Description

SUMMARY

PeopleSupport (NASDAQ: PSPT) is an offshore business processing outsourcing company based out of Los Angeles with operations mainly in the Philippines. Founded in 1998 primarily on venture capital funds, it has become a profitable company that, until recently, was marked by Wall Streeters as a mega-growth opportunity. The loss of a major client, Vonage, and a resulting downward revision of earnings estimates for the years has punished the stock mercilessly, almost halving it in three months. My thesis is that this is an extreme overreaction by Mr. Market, thus creating a great value opportunity in what looks to be a high-growth, well-managed opportunity.

BPO BUSINESS BACKGROUND

PSPT’s outsourcing business is more formally known as offshore business process outsourcing (“BPO”). As many are aware -- largely due to the media blitz on outsourcing over the past several years -- BPO services have become more and more popular for businesses looking to streamline costs. By locating call centers overseas, BPO providers employ a cheaper workforce and allow U.S. companies to absolve themselves of expenses related to maintaining customer service centers and customer service employees. BPO does not end at customer service, though. Other submarkets include processing services, human resources, procurement, logistics support, finance and accounting services, IT and training.

PSPT offers two main services, “customer management” and “transcription and captioning.” The former is what people generally associate with BPO. This is your run-of-the-mill customer service phone operators. The latter is a relatively new business acquired by PSPT (more on that later) where the company outsources transcriptions of audio and video, and puts in the captions on all types of video programs, from TV to DVD, commercial to educational. If you’ve ever seen the close captioning on a muted TV, then you know what the latter service entails. Likewise, if you have ever seen a transcript for a TV show or interview, ditto.

To give perspective on why this is an exciting industry, estimates on the growth of the BPO industry range from 25-79% annually. Gartner, the international research firm, for example, estimates that offshore BPO for U.S. companies will grow from a $6.4 billion industry in 2005 to $42.9 billion in 2009.

That being said, the main determinants of a BPO company’s quality are (a) the amount of employees, or “seats,” they can put at the disposal of a client, and (b) the efficacy of those employees. It is now cliché to make jokes about a customer service agent named “Summer” from “Alabama” who speaks with a heavy Indian accent and barely understands your requests. BPO companies have taken steps against this stereotype by training their employees to speak with an American accent (or English accent, depending on the market they service) and by only hiring top quality candidates, who are proficient in English. Unfortunately, in the saturated Indian market, the top quality candidates are fewer and fewer to be found.

COMPANY BACKGROUND

With that information, enter PSPT. Their model is slightly different than the pioneers of this field. PSPT operates mainly out of the Philippines. For a brief background on why this is an attractive employee market, a few facts should help understand PSPT’s choice. First, the Philippines is the third largest English-speaking population in the world. Around 92% of the population speaks English, mainly due to historic ties to the U.S. and its use as the language of instruction from third grade on for math, science and health. English is also the primary language of instruction for all colleges located in the Philippines. Second, the nation has modeled many of its government and accounting systems on the United States, so Filipino natives are familiar with American business practices. Third, the country offers tax holidays and other incentives for foreign investment.

PSPT operates on a “spoke-and-hub” model, where call centers overseas are the “spokes” that feed into the U.S.-based “hub,” which then acts as the repository for all data and routs the various calls and communications back and forth across the Pacific. A benefit of this model is that it allows quick integration of new centers; for example, the new Costa Rican “spoke” came online this past year (2006) quickly and efficiently. Another benefit is that it allows the company to directly monitor and run the major IT operations in-house, which means they do not have to rely on overseas employees if problems exist. (The irony of a BPO company not outsourcing IT is not lost on me...)

Before moving on to the numbers, I’d like to briefly go over the history of the company, because I believe it gives a solid background on why I think this is a value situation. PSPT was founded in 1998, and was funded by venture capital funds. Originally, the company ran on the premise of servicing tech companies. At that time, all call centers were located in the U.S. and PSPT’s client base was almost exclusively tech. In 2000, sensing (and experiencing) the tech collapse, the company restructured drastically. It first moved the call centers to St. Louis, but then eventually switched over to the Philippines (a switchover which was finalized in 2006). This switch resulted in significantly lower operating costs for employees, and was facilitated by the strong telecommunication infrastructure between the U.S. and the Philippines. Next, PSPT broadened its search for customers and expanded out of the purely tech realm. While the company’s major customers are still tech-related (Expedia, Earthlink), it has demonstrated this move by securing other large customers in the non-tech realm (notably, Washington Mutual).

PSPT turned a profit for the first time in 2003, and it has been no looking back since. Revenues increased at an annualized rate of 54% from 2003 to 2006 ($30M to $110.1M), and the most recent 8-K shows that revenues continue to grow healthily. Generally speaking, growth like this leads to astronomical P/E ratios and stock prices that are far from values. What, then, creates this value situation? One word: Vonage.

THE CASE AGAINST PSPT

OK, get ready for some doom and gloom. About four months ago, one of PSPT’s biggest clients, Vonage, decided to not renew its contract, which ended in May 2007. The announcement of this non-renewal plunged the stock price down, and subsequent downward revisions of estimates in the 2006 10-K and recent May 3, 2007 8-K maintained a stock price between 11 and 12 (although it is currently trading around 11). PSPT revised revenue estimates for the year to the $133-137M range, rather than a previously predicted $140-144M.

The reason for this reaction is that Vonage accounted for about 13% of PSPT’s 2006 revenues. Along with the two other largest clients, Earthlink and Expedia, about 43% of PSPT’s 2006 revenues came from just these sources. Now that they are no longer counting on Vonage, the company has started focusing on the new triumvirate of clients, Earthlink, Expedia and Washington Mutual, showing that these three accounted for 46% of Q4 2006 revenues.

Obviously, the worry is that the loss of another major client could spell the doom of PSPT. These three have contracts that end in the next three years, so many worry that PSPT will disappear as quickly as it grew. Relying too much on few clients is, of course, anathema to a long-term business growth strategy, and losing such a strong revenue source is scary indeed.

Another take on the situation is just that investors worry that the current ratios are too high. Based on 2006 earnings, PSPT is trading around 16-17 P/E, 1.3 P/B and 2.5-2.6 P/S. Not horrible numbers by any stretch of the imagination, but some might look at it as non-bargain levels and walk away.

Yet another problem that I see is that barely any insiders have bought PSPT stock at these levels. In fact, if you look at Form 4s over the past several months, Lance Rosenzweig, the CEO, has been on a selling rampage. Granted, that is due to an automatic 10b5-1 plan, but I would prefer to see him eat some of his own cooking. As a legitimate concern, I cannot disagree with this red flag. This is definitely something I would like to see change. Insiders have basically bought *nothing* over the past several months. A few thousand shares, here and there, but that is about it. All the most recent Form 4s have been due to the grant of stock options.

Still another problem is that PSPT’s operations are charged in Philippine pesos and tied to the U.S. dollar, and the Philippine peso has appreciated greatly over the past year. Should the peso continue to rise in strength, that could affect future income because the formerly cheap employee base will be paid more in relation to what the company earns. For completeness' sake, the peso is currently trading a little under 46 pesos to the dollar, whereas it traded at around 53 pesos to the dollar in January. PSPT has taken steps against this appreciation in the form of currency swaps, but that is understandably not the ideal situation.

Finally, the company has been free with stock issuances over the past few years, so another concern is that they will continue to dilute stockholder value with further issuances. On this particular concern, I’m not sure I believe it since major stock issuances have been in connection with significant fundraising. The most recent offering raised $92M and diluted equity by about 5M shares, bringing the total to around 23.5M shares. Frankly, I see a split as more likely than another stock offering, at least for now.

THE CASE FOR PSPT

Given the ratios mentioned above and the loss of Vonage, some might ask why I, too, have not walked away. The reason is that, even given all this information, I believe PSPT’s valuation is ridiculously low.

First, with respect to the Vonage concerns, losing a large customer is always tough on a business, but I am not overly concerned about the loss. First, while PSPT has not elaborated on why Vonage is ending its engagement, there are two possibilities: (a) it is PSPT’s service, or (b) Vonage is cutting down on its expenses. Given Vonage’s troubles with maintaining profitability and its business model, the latter seems to be the case. This is supported by PSPT’s scaling in seats. The company went from about 3,100 seats in 2004 to more than 8,000 in 2006. This suggests to me that management sees growth in demand for PSPT’s services, regardless of whether Vonage is opting out of its contract. A second reason I believe it is not the quality of PSPT’s services is that revenues increased yet again in Q1 2006, despite the fact that Vonage severely scaled down its use. (The underlying premise here is that the increase in revenues came from other sources, including new customers and the existing big companies. Again, this suggests PSPT is creating and filling demand.)

In the 2006 10-K, PSPT reported that Vonage accounted for about 13% of revenues. This means that the Vonage account generated about $14.3M for the company. Now, let’s assume PSPT’s projected revenues for 2007 ($133-137M) include a full year of Vonage fees. At 13% of the company’s business, that would amount to about $17-18M. If we subtract that out of year-end revenues, we are left with about $116M, an approximately 5% increase over 2006 numbers. Granted, that is not the kind of growth we are hoping for a young company such as this, but it still an improvement in revenues despite the loss of a major cash inflow.

(I’ll note that Vonage’s contract ended in May 2007, so the actual 2007 revenues should be higher than my conservative estimate above.)

Second, as to the concern that PSPT relies too much on just three clients, it is notable that it has reduced the percentage of the triumvirate from 57% a year ago to just 46% now. Given revenues have continued to increase, this suggests robust growth in new client accounts, which, in turn, should allay fears that the company is becoming complacent and only relying on the few big guns to drive profits. I was heartened to see that PSPT addresses this concern in its SEC documents and outlines its basic strategies for reducing this percentage even more. (The cynical among us might note that the Vonage loss definitely incentivizes PSPT to increase its search for new, large clients.)

Third, even if revenues stay flat for a year or two, the growth in BPO in general should benefit PSPT immensely. The Indian market has been saturated, with many of the best and brightest already employed by BPO firms. New markets have become more popular, including China, Russia and, of course, the Philippines. Given that the Philippines offer something north of 42M people who speak English, this is a substantial employee market from which PSPT may draw. When you consider they currently employ only a couple thousand (~8,000), you being to realize that this market is currently undertapped. What’s more, PSPT only hires employees with at least two years of college education, which improves the end user experience and makes PSPT a solid choice for BPO services.

Another thought that has occurred to me is that the BPO industry would actually benefit from an economic downturn. Now that the media furor over the topic has largely played itself out -- Google results show that most recent stories on outsourcing focus more on the business economics than outrage over the practice -- a downturn in corporate profits and/or spending should cause companies to reexamine their cost structures and, in many cases, opt for cheaper BPO services.

Fourth, considering the dollar’s recent weakness, net income is actually depressed in comparison to recent years, yet it is still appreciating handsomely. For example, despite the dollar's weakness, net income grew by 24.5% between 2005 and 2006 and by 6.7% YOY between Q1 2006 and Q1 2007. If/when the dollar strengthens against the Philippine peso, it should cut down on SG&A (and general operating) costs dramatically and provide a nice bump in income.

Fifth, PSPT has proven it makes strategically sound acquisitions. Its first acquisition was the Filipino BPO company that allowed PSPT to expand overseas. The second, and most recent, was the acquisition of RapidText, Inc., and caption and transcription service based in Burbank, CA. PSPT paid about $8.9M out-of-pocket for the company, with about $7M in goodwill. Granted, that’s a lot of goodwill, but the expansion into transcription makes sense. The RapidText business should pay its purchase price back in 2-3 years, and, if PSPT grows it the way it did its customer management services, should help expand the company dramatically.

OK, OK, BUT WHAT ABOUT VALUATION?

All right, now for the good stuff. What struck me first about PSPT’s financials is that total liabilities hover less than 1.5x 2006 EBITDA. The company has grown organically over the past several years and its debt overhang is extremely low. Debt/equity is, in fact, about 0.13, which strikes me as extremely strong for a young company in a high-growth phase.

EBITDA growth has also been strong, yielding well over 80% growth since the company’s IPO. Granted, this is not a good deal of data from which to infer future growth, so I only note it to demonstrate that PSPT has, indeed, lived up to its initial hype, at least in recent years.

The interesting numbers come once we start analyzing FCF and extrapolating forward. Considering the recent turmoil with respect to Vonage, I wanted to be conservative with my estimates. My analysis of the industry and management suggests that the company would hang on even given a worst-case scenario such as another major customer reneging on their contracts, so I assumed flat FCFE growth for 2007 and 10% growth after that, with constant growth of 6% after that. (Discount rate at 10%.) Even given these conservative estimates, the enterprise value should be something like $430M, as opposed to the current $280M. If we are slightly more liberal with estimates, giving PSPT flat 2007 growth, 15% growth rate over 4 years after that, 10% growth over the remaining 5 years with ^5 constant growth after that, the numbers get even more exciting and we are left with a $500M market value. (Again, this employs a 10% discount rate.) Even a flat 2007 plus constant 6% growth every year afterward yields a $336M market cap, representing a $2 differential between the current price and what it should be. (I think this last scenario is truly worst-case.)

In all, I don’t see an inordinate amount of downside to this company. It is in a growing industry with a solid infrastructure in place, and an experienced management team which has shown the ability to expand the business and make it extremely profitable. It lost a major customer, but that is what created the value opportunity in the first place.

Catalyst

- Announcement of a new large customer(s) that could replace Vonage as a significant revenue stream.



- Expansion of existing and new customer relationships and services, resulting in steady (or explosive) increases in revenue and net income.



- Strengthening of the dollar vs. the Philippine peso, resulting in significantly increased income and earnings due to lower operating costs.



- Initiation of positive coverage by major Wall Street banks with favorable ratings. Current analyst coverage is somewhat weak/sparse. For the time being, the lack of Street coverage allows the stock to languish, which creates opportunity.



- Recognition by the market of the company’s intrinsic value due to value investors such as ourselves.