positions.