Exlservices: A Business Process Outsourcing Company To Watch

| About: ExlService Holdings, (EXLS)
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Exlservices holdings (NASDAQ:EXLS) is one of the upcoming BPO companies. Unlike other BPO heavyweights like Genpact (NYSE:G), it was not started as a backoffice of a MNC. Instead it was started in 1999 by a group of experienced professionals including Vikram Talwar and Rohit Kapoor.

Vikram was then the CEO and Managing Director of Ernst & Young and Rohit managed international investments for clients at Deutsche Bank. In August 2001, Conseco acquired EXLS and operated it as its wholly owned subsidiary. Later, in November 2002, Oak Hill Capital Partners L.P. and FTVentures along with some members of our senior management team bought EXLS from Conseco, making it a third party pure-play business process outsourcing service provider.

Its first year as a public company has not been bad. It started trading in Oct. 2006 for around $16.00, and as of Sept. 13, 2007, it was at $21.00. The high was at $26.00, attained in Feb. 2007 when the market was booming, and its low was at $16 last month, mostly because of the mortgage crisis.

Norwich Union & Centrica (2 main clients): Exlservices provides services to Norwich Union (an Aviva company), which represented $41.2 million, or 33.8%, of their total revenues in the year ended December 31, 2006 and $36.4 million, or 49.2%, of their total revenues for the year ended December 31, 2005. They also provide services to Centrica, which represented $19.1 million, or 15.7%, of their total revenues for the year ended December 31, 2006 and $1.6 million, or 2.2%, of their total revenues for the year ended December 31, 2005, under an agreement that has an initial term that expires in July 2008 and that can be terminated by Centrica for cause only during its initial term, work orders or engagement schedules.

Client has option to buy back a portion of the company: Norwich Union has the option from January 2008 through February 2011 under one of its contracts with EXLS to purchase the shares of EXLS's subsidiary that operates one of its facilities in Pune, India, by paying them an amount that will approximate the net asset value of that facility on the date of transfer. The exercise of this option would result in both a loss of revenues and the loss of all of their employees who are at that time working under that contract.

Norwich Union has recently exercised its option to assume the operations of the facilities of one of its third party vendor-contractors and has publicly announced its intention to start exercising its option to assume the operations of the facilities of certain of its other third party vendor-contractors, including EXLS's facilities in Pune. The affected facility generated 18.9% and 26.7% of their total revenues in the year ended December 31, 2006 and December 30, 2005, respectively.

The underlying point here is determining the net asset value of its Pune facilities, and will they be compensated for such intangible assets as the domain knowledge incurred by employees since the company was started.

Operating costs will be higher in 2007 & 2008: The company has planned to add two huge facilities, one of which in Noida, India, will have a 1,200 seat facility. Initially, whenever a facility is added, the total telecommunication, rental and administrative costs compared to its revenues go up rapidly. But once they start being utilized fully, the revenues catch up with the costs. So it is expected that the margins for 2007 and 2008 would be squeezed.

Inductis acquisition: On July 1, 2006, Exlservices completed the Inductis Acquisition. Inductis is a provider of research and analytics services. The Inductis acquisition has expanded the types and sophistication of the research and analytics services they offer. The total consideration for the Inductis acquisition, including the assumption of liabilities, earn-out and contingent payments and transaction costs, could be approximately $31.5 million. They paid approximately $12.2 million on the closing date in the form of $3.0 million in cash (including amounts paid for working capital adjustments), the issuance of 1,049,962 shares of their common stock after withholding in respect of taxes and $0.9 million in transaction costs, and paid a $0.4 million bonus in January 2007. They also assumed $4.3 million of Inductis debt, which they repaid in full on September 26, 2006.

For the period ended December 31, 2006, Inductis’ profit adjusted earnings revenue (which amount is defined in the Inductis acquisition agreement to equal either its revenue or a lower amount if certain profit margin targets are not achieved) was equal to $26.6 million dollars. As a result, per the terms of the Inductis acquisition agreement, Exlservices recently issued an additional 257,273 shares of their common stock (worth approximately $5.4 million based on the closing price of our common stock at December 31, 2006) to the former holders of Inductis common stock. 19,509 shares of restricted stock previously granted to the former holders of Inductis common stock have been earned based on the achievement of certain performance-based criteria and will vest over a three-year period.

Exlservices also agreed to make certain additional earn-out payments to the former holders of Inductis securities based on the satisfaction of certain agreed-upon financial performance goals for the historic Inductis business in 2007 and certain additional contingent payments in a mix of cash and additional shares of their common stock, the mix of which cannot be determined until the size of the contingent payments, if any, is determined, based on the satisfaction of certain agreed-upon financial performance goals for the historic Inductis business in 2007. The value of any such contingent payments is expected to range from $0.6 million to $6.5 million.

Revenues & Profits: The revenues increased from $60mn (2004) to $73mn (2005) and $120mn (2006). The gross profit was $21mn, $26mn and $47mn respectively. Operating income was$5.3mn, $5.5m and $15mn and net income was $5.3mn, $7mn and $14mn respectively.

Out of Pocket Expenses as Part of Revenues: The out of pocket expenses that were part of revenues were $4.1mn (2004) , $3.3mn (2005) and $4.9mn (2006).

Revenues by Segments: The company's revenues are mainly divided into BPO, advisory activities and analytics.

BPO - $55mn (2004) , $65mn (2005) , $97mn (2006)

Advisory - $4.6mn (2004) , $7.2mn (2005), $14.9mn (2006)
Analytics - 0 (2004) , 0 (2005) , $14.9mn (2006)

1. Capital lease - The motor vehicles are leased under this category with the long term capital lease obligation being $227,651.

2. Operating lease - The facilities, office furniture and certain equipment are leased under this category.The total minimum lease payments for 2007, 2008 and 2009 are $2.9mn and the rent expenses were $2.49mn, $2.45mn and $1.64mn for 2006, 2005 and 2004 respectively.

Book Value: The book value has increased from $30.9mn (2005) to $127.1mn (2006). The main increase was in additional capital from $17.1mn to $98.4mn and the increase in retained earnings from $15.2mn to $28.6mn respectively. The goodwill is $16.6mn.

The Breakup of its Fixed Assets are as follows:

Network equipment, cabling and computers (estimated life 3 to 5 years) - $20mn
Buildings (estimated life 30 years) - $3mn
Leasehold improvements (estimated life 3 to 5 years) - $8.4mn
Office furniture and equipment (estimated life 3 to 7 years) - $3.6mn
Motor vehicles (estimated life 3 years) - $1mn
Construction in progress - $3.5mn

Construction in progress represents advances paid towards acquisition of fixed assets and the cost of fixed assets not yet placed in.

Three Taz Audits: U.S. and Indian transfer-pricing regulations require that any international transaction involving associated enterprises be at an arm’s-length price. Transactions among the Company’s subsidiaries and the Company may be considered such transactions. Accordingly, the Company determines the pricing among its associated enterprises on the basis of detailed functional and economic analysis involving benchmarking against transactions among entities that are not under common control. If the applicable income tax authorities review any of the Company’s tax returns and determine that the transfer price applied was not appropriate, the Company may incur increased tax liability, including accrued interest and penalties. The Company is currently involved in disputes with Indian tax authorities over the application of some of its transfer pricing policies. The Company has received three assessment orders from the Indian tax authorities with respect to their audit of certain of the Company’s subsidiaries.

The first assessment for the Financial Year 2002-03 requires that Exl India pay additional taxes in the amount of approximately $2.2 million. The Company has paid approximately $700,000 to the Indian tax authorities under protest as a deposit in respect of the first assessment while it is contesting the above order before the appellate authorities.

The second assessment order issued by the Indian taxing authorities regarding transfer pricing is with respect to their audit of EXL India’s 2004-05 tax year. The assessment order alleges that the transfer price applied to transactions between EXL India and EXL Inc. for the 2004-05 tax year was not appropriate and requires that EXL India pay additional taxes of $3.6 million. They have paid approximately $1.6 million to the Indian tax authorities as a deposit with respect to their assessment while they are contesting the above order before the appellate authorities.

The third assessment requires the payment by Exl Inc. of approximately $3.2 million for the financial year 2002-03. Out of $3.2 million, the Company has already paid $1.6 million as a deposit in respect of the third assessment while it is contesting the above order before the appellate authorities.

Based on advice from its Indian tax advisers, the facts underlying its position and its experience with these types of assessments, the Company believes that the probability of loss is remote and has accordingly not accrued any amount with respect to these matters in its consolidated financial statements. The Company does not expect any impact from these assessments on its future income tax expense.