Synopsis

8.8Business Description

Convergys Corporation is a business process outsourcing (BPO) provider that was spun out of Cincinnati Bell in 1999. Convergys is essentially two different businesses, consisting of the customer management group (CMG) and the information management group (IMG). The company sold its Human Resource Management business in 2Q10. The two remaining divisions provide call center outsourcing services (CMG) and billing software and services (IMG), respectively. CMG represents 85% of revenue, while IMG comprises slightly more than 15%. Nearly half of Convergys' 75,000 employees work in offshore locations, mainly in India and the Philippines, with the company's headquarters in Cincinnati, Ohio. CVG also owns a 33.8% interest in the local AT&T Wireless subsidiary in the Cincinnati/Northern Kentucky region and a 45% interest in a local cell tower operator in the same region. 

Why Opportunity exists

CVG has gone through some rough sledding the last couple of years.  Besides being disproportionately distracted by an unprofitable HR BPO unit, they have faced challenges in both their call center and billing franchises.  The call center business, while reasonably diversified, faces cyclical exposure and has come under pressure this year as call volumes have softened, particularly in their key communications vertical.  Fewer product activations and apparently better network service have led to fewer customer calls.  They have also suffered, to a lesser extent, from a reduction in call volumes at their financial services customers as credit card activations and mortgage activity have declined.  Two years ago, they acquired Intervoice, a $200mm revenue company, to bolster their technology platform and service offerings.  The integration has been slow to materialize, and margins have been impacted with increased SG&A.

Customer Management Group:

The billing business has been forced to resize itself after losing two large programs (Sprint and AT&T).  The Sprint loss was somewhat unique in that after the Nextel merger, the incoming CEO (from Nextel) decided to keep Nextel's billing software instead of Sprint's.  You could make the argument that this wasn't a true, competitive loss. 

Information Management Group:

Margins in both segments have dipped below their long-run and peer averages.  We believe the company never lost its "Bell" mentality after being spun out of Cincinnati Bell and morphed into a sleeping giant when times were good.

Finally, we believe CVG has somewhat of hidden asset in its wireless interests which are not consolidated in the income statement, but generated significant and steady free cash flow.

New Management

Earlier this year, the Company replaced long-time company man CEO, David Dougherty with board member, Jeff Fox.  Fox is the first outsider to run CVG.  Fox had joined the board a year earlier as part of JANA Capital's attempt to shake things up after accumulating an approximate 14% stake.  Previously Fox had been at Alltel since 1996, most recently serving as COO.  Consequently, he knew CVG very well having been a customer care and billing customer and having served on the board.  Of equal importance, he had purchased a significant amount of stock on the open market before becoming CEO (and he has recently purchased more on the open market).  Everything we have heard suggests he is a smart, aggressive, hungry CEO who can be expected to cut costs.  Contrast this with the previous management who supported a staid, "Bell-like" atmosphere at the company, and one can see a potential opportunity.  After initially signing a one-year contract, Fox has extended under an "at-will" agreement and will receive the lion's share of his comp in stock.  His family still lives in Arkansas, and we believe that he knows the playbook for success at CVG - improve margins, refocus the company on gaining greater share with current customers, dispose assets, use the balance sheet and potentially sell the company.  Fox was the #2 at Alltel before getting his shot to be the #1 at Convergys.  He wants to show success here as part of an ambition to be a CEO at an even larger company. 

It's likely that his initial one-year term gave investors pause, but our conversations with him have given us comfort that he is tackling the issues with a long-term perspective and is not looking for a quick exit.  He holds options on 300K shares that vest over a 5-year period, and approximately $3mm of his $5mm comp targeted for next year is under the company's Long Term Incentive Plan which typically vests over a 3-year period.  We also do not think that investors have had a chance to get to know him.  Besides the public earnings calls, Fox has limited his exposure fairly tightly, choosing instead to focus on internal execution.  Once investors get to hear his vision and kick the tires so to speak, we suspect there will be broader support for the stock.

Thesis

Convergys represents a classic sum-of-the-parts investment with new management and an activist holder with board representation poised to unlock value.  We believe that each of the three main assets (CMG, IMG and the Cellular Partnership) valued independently yield much greater value than the current market cap indicates.

Our sense is that the customer care business is commonly perceived as a poor-quality, commodity type business.  While there is some element of that in play, our calls with customers and competitors indicate that the business is somewhere a few notches above.  Convergys is a top-tier customer service provider - on that point many industry players agree.  They are the second largest in the industry, they have an extensive global network of call centers, and their service level is held in esteem by both customers and competitors. 

While some of CVG's wounds have been self inflicted, the entire customer care industry has struggled as volumes have declined due to the economy. (Apparently, customers do not call their wireless company to complain about their service as often when they are behind on their bill.) We believe that there are a few opportunities within CMG that Wall Street is not currently focused on. We think that CVG's customers are now looking to consolidate vendors and that there is an opportunity for them to take market share from their smaller competitors in the years ahead.  Two key points came through in all of our research calls:  customers will not take business away from vendors meeting their requirements, and managed process solutions are becoming more important in winning new business.  On both points, Convergys performs very well.  We have gotten the sense that they have won share or maintained share with many of their important customers.  At their largest customer, AT&T, we believe that Convergys is their top outsourcing vendor and has performed at a level higher than even AT&T's internal operations.  Managed processes encompass your basic back-office work (e.g. A/R or A/P processing), and more and more clients are looking for these solutions from their customer service partners.  This type of work is more highly integrated with the customer and serves to increase the stickiness of those relationships.  We believe that CVG's expertise in this area combined with their high level of execution should enable them to win more share with their current customer base.

We also believe that the company had morphed into a sleeping giant when volumes were growing.  Looking at the chart below, CMG appears to be overspending on SG&A.  Over the last four years, SG&A costs as a % of sales have increased from 18.6% to as high as 27.5% in 1Q10.  They also lag peers such as Teleperfomance (#1 global competitor), Teletech, Startek and APAC.

Customer Management Group:

Some of this is justified as the company spends more on managed service infrastructure, but some is bloat from their Intervoice acquisition and the previous corporate culture.  Former executives consistently told us that the previous CEO ran the company with a "Bell-like" mentality.  He was a "nice guy" and wasn't interested in holding people accountable.  Their sales organization was focused more on winning new customers than growing their existing relationships.  We believe Fox is transforming the company into a much more customer centric organization.  He has already converted the business from a sales rep model to an account management model.  Additional cost-cutting efforts appear to be bearing fruit as well.  Absolute SG&A spend came down sequentially in 3Q10 despite a 4% increase in revenue.

Improving call volumes should also help boost margins going forward.  The company bases their short-term agent staffing levels in large part on client forecasts of call volumes.  During the early part of 2010, those forecasts proved to be too optimistic and were ratcheted down in the 2^nd quarter.  Capacity utilization suffered and most in the industry were caught off-guard.  We believe the 2^nd quarter was a trough in terms of call volumes.  All evidence suggests volumes have since improved, and indeed, one competitor told us that Q3 and Q4 saw increased booking levels across the industry.  This will translate into revenues in 1H 2011.  We believe that CMG will have relatively easy comps in 1H and are projecting modest growth of 3.7% for the full year 2011.

Convergys's Information Management Group is another business that is of higher quality than may appear given the recent history.  Our checks indicate that nobody actually wants to switch billing platforms.  These are highly integrated systems that run mission critical functions.  Convergys has the reputation of providing quality service, if more limited in scope.  Their competitors, Amdocs especially, have broadened their portfolio of solutions to encompass more BPO services.  We do not believe there is a structural shift moving away from niche players like CVG, but instead believe IMG has been on the wrong end of industry consolidation.  According to the company, AT&T has acquired a number of their customers and subsequently converted their billing systems away from Convergys.  I mentioned the Sprint/Nextel merger earlier.  On the positive side, the company has indicated that the Sprint and AT&T related client migrations have ended.  They have also developed a new billing system for smart-grid application which could provide nice upside going forward in a new customer vertical.  So far they have signed Duke Energy as a customer.  While growth in this segment would be nice, we are satisfied that the declines appear to have stabilized and they have resized their cost base.  We expect margins to improve going forward.  Additionally, they have recently announced a number of new client wins which is encouraging.  The unit had been up for sale, but Fox has taken it off the market and refocused efforts on growing revenue at the business.  We believe that ultimately this unit gets sold or spun off.

The cellular partnership consists primarily of AT&T Wireless's subsidiary in the Cincinnati region.  The tower stake is not significant.  The cash flow from this investment has been pretty consistent over the last two years corresponding not only to AT&T's success, but also to the significant investment made in the asset in prior years.  Operating in the Cincinnati region provides both positives and negatives.  On the one hand, the area is more competitive due to the presence of Cincinnati Bell Wireless.  On the other hand, CBW is a weak competitor who has underinvested in their network and focused more on pre-paid subscribers.  Additionally, Cincinnati is home to a number of Fortune 500 companies (Kroger, Macy's, P&G, CVG), so data plan penetration from business use is higher and more stable.  Our checks with suppliers in the region suggest that AT&T has not executed particularly well in the region.  Their distribution network was very subpar with little retail presence.  That is changing as they invest more in distribution, providing upside with the partnership. 

Customer Management Group:

Information Management Group:

There are a number of avenues for CVG to create value.  The analysis above breaks apart the company based on reasonable projections.  We think 3.9x EBITDA undervalues the base call center business on an absolute and relative basis (peers trade at 6-7x). There have also been a number of transactions in the space proving a willingness to pay for these businesses:

• Thomas Lee and Quadrangle bought West Corp for 6.3x EBITDA in Oct 2006
• Sykes bought ICT Group for 8.1x EBITDA in Oct 2009
• Xerox paid 7.8x EBITDA for Affiliated Customer Services in July 2009
• Convergys paid 10.5x EBITDA for Intervoice in July 2008

 If Fox is successful in refocusing the company, CVG has an opportunity to grow margins meaningfully in both segments.  Returning SG&A to comparable peer levels in 2012 would yield an incremental $131mm in EBITDA (assuming 3% revenue growth). 

The cellular partnership also provides opportunity for meaningful earnings power expansion.  Currently, AT&T has 20% market share in the Cincinnati region compared to 29% nationally.  CBW has been losing share and focusing more attention on their cloud business, so AT&T should continue to gain share and expand margins to closer to national levels.  Assuming they can get to 25% market share, we think the partnership interest alone is worth over $5.40 per share.

Putting all of this together (and backing out the current debt) yields an intrinsic value of $27 per share. 

CVG's B/S also looks underutilized as net leverage stands at 0.3x LTM EBITDA (includes cash flow from cell partnerships).  It has operated in the past at 1x which could provide approximately $264mm in buyback capacity.  Assuming such a buyback at the current stock price would reduce the share count by 19.8mm shares.  Accounting for the proforma debt, one reaches an intrinsic value of $30 per share.

Risks

• CVG has a fairly high degree of customer concentration. AT&T alone represents 22% of total revenue, and their three largest customers (incl DirectTV and Comcast) comprise 37.5% of total revenue. IMG's history shows what can happen when you lose large, global accounts as customers. Our conversations with AT&T and Comcast, however, give us confidence in the health of their relationship with CVG.
• CVG, along with most outsourcers, has some degree of currency risk. They operate centers in Canada, India and the Philippines and take on costs in those relative currencies, while most of their revenues are denominated in USD. They attempt to hedge their exposure as much as possible.

Catalysts

• Analyst expectations are still very low and underestimate next year's earnings power. Half of the analysts covering the stock have it rated as either a Hold or a Sell. CVG should outperform consensus estimates for 2011.
• A more direct route to full value recognition would be for a sale of IMG and the cellular partnerships. Possible bidders for IMG include peers in the BSS space looking to augment their position vs market leading Amdocs. Given the defensive characteristics of the business, private equity would also make sense. AT&T is the only buyer for the cellular partnership.
• The company recently began buying back stock. Their B/S is under-levered which could enable further stock repurchases.