Startek Delivers For Investors, Achieving Profitability Sooner Than Expected

| About: Startek Inc. (SRT)

Summary

Gross margin and net earnings contribution from a successful and timely Accent integration have been confirmed.

Higher overall capacity utilization, combined with the absence of the dilutive effects seen in Q3 to result in a higher overall gross margin was confirmed. Further SG&A cost reductions confirmed.

A very good chance we see a back-to-back EPS gain after Q1 results are announced; last time this happened was in 2009.

On my last article, I made the case that the worst was behind Startek (NYSE:SRT) and that stable AEBITDA and sustainable profitability was within their reach. Their Q4 results came in way better than expected, yet the stock currently trades near the level it was before the announcement.

Once the Company shows consistency in their results as the year progresses, both the analysts and the market will evolve from skeptics to believers. However, if the investment thesis makes sense to you today, herein lies the opportunity to profit from this disconnect.

The most important quotes from CEO Chad Carlson during their earnings call: "Q4 results are just a glimpse of the kind of results STARTEK is capable of producing…Utilization increased during Q4 and this continued effort will result in stronger gross margin performance; we will continue to optimize our footprint in 2016…."

Startek reported Q4'15 revenue of $82.3 million for a non-GAAP EPS of $0.08/share and GAAP EPS of $0.02/share; the first GAAP EPS gain in 3 years. The return of stronger call volumes from core clients plus new client revenue growth, combined with cost reductions and a successful integration of Accent, produced much healthier margins.

Given the lack of incentive for Street analysts to dig deeper, Q4 earnings significantly beating consensus estimates by a very wide margin, the Company beat consensus estimates by 32 cents on a non-GAAP basis! I expect Q1 results to show continued AEBITDA stability and another healthy EPS beat.

Reiterating STRONG BUY rating

After a very trying year for Startek, Q4 results confirmed that they have the right formula and have made the right moves to achieve sustainable profitability. It also confirmed, in my view, the investment thesis we have been expecting. As they scale higher revenues with their improving cost structure, Startek has the ability to achieve their targeted AEBITDA margins of 10% to 12% as annual revenue levels reach $350 to $450 million over the next 12 to 18 months. The Company achieved an AEBITDA margin of 6.9% in Q4 (with an annualized Q4 revenue level of $329 million). However, the quarter still did not show the full benefit of the Accent synergies and other planned cost savings expected in early 2016.

Why anybody would be willing to sell shares at current levels is truly beyond my comprehension.

Startek's three business segments had the following quarterly results on a non-GAAP basis and before the impact of growth investments (the total and segment non-GAAP Gross Profit % are estimates since the Company has not provided a breakdown per segment of their growth investments):

December 2015

September 2015

June 2015

(millions)

Sales

GP

GP%

Sales

GP

GP%

Sales

GP

GP%

Domestic

$52.7

$7.0

13.3%

$44.6

$0.5

1.1%

$37.1

$2.4

6.6%

Offshore

$17.3

$2.1

12.2%

$17.1

$2.1

12.0%

$18.1

$2.5

13.7%

Nearshore

$12.3

$1.9

15.6%

$11.1

$1.6

14.5%

$8.2

$1.3

15.6%

Total

$82.3

$11.0

13.4%

$72.8

$4.2

5.7%

$63.5

$6.2

9.8%

Click to enlarge

The top 4 clients accounted for about 50% of revenue during this quarter as compared to around 80% of revenue during the same quarter last year. This speaks to the significant transformation and achievement in terms of revenue diversification. In fact, Startek served about 16 clients 3 years ago compared to 58 clients in the core business plus 210 clients under the healthcare vertical serviced today. I use this 3-year comparison given that the current stock price level is where it was 3 years ago. The market is giving no value to the significant transformation and repositioning achieved during that time.

Revenue from verticals excluding telecommunications/cable and media increased to $26.3 million, representing 32% of total revenue during the quarter as compared to 17% in the same quarter a year ago.

Their strategy is to continue to expand into vertical markets they currently serve, including: communications, media and entertainment, retail, healthcare, education, financial services, utilities, and non-profits. The Company has made significant strides into the diversification and expansion of their client base. As a result, we should see further reduction to the client concentration risk exposure the Company has had historically.

The focus for 2016 is to leverage the investments made during this transformation process with new capabilities, service differentiation, and constant strong performance with their large clients as a solid reference to move into more clients that have a better margin profile and with better scale than before given their new structure.

I estimate that Startek ended Q4 2015 with a total of 13,850 available agent seats across its facilities, as follows:

# of Agent Seats

As at Q4 2015

Domestic

6,100

Offshore

5,435

Nearshore

2,315

Total

13,850

Click to enlarge

Gross margin increased sharply to 13.4% on a non-GAAP basis as compared to the 5.7% achieved the previous quarter. Startek achieved AEBITDA of $5.7 million and AEBITDA margin of 6.9% this quarter up sharply from the ($1.25 million) achieved last quarter. The reported GAAP gross profit of $9.7 million included $0.72 million in F/X hedging contract losses, as well as, a $0.6 million impact due to growth investment expenses and capacity build out for a GAAP reported gross margin of 11.8%. Excluding these investment expenses impact and the F/X losses, the business already ramped and produced 13.4% in non-GAAP operating gross margin.

SG&A expenses came in at $8.4 million or 10.3% of revenues, $0.9 million lower than the previous quarter. However, that total included $260k in non-recurring integration related expenses. Back in Q2'15, the Company had indicated that once Accent was fully integrated in Q4'15, SG&A should total $9 million for the quarter, so results came in well below that guidance as more integration savings were achieved. At this level, and given the added revenues from Accent, the SG&A structure was leveraged to achieve under 11% of revenue, surpassing their previously stated goal of under 12% of revenue.

SRT's cash balance ended at $2.6 million. The Company generated AEBITDA of $5.7 million. After growth investment expenses of approximately $600k and non-recurring integration related expenses of $260k, the reported AEBITDA was $4.8 million. After cash restructuring charges payments of $520k and working capital needs of $4.7 million, the Company was operating cash flow negative by ($380k) for the quarter. After CapEx of $1.2 million mostly for new capacity, they were free cash flow negative by ($1.6 million) this quarter. The free cash flow shortage was financed with cash on hand and their credit facility. Management expects their current cash balance together with their borrowing capacity under the line of credit to be sufficient to cover their liquidity needs.

On my last report, I expected the Company to need an additional $4 million from their credit facility during Q4 mostly for accounts receivable financing; the increased usage was actually just $3.8 million. I now think they may not need any further financing from their credit facility depending, of course, on the revenue level achieved in Q1'16. I still expect the Company to be FCF positive and start paying down debt by Q2'16 (if not before) and end free cash flow positive for the year.

Accent Acquisition

In my view, the acquisition of Accent has proven to be very opportunistic with integration nearly complete several months ahead of schedule, retention of almost 100% of the clients and the expansion of business with several of them. The acquisition clearly contributed to net earnings during Q4, and is expected to contribute more starting from Q1'16 when the full benefit of the synergies take effect.

During 2014, the Company spent $17.1 million for 2,900 new seats yielding an average cost of $5,900 per seat. With Accent, they acquired 2,000 seats for a purchase price of $16 million yielding an average cost of $8,000 per seat. However, the Accent seats already came with a producing workforce eliminating employee hiring and ramping expenses. And more importantly, these seats brought their own revenue with 18 clients across different verticals, including brands such as Sprint, Lennox, Whirlpool, Panasonic, BJ's, Sharp, Bridgestone-Firestone, Char-Broil, and others.

AEBITDA Analysis: Actually Achieved vs. Reported and how it has been allocated.

The following is a simple AEBITDA and cash flow analysis to reconcile the actual AEBITDA generated to the AEBITDA reported, and to clearly see how/where the cash was utilized.

(Millions)

Q4'15 A

FY2015 A

FY2016 E

FY2017 E

Total Revenue

$82.3

$282

$334

$358

Gross Margin (NonGAAP)

13.4%

10.2%

14.1%

15.5%

AEBITDA (Cash Generated)

$5.7

$7.9

$26.9

$35.6

AEBITDA Margin

6.9%

2.8%

8.0%

9.9%

Uses of Cash

Growth Investment Expenses

($0.6)

($2.0)

($2.0)

($1.0)

Non-recurring Expenses

($0.3)

($1.3)

$0

$0

Reported AEBITDA

$4.8

$4.6

$24.9

$34.6

Turnaround Investment Expenses

(Cash Restructuring Charges)

($0.5)

($2.6)

($0.9)

$0

Capital Expenditures

($1.2)

($7.7)

($5.0)

($5.0)

Acquisitions (Cash payments)

$0.7

($18.3)

($0.7)

$0

Working Capital

($4.7)

($4.2)

($5.5)

($2.2)

LT Debt/Capital Lease Payments

($0.5)

($2.0)

($3.4)

($2.9)

Cash Interest Expense

($0.4)

($1.5)

($1.6)

($0.8)

F/X Effects

($0.2)

$0.2

$0

$0

Balance

($2.0)

($31.5)

$7.8

$23.7

Sources of Cash

Asset Sales

$0

$1.0

$0

$0

Line of Credit draw (repayment)

$3.8

$27.8

($8.0)

($24.0)

Net Cash (decrease) increase

$1.8

($2.7)

($0.2)

($0.3)

Click to enlarge

Outlook

The results the Company achieved in Q4 are a confirmation that the investment thesis remains intact despite the challenges Startek faced during 2015. The Company continues to maintain a great performance with their clients and continues to position itself to gain market share. Their focus in 2016 is to continue to fill existing capacity as they continue to convert the sales pipeline into revenue. Higher capacity utilization, with their footprint and IT transformations already in place and the Accent acquisition completed, will quickly translate into higher revenues, higher margins, and higher AEBITDA.

In addition, they have had success cross-selling and displaying the value of an enhanced customer engagement capability with analytics, insights and social media services to existing clients. During 2015, Startek won $53 million in annual contract value of new business, more than offsetting the business lost from the ATT Mobility program. A good portion of those contract wins have been in ramping mode and will only start to show up in their revenue during 2016.

I expect Startek to reach capacity utilization levels of around 85% as they exit 2016, which would result in total revenue of around $334 million with a gross margin of around 14%. This revenue level would represent a 6% organic growth from the 2014 total revenue level plus the revenue acquired from Accent (assuming no gain or losses from those Accent sites); not a farfetched scenario from my perspective.

At the revenue level estimated for 2016, I would expect an AEBITDA margin of no less than 8% for an AEBITDA of around $27 million based on their targeted financial model. Moreover, current plans call for the buildout of just one more new facility in Tegucigalpa, Honduras during 2016 to replace the temporary space they currently use there. As a result, I would expect growth investment expenses to come in lower than 2015, which would also yield a higher reported AEBITDA. Also, the fact that restructuring, repositioning and IT transformation efforts are complete will result in record GAAP profitability going forward.

Price Targets and Valuation

I estimate Startek's profitability and AEBITDA to improve, as follows:

(Millions)

FY2012 A

FY2013 A

FY2014 A

FY2015 A

FY2016 E

FY2017 E

Total Revenue

$198

$231

$250

$282

$334

$358

Adj. Gross Margin

11.6%

11.8%

15.5%

10.2%

14.1%

15.5%

AEBITDA

$7.9

$10.9

$17.4

$7.9

$26.9

$35.6

AEBITDA Margin

4%

4.7%

7%

2.8%

8.0%

9.9%

Click to enlarge

Based on a lower than peer average EV/EBITDA multiple of 5.5x times the AEBITDA of $26.9 million expected for the next 12-month period including the quarters ending in March 2016 to December 2016, yields an estimated enterprise value of $148 million. Subtracting total net Debt of $29.6 million yields a Fair Market Capitalization value of $7.53 per share within the next 6 to 9 months.

Using a lower than peer average EV/EBITDA multiple of 5.5x multiplied by the AEBITDA of $35.6 million expected for the 12-month period including the quarters ending in March 2017 to December 2017, yields an estimated enterprise value of $195 million. Subtracting total net Debt of $29.6 million and adding the estimated AEBITDA of $26.9 million expected for the prior 12-month period including the quarters ending in March 2016 to December 2016 yields a Fair Market Capitalization value of $12.28 per share within the next 12 to 18 months.

A normalized AEBITDA number is what a potential acquirer would be looking at as a base for valuation purposes. We arrive at the following valuations based on a range of EV/EBITDA multiples:

EV/EBITDA

Multiple

Est. 2016

AEBITDA

Stock Price

Valuation

5.5x

$27 million

$7.53

6.5x

$27 million

$9.24

7.5x

$27 million

$10.95

Click to enlarge

EV/EBITDA

Multiple

Est. 2017

AEBITDA

Stock Price

Valuation

5.5x

$36 million

$12.28

6.5x

$36 million

$14.55

7.5x

$36 million

$16.81

Click to enlarge

As the Company is able to reach and maintain a targeted AEBITDA margin of 10% to 12% depending upon the total revenue level as per their financial model, AEBITDA will continue to increase as new business wins find their way into higher revenues. An increasing AEBITDA base, together with further client and vertical diversification into healthcare and other industries, will determine the proper EV/EBITDA multiple for fair valuation.

The Company is already growing their existing Receivables Management business and their Healthcare related business, which carry higher multiples than the regular Contact Center business; in addition, Startek is deploying their customer engagement and analytics model throughout all of the business lines. As these verticals continue to grow as a percentage of their overall business, a higher EV/EBITDA multiple would be warranted.

Street analysts (Baird/Lake Street) following Startek use a 7.5x EV/EBITDA multiple and/or an EV/Revenue multiple range of 0.3x to 0.5x to arrive at their valuations. Unfortunately, they remain skeptical of the transformation and earnings power translating into a much lower margin and AEBITDA expectation from their point of view. As Startek approaches their targeted AEBITDA margins of 10% to 12% and shows sustainable profitability and growth, I will also use the higher 7.5x EV/EBITDA peer average multiple as my valuation metric.

Risks

Risks to this valuation and other forecast assumptions include:

Lower than expected Call Volumes during any given quarter: Call volumes can be unpredictable even for Startek's own clients and can be a challenging part of this type of business. The Company, together with clients, actively reviews call volume forecasting models for 90 to 120-day periods; however, forecasting volumes is more an art than a science.

Slow new business pipeline conversion: If Startek is not successful in converting their large new business pipeline into actual revenue at a healthy clip, the low capacity utilization will continue to show low gross margins and suboptimal AEBITDA. New business announced during 2015 shows great execution so far.

Execution risk: This management team has proven to be very capable, and although this risk is always present, I believe it continues to diminish given their operating platform.

Customer Concentration risk: Given what has been achieved so far, this risk continues to diminish. The concentration of revenues to AT&T (NYSE:T), for example, has decreased significantly, dropping from over 66% of revenues in 2010 to 10% now. Moreover, the top 4 clients accounted for about 50% of revenue during this quarter as compared to around 80% of revenue during the same quarter last year.

This speaks to the significant transformation and achievement in terms of revenue diversification. In fact, Startek served about 16 clients 3 years ago compared to 58 clients in the core business plus 210 clients under the healthcare vertical served today. I use this 3-year comparison given than the current stock price level is where it was 3 years ago; the market is giving no value to the significant transformation and repositioning achieved during that time.

Stock Price Catalysts

Near and long-term catalysts that may drive the stock higher include:

Execution, Execution, Execution. Announcements of continued new business wins, verticals demonstrating successful pipeline conversion.

Consolidation in the industry. Although I would be surprised if they were to be acquired within the next 12 months, the possibility of a takeover cannot be ruled out as Startek's management now has the credibility and the evidence of not only delivering results, but of also successfully turning a business around. A larger public or private competitor and/or a private equity firm may take notice and target them to apply this operating platform to a larger operation. Startek's sizeable federal and state NOLs also makes a transaction palatable from a tax savings perspective with NOL carry forwards totaling $53 million (for each, federal and state) as at FYE2015.

Although the information contained herein has been obtained from sources that Omar A. Samalot believes to be reliable, he does not guarantee its accuracy and such information may be incomplete or condensed. All opinions and estimates included herein constitute his judgment as of this date and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. He, or persons involved in the preparation of this report, may from time to time have long or short positions in these securities, and may buy or sell these securities.

Copyright © Omar A. Samalot, 2016.

Disclaimer: Omar A. Samalot is an independent financial analyst and owns SRT shares as of the date of this report. The content of this article cannot be copied or distributed without the author's written consent.

Disclosure: I am/we are long SRT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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