ExlService Holdings: Riding the Outsourcing Wave

Globalization of the world’s economy and the breaking down of national barriers have facilitated freer trade and more open markets, resulting in a vastly more competitive environment for goods and services across virtually every industry. Over the years, there has been a significant increase in movement of one of the primary factors that fuels business: human labor. Today, businesses routinely cross national borders seeking lower operating costs (and more favorable tax rates). As an example, in India, the average entry-level college graduates earn as little as one-tenth of what their U.S. counterparts make. ExlService Holdings, Inc. (Nasdaq: EXLS) employs IT experts, customer service specialists and other professionals in India to provide business process outsourcing [BPO], research and analytics, and advisory services primarily to Global 1000 companies, taking full advantage of this wage disparity. Its customers reap the benefits as well, slashing costs by as much as 50%.

American Express Company (NYSE: AXP), Dell Inc. (Nasdaq: DELL), Norwich Union/AVIVA [LSE: NU], Centrica [LSE: CNA], Fortune 50 banks and others have hired ExlService to handle their back-office operations ranging from customer service, accounting services and Web support to mortgage, loan and insurance processing. Clients in the banking, financial services, and insurance industries (BFSI) in the United States and the United Kingdom account for 75% of ExlService’s revenues.

But ExlService is far from the only firm to capitalize on the offshore outsourcing trend, as American and European companies rush to trim costs amid heightened competition and rising expenses. Direct adversaries include other India-based BPO providers, such as WNS Holdings Ltd. (NYSE: WNS) and FirstSource, with additional competition coming from several IT services firms: Infosys Technologies Ltd. (NYSE: INFY), Electronic Data Systems Corp.'s mPhasis (NYSE: EDS), General Electric Company's Genpact (NYSE: GE), Citigroup Global Services (NYSE: C) and HCL Technologies [BSE: HCLT].

ExlService, which stands out in the pack, has been attracting attention lately. In May, upon upgrading ExlService from to “buy” from “hold,” with a price target of $31, Citigroup analyst Ashwin Shirvaikar explained: "Our changed rating is due to our view that there is margin upside on a full year basis, to management's 12% guidance, that demand trends are good enough to result in revenue upside above expectations and that the recent price action in the stock creates a nice buying opportunity."

ExlService reported second-quarter earnings on August 8. For the quarter, the company reported revenue of $43 million, up 71% year over year, and net income that increased an amazing 400%, to $5.6 million.

Robert W. Baird & Co., citing the company’s potential for several years of 25%+ revenue growth and 30-35% EPS growth, published a research note on August 10, maintaining its "outperform" rating on ExlService, while raising its target estimates to $27 from $25. "EXLS reported solid results, with EPS and revenue both exceeding our expectations as demand remains strong in offshore BPO," said Senior Research Analyst David J. Koning. "We believe valuation is attractive, given our expectation that EXLS should grow revenue organically at least as fast as the offshore BPO industry long-term."

Koning said he believes industry revenue growth "could be around 30-35%/year from 2005-2010 (and thus far EXLS has fully participated)." Citing EXLS's recent success, he noted, "Execution has been outstanding—over the past two quarters, the company has significantly beaten expectations, and we expect the company to continue to at least meet its near-/intermediate-term goals."

Said ExlService CEO and vice-chairman Vikram Talwar, in a conference call following the second-quarter earnings release: "I am enthusiastic about the continued rapid growth in EXLS's business during the quarter and the strong interest we are seeing from new and existing clients. EXLS secured eleven new clients this quarter including several blue-chip names in line with our strategy of acquiring the highest quality clients in select industry domains. We also entered a new vertical this quarter with the addition of a Fortune 500 transportation services provider."

Of course, there are reasons to have concern about ExlService. Some pundits argue that there is little to differentiate it from its competitors, meaning the company must constantly strive to provide top-notch service at very attractive prices, which could limit future price increases and cause revenue growth to stall. (Rapid economic growth in India has resulted in pay rising faster in India than in developed Western nations, which has led to some Indian BPOs to sub-outsource to countries with even lower wages.)

Recently, stepped up competition—from places like China, Vietnam, the Philippines, the Czech Republic, Hungary, Brazil, and even Mauritius, an island nation off the coast of Africa in the southwest Indian Ocean—along with the fact that more firms are cutting out the middleman and setting up their own offshore operations have caused a significant slowdown in the global outsourcing market over the past year. So far, this hasn't hurt ExlService, which continues to ride a wave of success. And Baird analyst Koning is bullish on the sector in the long term, saying, "We expect significant demand for Indian labor/process expertise to support strong growth for many years."

All in all, the company holds great promise, and investors should keep the BPO on their radar for several reasons. It's smaller and nimbler than much of the competition; it's headquartered in the United States, providing a level of comfort for its top clients; India, unlike China or Russia, is a solid democracy with a high-skilled, low-cost and English-speaking labor pool; and the company offers an exceptional prospect of steady growth for the next several years.

ExlService shares closed at $17.90 on Monday, with a 52-week trading range between $15.45 and $29.24. Analysts’ collective one-year target estimate is $27.00.

Disclosure: none