We believe that ICT Group Inc. (Ticker: ICTG) represents a compelling investment opportunity with 50%+ upside over the coming 6-12 months.  The investment thesis is predicated on a few basic elements:

 

 

Put simply, ICTG is a rather compelling long if you believe that they can hit historical/industry margins in 2008.  It is our belief that they can – it is also the contention of management and Street analysts.  Given the way the market is currently valuing the stock investors clearly believe a margin recovery won’t occur.  If we can conclude otherwise - therein lies the opportunity.

 

 

 

ICTG is a call center company offering primarily customer care for U.S. companies.  They have 12,600 seats servicing largely in-bound call volume.  Roughly 30% of their seats are currently in low cost countries (primarily the Philippines).  By mid 2008 they will have closer to 50% of seats in low cost countries.  ICTG serves primarily financial, government, and healthcare clients. 

 

ICTG was once a high flying stock and touched $36.50 in November of 2006.  Just 9 months later it has fallen ~60.0% to a near 52-week low of $15.00.  In reality, the stock was way ahead of itself when it was in the mid 30s.  As sometimes happens, the move to the downside has also been overdone.  We believe a share price of $22.50 (50% upside) to $25.00 (67% upside) represents fair value.

 

Generally speaking there are good fundamental drivers in place for ICTG.  Companies continue to transition internal call center and CRM functions to third party providers.  In addition, there is significant demand for high quality call center capacity in low cost countries.  These dynamics have fueled – and will continue to fuel ICTG’s growth.

 

 

 

 

ICTG had a number missteps of since the beginning of 2007:

 

 

 

 

Based on this series of missteps and revisions, it is clear why the stock is in the doghouse.  Shareholders seem to have taken a decided, “I’ll believe it when I see it” attitude.

 

To some extent though, ICTG’s 2007 troubles can be appropriately described as growing pains.  The company had difficulty meeting unexpectedly high call volumes from two large North American clients in the first quarter, incurring performance penalties and high operating expenses related to training and temporary labor.  Neither of these relationships is at risk, and one client has opted to transition to offshore call handling, leading ICTG to accelerate its 2007 Philippines expansion plans.  The aggressive expansion of offshore capacity is the primary cause of weak margins in 2007, as the company must incur operating expenses on pre-revenue and sub-capacity facilities.  At the end of July, management announced plans to slow the acquisition of new offshore clients to focus resources on the planned migration of existing domestic clients, curtailing 2007 revenue guidance.

 

 

 

One’s first reaction to recent history might be that management does not have much ability to control certain elements of the business.  Therefore, trying to project where the business would be heading is quite difficult.  We contend that 2007 has been a confluence of challenging events (abnormal call volumes, rapid migration abroad, etc…)  Once these are worked through we (and management) can actually get a pretty good ideas of where margins and earnings will be.  What do we have to point to in this regard?

-         History:  In 2006 ICTG generated operating margins of 4.2% and as high as 4.6% in certain quarters.  In 2006 EBITDA margins were about 5.7% higher than the EBIT margins implying 9.9% EBITDA margins.  (For what it is worth, we believe there is excess D&A being generated from all the investment in offshore call centers.  For instance, 75% of LTM Capex was related to workstation expansion.  Meaning, once the transition to offshore slows down in 12-18 months D&A will be meaningfully higher than Capex.  ICTG should start to cash flow nicely again since OCF will not be diverted to Capex.)

-         Basic Offshore Economics:  It well understood that offshore revenues per hour are often roughly half of what they are in the U.S.  But, gross margins are meaningfully higher.  In fact, operating income dollars per hour are higher abroad.  For example – a fully costed call center employee onshore might $25 per hour to with $0.50 to $1.50 in margin.  Offshore that same service might be $15 per hour with $2.00 per hour in margin.  Thus, as ICTG rapidly moves capacity offshore this creates a headwind to revenue.  But, operating income margins and operating income dollars benefit meaningfully.  Even though revenues will only increasing at roughly 7.5% in 2008 – we expect call volumes to increase 15% to 20%.  As a point of comparison 1^st half 2007 revs grew 1% over 2006 but call volumes were up 18%.  Growth in call volume is probably the best long term measure of the underlying demand for ICTG services.   

-         Comparables:  By mid 2008 ICTG will have 50% of its seats in low cost countries.  This is essential to driving operating margins to a higher level.  Other industry participants that have a high percentage of seats abroad generate meaningfully higher margins.  Take TTEC and SYKE as examples.  Both have 60%-65% of capacity abroad and generated TTM EBIT margins in the 6.1%-8.3% range.  Thus, we think by mid 2008 when ICTG has 50% of their capacity abroad they can at least get to 5% EBIT margins.

-         The Street:  Analysts show a range of 2008 EBIT margins of 4.0% to 5.2% with a mean of 4.5% (30 bps higher than 2006).  We point this out not because we put substantial weight on their estimates - rather, only to show that we are not the only people out there suggesting the margin recovery story.  Despite the fact the most of the analyst agree with the margin recovery thesis – some maintain a rather negative bias on the company.  These were some of the same analysts that had ‘buy’ recommendations on this stock when it was in the $30s.

-         Management:  ICTG management says operating margins will be higher in 2008 than they were in 2006.  CEO John Brennan on the 2Q Call:  “We believe – our expectations are that ’08 operating margins will be improved from ‘06”.  Again, later in the same call:  And so, we think we’ll be back to, and in better shape, in 2008 than we were in 2006”  Of course, given management’s past missteps we are not simply going to take them for their word on this.  But, given how badly they’ve been burned missing previous estimates, we think they are being highly conservative in this matter.  In fact, there’s evidence of this again on the 2Q Call: 

o       Buyside Question:  “…a comment around ’08 margins being better than ’06.  Shouldn’t that, in essence, be a lay-up given how dramatically the shift in the business mix has been to offshore, where I thought margins on a percentage basis were much higher?”

o       CEO Answer:  “Yes, we believe it should be a lay-up.  I guess after being battered for the last six-months, I don’t want to get into a lay-up, but basically it should be.”

 

The above factors lead us to believe that margins in 2008 should be at least as high as those in 2006.  We mostly rely on the fact that ICTG generated 2006 EBIT margins of 4.2% and EBITDA margins of 9.6% with only 16% on average of their seats abroad.  By mid 2008 nearly 50% of their capacity will be abroad and offshore margins are currently running in excess of 15% fully loaded for SG&A.  In fact we believe that 2008 EBIT margins of 5% (or greater) are well within reach implying EBITDA margins of 10.4%.   In our valuation below we use EBIT margins of 4.2% (2006 margins) as a base case and 5.0% as an upside case. 

 

If margins recover, what is ICTG worth?  Revs in 2008 should be about $500 million.  This is based on 2007 revenues of $470 and 2008 call volume growth of 15% which will translate into rev growth of about 7.5%.  2008 revenues could be $5mm higher or lower but $500mm is a good baseline and one that most analysts seem to agree with.

FD Shares Outstanding             15.8mm

Share Price                                           $15.00

 

Market Cap                                         $237mm

Net Debt                                              -$30mm

 

Enterprise Value                                   $207mm

 

Valuation Base Case ($500mm Revs, 4.2% EBIT Margin, 9.6% EBITDA Margin)

EV to Revs                   0.4x

EV to EBIT                  9.9x

EV to EBITDA            4.2x

 

Valuation Upside Case ($500mm Revs, 5.0% EBIT Margin, 10.4% EBITDA Margin)

EV to Revs                   0.4x

EV to EBIT                  8.3x

EV to EBITDA            4.0x

 

For a growing business with expanding margins ICTG looks pretty cheap on 2008 multiples.  It is worth noting too that we believe that D&A is running at roughly $26.5mm which overstates the long term capital intensity of this business.  A lot of investment is required to move seats offshore.  This transition will slow down meaningfully in 12-18 months.  After this the we believe the recurring maintenance Capex is something like $7.5-$10.0mm (see 2Q call for guidance in this area).  Thus, ‘EBITDA minus Maintenance Capex’ multiples would be somewhere in the range of 4.6x to 5.0x.

 

Mgt has said that through the end of 2007 cash should stay level at ~$30mm as current year Operating Cash Flow goes to capital expenditures in offshore facilities.  In 2008 ICTG should start generating meaningful cash again and the cash balance will grow.

 

On a relative basis, ICTG also looks rather cheap.  For comparables we look at TTEC, APAC, SYKE, CVG (partial comp), PSPT, and SRT.  None are perfect comparables – probably the best two at least in terms of the direction that ICTG is heading are TTEC and SYKE.  On 2008 multiples all six trade in the following ranges:

 

                                                Low                 High                 ICTG (Consensus)

EV to Revs                               0.5x                 1.5x                 0.4x

EV to EBIT                              9.5x                 18.0x               9.2x

EV to EBITDA                        4.6x                 10.6x               4.3x

 

Also:

 

EV per 6/30/07 Workstation    $18.9k             $67.6k             $16.4k

 

As you can see ICTG is below the low end of the range in all cases.  It is worth noting that the low end of the range is anchored by companies with high customer concentration (SRT and APAC for example) and high concentration in the commoditized telecom area (SRT).  ICTG in contrast has the lowest customer concentration of the group with the top 10 customers accounting for 48% of revenues (per 10k).  ICTG is also concentrated in areas like financial, government, and healthcare which are considered higher quality and faster growing verticals (higher value added customer care reps / longer training time for reps at 4-6 weeks creates better customer stickyness). 

 

We think that as it become obvious that ICTG is rapidly and successfully transitioning seats abroad it will trade more in line with its peers – specifically those with diverse and high quality clients.  ICTG was once valued in line with these players and we believe it will be again soon.

 

When the market realizes that 2007 is truly an anomaly and starts to give ICTG credit for improved margins we think near-term the stock can move to $22.5 (still 40% off 2006 highs).  This is based 2008 multiples of:

 

0.6x EV to 2008 Revs                                      - Middle to low end of comps range

12.2x EV to 2008 EBIT                                   - Middle to low end of comps range

5.9x 2008 EBITDA                                           - Middle to low end of comps range

$24.3k EV Per 6/30/07 Workstation                - Middle of comps range

 

Catalysts

-         The nearest term catalyst we are aware of is the 3Q conference call which should be in late October.  At this time ICTG management will give rough guidance (growth rates and margins) for 2008.  As well, we will get an update on they key clients they have been migrating abroad.  We suspect that the market will be much more willing at this time to digest 2007 as a transition year and focus on 2008.

-         Potential sale of the company:  We do not have any specific reason to believe there is a near term event of this nature.  We simply know from our industry diligence that ICTGs base of clients focused in the financial / healthcare / government verticals would be a highly sought after asset.  The current valuation also makes for a rather compelling case – a competitor could easily pay a nice premium and still be well within industry multiples.  The reality is, the CEO owns 37% of the common (has not sold a shares since April 2006 at $24).  What he wants to do will govern but we think if/when he is ready to sell – a number of buyers will step up.

 

In conclusion – ICTG is a growing company with management well aligned with shareholders.  It is cheap on an absolute basis.  It is cheap on a relative basis.  Investors just need to get comfortable with the margin recovery.  This margin recovery is almost entirely predicated getting though 2007 challenges and migrating more call center seats offshore.  ICTG is taking the necessary steps.  At the very least we can look to 2006 margins as to what ICTG can achieve going forward.  In reality though, they should be able to meaningfully outperform 2006 as they move to 50% of seats abroad.  Other companies that have moved aggressively into low cost countries provide specific evidence of what levels of margins can be earned.  ICTG will get there too -- and we believe in the process be valued meaningfully higher.