Introduction / Investment Thesis

Third time’s the charm.  The timing is finally right on StarTek (“SRT” or the “Company”), which has been written up twice in the past on VIC.  StarTek, as you may already know, operates in the call center industry and has LTM revenue and EBITDA of $233mm and ($0.3)mm.  The current equity market capitalization and enterprise value are $36.6mm and $20.0mm, respectively. 

The brief investment thesis is that StarTek has been going through a multi-year operational restructuring whereby they have transitioned their asset base from domestic call centers to an offshore platform.  From a capital perspective, this transition is now largely complete and StarTek is on the verge of a major inflection point in their financial performance.  Generating margin/profit in the call center business is largely about maintaining high utilization rates.  StarTek’s recent financial performance and lack of profitability can largely be attributed to low utilization rates caused by the natural process of ramping offshore call centers and shutting down domestic call centers (and hence running at low utilization levels in all geographies).  From an investment perspective, the exercise has been to determine (i) the earnings power of the business once the dust settles, (ii) when the “dust will settle” and (iii) evaluate the ability of management to execute operationally.  Through significant due diligence, my conclusion is that there are very good things happening at the Company which will start to be reflected financially in 2012 and beyond.

The reason that SRT is trading where it is are obvious:  the laggard player in an already marginal industry, LTM losses on an EBITDA and EPS basis, zero communication with Wall Street, no sell side investment coverage, micro capitalization, limited trading liquidity, year end tax loss selling and being dropped from the S&P small cap index in June 2011.

The investment thesis is that StarTek is on the right track operationally, will generate $10mm+ of EBITDA in 2012, can generate a 10% margin in the next 2 years, has an excellent CEO, and over the past few years has invested in state of the art call centers in the right geographic locations. 

From a valuation perspective, you are currently buying at close to “net net” value and well below net net value + real estate value.  Further, you are only paying about 1.5x EBITDA generating power that will become evident during 2012.  While I am hesitant to make proclamations of “no downside from here” (famous last words), I think that if you study this one you will probably also conclude this is a favorable risk reward with upside scenarios in the $6-10 range. 

Read on, and I look forward to your thoughts/questions.

Business Description

I’m not going to rehash the SRTs business description, but here are a few quick bullet points so you know what we’re talking about:

• Call center business with LTM revenue and EBITDA of $233mm and ($0.3)mm
• Focus on the telecom vertical, with significant customer concentration with AT&T and T-Mobile at 54.4% and 21.4% of revenue, respectively (much more on this obviously important factor later)
• Offshore revenue at 32% of revenue and growing
• Asset Base includes 8 US call centers (377k square feet), 2 Canadian call centers (122k square feet), 4 offshore call centers (~400k square feet), see Schedule 1 at the address shown below for more detailed information about SRT’s call center properties

http://www.mediafire.com/?3ydskgrw92ua4tm

Recent History

Things started going downhill for StarTek in 2006, when it became apparent that they had underinvested in the business and were behind the curve in terms of transitioning call center seats to offshore locations.  In early 2006 Emmet Stephenson (founder of the Company), left the Board of Directors and was replaced by Larry Jones (“Jones”) who would eventually take over as CEO.  The catalyst for Jones taking the CEO role in January 2007 was a realization that the business was underperforming, the resignation of the CFO and an overall loss of confidence / void in leadership.  Jones had a reputation as a strong CEO, doing significant work for private equity firms and turnaround assignments in his past, though he did not have specific call center experience.

The Jones era lasted from 2007 until June 2011.  During this period, the Company made the decision to start moving offshore which proved to be a more difficult and tumultuous period than expected.  One challenge was that the T-Mobile relationship was on shaky ground at the time and significant time and resources needed to be applied to stabilizing the existing business, not to mention the difficulty in simultaneously building the offshore call centers.  The Company also made the mistake of aggressively building its offshore call center footprint before there were firm customer commitments to fill those call centers.  SRT was thus in the awkward position of launching large call centers without adequate customer demand to fill the capacity.  Further, the exodus of customers from the domestic call centers happened faster than expected.  The financial result of all of this was low utilization across all geographies and depressed margins.

Despite poor financial performance over this period, a number of accomplishments were made including:

-          Strengthening the key customer relationships (AT&T / T-Mobile)

-          Building a fleet of state of the art call centers in thePhilippinesandCosta Rica.  One industry executive made the following comment regarding SRT’s call centers: “The locations offshore are world class and the locations are phenomenal; I think they will fill those up” and with respect toHonduras, “I think they are in the right spot there and I applaud that”

-          Upgrading the management team

With respect to the management team, the key event was hiring Chad Carlson as COO in June 2010.  Carlson, currently in his mid 40s, was previously EVP of Global Operations at Sitel (privately held and one of the leading players in the call center industry). Chadhas a stellar reputation in the industry for knowing how to standardize call center operations, build new call centers and maximize margins.  One industry consultant said “he is extremely strong from an execution perspective – one of the better operators in our industry and will deliver on client commitments. Chadwill execute – I would take that to the bank”.  He seems to be a tough executive, stingy with capital and very “street smart”.  While I have heard that he is good with clients, I have also heard that his strong point is operations and he has less experience on the sales side. 

The other key hire was Sheila Fisher as SVP of sales on Jan. 1, 2011.  Fisher had recently VP of sales at ACS, and has a very strong reputation in the industry.  One industry executive familiar with the situation noted that this is the first time in recent memory that SRT has had a real “A player” in the sales role.  Further to this point, management recently noted that “our pipeline is stronger and larger than ever”, so we may soon see some evidence of improved sales execution.

In March 2011, AT&T announced that they would acquire T-Mobile.  This was a negative event for SRT because it would further accentuate the customer concentration to having one 75-80% customer.  I have heard that AT&T was concerned with SRT’s customer concentration in light of the merger and that was the cause of the loss of a piece of the AT&T business and related shutdown of the Collinsville, VA call center in June 2011.

Also in early 2011 founder Emmet Stephenson returned to the Company, this time paired with Privet Fund who collectively own 25.8% of the Company (primarily Stephenson’s stake).  It appears that Privet’s average cost is in the mid $4 range.  After a brief scuffle, Privet received 2 board seats in May 2011. 

In June 2011, SRT announced that Carlson would take over in the CEO role from Jones.  My understanding of this transition was that (i) Jones was not interested in the role any longer in light of the ATT / T Mobile merger, (ii) Jones had never intended to become CEO in the first place and viewed his role as a medium term assignment and (iii) Carlson was hired as COO with an eye to be transitioned into the CEO role and he had already proved himself to be very effective in his first year.

Also on June 23^rd, S&P announced that SRT would be eliminated from the S&P Small Cap 600 index on 6/30/11. 

The cumulative impact of the 2011 events resulted in SRT’s stock price declining from $5 at the start of the year to $4.15 in mid June and then the $3.50 range by mid July 2011.

In July 2011, SRT announced that they would open a new call center inHonduras“driven by client needs”.  Management has stated consistently that they would not open new call centers without a firm customer commitment.  TheHondurascall center was also important because it is viewed as “ahead of the curve” in the industry. Hondurashas a good political climate, a large pool of motivated English speaking workers and has not been tapped in the call center industry.  TheHondurascenter could be an interesting template for growth for StarTek.

Most recently, on December 19^th 2011, AT&T announced that it would end its bid to acquire T-Mobile.  While there was a modest positive stock price reaction to this news, this was clearly a very major positive (and perhaps lucky) development for the Company that was largely ignored. 

Investment Thesis

The investment thesis here is simple: StarTek has built an attractive fleet of offshore call centers which are currently in ramp phase.  Current results reflect a lot of noise and the inefficiencies inherent in running at low utilizations.  The ramp will occur in 2012 and will result in dramatically improved overall financial performance.

Lets think about EBITDA generating power in this business, and in that regard I think its useful to think about the key variables of seats, utilization rates and margin assumptions.

The case outlined above reflects all of the announced seat reductions in theUSandCanadaplus some incremental seat losses.  The assumed utilization rates and margins shown are all below what management thinks are reasonable goals.  This simple model provides a basic framework for potential investors to think about different financial scenarios for SRT.  In reality, I think there are much higher earnings power scenarios than the one shown here, but I realize the danger in relying too heavily on this type of analysis.  The point is to think about reasonable scenarios given the qualitative evidence about the trajectory of the business.  My conclusion is that the current valuation of SRT is far too low in light of these scenarios.

By far the most important of these targets is the offshore gross margin, which management has targeted at 30%.  The firstPhilippinescall center (the much smaller of the two),MakatiCity, is already hitting these numbers and Ortigas is ramping.  A few management comments on the Q3 2011 conference call with respect to the offshore operations:

“We expect quarterly offshore growth to continue at similar rates through the end of the year and into 2012 based on existing client commitments”

“Offshore gross margin improved to 12.2% compared to 7.3% last quarter and compared to negative 3.9% in the third quarter of 2010. The ramp activity that has been occurring in both thePhilippinesandCosta Ricahas now translated into a scale of operation that is delivering very healthy incremental profit on sizable revenue gains. Compared to last quarter, current quarter offshore revenue grew by $2.8 million and gross profit grew by $1.1 million, delivering incremental margin of 39%. We expect this trend to continue now thatMakatiis running at full capacity and delivering expected margins. Ortigas is profitable and scaling and as we continue to ramp inLatin America.”

“OurMakatisite in thePhilippinesis full and generating significant gross profits in cash and our Ortigas site is ramping quickly.  At one point in the third quarter, we had over 500 agents in training and over 35 training classes which will be coming online over the fourth quarter. OurCosta Ricasite had an additional program from an existing client. And ourHondurassite went live two weeks ago. All of these ramps are coming online with solid performance and overall client satisfaction is good.”

Though it is not “official guidance” (whatever that means), the CFO Dave Durham did make the following comment on the Q3 2011 call:

“We fully expect to return to profitability in 2012 and that is absolutely what we’re focused on. We do expect, as we mentioned last quarter, for profitability to be down for the rest of 2011, but positioned at the end of ‘11 to be profitable for the year 2012.“

The point here (for anyone that actually did the math) is that “profitable” on a net income basis actually implies about $16mm of EBITDA.  Before we get too excited here, I will note that (i) subsequent to this call the CFO was replaced with a former Sitel executive, and (ii) I think this comment was too aggressive – it would be great it that actually happens in 2012, but I am setting my expectations at a much more conservative level.   I hesitated to even make that note in the write-up, but decided its better to put more information in here than less.

Comparing the EBITDA generating power of StarTek to the market’s current valuation of the business clearly highlights the value case as the revenue and EBITDA multiples are .1x and 1.9x, respectively. 

The publicly traded comparables include Convergys (CVG), Stream Global (SGS), Sykes Enterprises (SYKE) and TeleTech Holdings (TTEC) and they trade at 0.5x and 5.0x revenues and EBITDA, respectively.   There are also a few M&A comps at significantly higher valuations including APAC Customer Services (acquired by NCO), ICT Group (acquired by Sykes in 2009) and PeopleSupport (acquired by Aegis in 2008). 

Furthermore, from a a balance sheet perspective there is significant downside protection in the form of $32.5mm of “net net”value (or $2.11 per share) and 241,500 square feet of owned real estate likely worth about $20mm (another $1.30 per share).  57,000 square feet of the owned real estate is currently vacant and being marketed for sale and another 47,500 square feet will be vacant to the extent that theEnidcall center is closed in 2012, as is rumored to be the case.

(1) Represents excess real estate atLaramie,WyomingandGreeley,Coloradosites currently marketed for sale.

Clearly, if the contemplated turnaround in financial results occurs, the stock should trade much, much higher – likely still at a discount to the peers due to the customer concentration, but there is still substantial room to close the gap. 

In addition, there have been 12 insider buy transactions in the past 6 months and no sell transactions.  These transactions are modest in size, but still point in the right direction given the number of transactions, the lack of any selling and breadth of buyers involved.  The buyers include directors and also a number of members of the management team including the CEO.  These transactions have taken place in the $3-4 per share range.

One further point is that the key hidden asset in SRT may be the amount of SG&A that could be eliminated if SRT is sold to a strategic buyer.  While I do not think a sale of the Company is likely in the near term, thinking about the value here to a strategic buyer which consists of (i) a large revenue base and important customer relationships and (ii) an attractive offshore footprint.

Further Information re AT&T / T-Mobile relationships

Since these relationships are so important, I’d like to highlight what we know and what I have learned on this topic.

With respect to AT&T, the relationship is focused on the wireless consumer business and is covered by several contracts that expire between 2012 and 2014.  I have discussed the AT&T relationship with a number of people who view it from different angles and to boil down all of those discussions my understanding is that the relationship is strong in some places and weaker in other places, but generally improving.  The relationship was improving significantly up until the AT&T / T-Mobile merger was announced, at which point AT&T became less comfortable with StarTek’s customer concentration.  I have heard that in the wake of the merger being cancelled StarTek is well positioned to win back some incremental AT&T business and the industry in general may get additional outsourcing business as AT&T looks to save money.  One industry professional who also does work with AT&T told me that they “turned the corner on AT&T” and that “they are competing, their metrics are doing well and are now at least average compared to the competition”.

With respect to T-Mobile, I have heard this relationship is very good right now and has turned around dramatically over the past 5 years and StarTek is well positioned to win incremental business. One industry professional stated that “T-Mobile has always looked favorably upon StarTek and really supportsChad[Carlson] as well”. 

Management summed up these relationships as follows on the Q3 call:

“the T-Mobile relationship and our performance there and some of our ramps that we’re doing for them continue. The AT&T relationship, I’m sure as you can appreciate, is pretty complex and that there are several different divisions and business groups that we’re engaged with there. And we have had some challenges where we’ve had to get key leadership roles in place to drive better execution and performance. That has created some headwinds for us on some areas of AT&T relationship, but we also have some bright spots in a few other areas of the AT&T relationship, and actually, have a win on some of the back office work that we’re doing with AT&T that will be – program will be implemented early next year. So, it’s really a mix there as they continue to evolve and we continue to evolve. And obviously the decrease in the level of our dependence on AT&T revenue is a critical diversification move for us and it’s one that I know AT&T has a keen eye on as well.”

Key Risks

• Loss of additional business with either key customer.  Clearly I am betting these relationships are getting better not worse and there are prospects for winning additional business, but this is the #1 risk factor
• Once again, bad timing.  I think that Q4 2011 will be bottom in terms of financial performance or will be roughly similar to Q3 2011.  To the extent there are customer losses or new business does not materialize as I believe it will there will be more pain ahead.
• Weak sales execution – they have the right call centers in the right places, they know how to run them, but will they be able to convince customers to show up to the party?  I think so, but we’ll see.

Conclusion

StarTek is easy to hate and its obvious why this stock has been discarded into the financial wastebin, relegated to being a “nanocap”.  However, I think if you do a bit of work here you will come to a similar conclusion as I do: this is a Company on the mend, managed by an aggressive and smart leader, and can be bought for pennies on the dollar.  There is a chance that this one surprises to the upside – they become an above average operator and their smaller size and emerging footprint offshore (andHondurasin particular) serves as an exciting growth platform.  Hope so, but of course I’ll settle for the “base case”.  I look forward to your thoughts and questions.