Description

Startek currently trades for approximately 1.5X our estimate of post offshore migration EBIT, at working capital, 50% of its tangible book value, and approximately 40% of its call center's replacement value.  This business process outsourcing (BPO) Company is currently in the process of transitioning their geographic delivery mix to become more aligned with economic reality and their peers, which when completed over the next 12 to 24 months, should enable the business to generate ~$43 million of EBITDA (vs. current Enterprise Value of ~$32 million) at targeted utilization rates.  Since posting a disappointing 1Q10 earnings report and lowering expectations for the remainder of 2010 (more on this later), the stock has traded down precipitously, providing an optimal entry point with risk/reward heavily skewed in our favor.  We believe an investment in Startek offers north of 100% upside with limited downside at these levels. 

Business Description:

Startek operates as a business process outsourcing (call center) enterprise primarily tailoring to the telecommunications channel.  The company provides outsourced sales and technical support, receivables management, provisioning, order management, and customer care, among other functions, for a host of blue-chip customers including AT&T, T Mobile, Comcast, Qwest, Vonage, and Time Warner Cable.  Approximately 75% of their revenues come from the wireless sector, 15% from wireline, and the remainder primarily from cable.  Like all BPO's, Startek's modus operandi is to improve customer retention, increase revenues (up-sell/cross-sell), reduce costs, and free up their customers time to focus on their core business.  Cost rationalization amongst large corporations is the single largest growth driver for the BPO industry, which is expected to grow 7% per annum through 2013, according to IDC.   In order to understand the rationale of outsourced vs. in-house business processing, consider the following example.  Startek's largest customer, AT&T, employs a 60k person unionized labor force of in-house agents that on average earn $35/hour.  Startek can perform the same functionality for $25/hr in the U.S., $17/hr near-shore (Coast Rica), and $13/hr offshore (Philippines) while freeing their customer from having to deal with hiring/firing practices, benefit obligations, and management distractions, among others.

How we got here:

After shedding several legacy, non-core business segments since its founding in 1987, Startek has transitioned into a pure-play telecommunications BPO company.  Startek landed its first flagship client in 1999, AT&T, who today remains their most significant customer.   AT&T provided the platform for Startek to win several new logos within the telecommunications sector, which today includes a host of major wireless, wireline, and cable operators.  After cycling through a handful of management teams over the past 15 years, the Company hired veteran turnaround specialist Larry Jones as CEO in 2007 in order to reestablish profitability amid the challenges posed by a consolidating and increasingly cost conscious telecommunications industry.  Jones, who most recently served as a managing principal of Aegis Management, viewed Startek as an attractive turnaround opportunity given the company's strong reputation in the telecom BPO market and blue chip customer base.  The new management team inherited a number of issues, including contracts bid at unprofitable pricing levels, call centers located in difficult labor markets, and an outdated and underinvested asset base.  Jones was quick to realize that Startek's call center locations lacked an off-shore presence, and quickly began shuttering unprofitable domestic call centers while concurrently implementing an off-shore expansion program.  At the time Jones arrived, all of Startek's call center seat capacity and labor force was domiciled in the U.S. and Canada, amongst the most expensive labor pools in the world.  Meanwhile, the Company's competition had already successfully transitioned into the new world of delivering BPO services by establishing a presence in India, the Philippines, and Costa Rica, among others. 

The development and implementation phase of Startek's offshore expansion program in currently underway.  Throughout the transition, Startek has had to absorb abnormally high start up, employee training, and travel costs with no offsetting revenue, which has significantly dampened margins in the short term.  These unabsorbed costs, coupled with a more challenging domestic telecommunications call center market, has created the perfect storm for the company.  The market has reacted by sending the stock down ~50% this year. 

Where we are today:

The company's three recently constructed off shore facilities (Makati-Philippines, Ortigas-Philippines, and San Jose-Costa Rica) will host a total of 3,655 seats and comprise roughly 35% of their total call center capacity.  Industry wide off-shore gross margins range from 30-40%.  Management's expectation is for 30% off-shore gross margins assuming 80% utilization.  The table below outlines our estimate of the Company's future earnings power post off-shore transition.  Management's estimates of forward earnings power under various scenarios can be found in their Investor Presentation dated 2/24/10 on the Company's website (p.24-26).

In order to achieve their targeted gross margins, Startek will need to operate at 75% utilization in the U.S., 80% in their Offshore segment, and 65% in Canada.  As of 1Q10, SRT's utilization rate was 78% in the U.S. and 63% in Canada, at or near their targeted utilization rates for these respective markets.  As for the offshore segment, the Company expects to be 27% utilized by Q310 and 50% utilized by year end.  All of the Company's offshore seats will represent incremental business from existing customers, with little to no anticipated cannibalization expected from their domestic business.  For the sake of being conservative, our model assumes that incremental revenue from Startek's offshore expansion is partially offset by domestic client migration.  The Company expects to achieve targeted off-shore utilization rates of 80% by the end of next year.  As shown above, under these assumptions, SRT should be on pace to generate $25MM in EBIT by the end of 2011, which is nearly equivalent to today's enterprise value. 

Downside Protection:

Startek is currently trading at ~50% of its $7.74/share in tangible book value (vs. P/TBV of 3.4X for peers) and 1X net working capital, primarily comprised of cash and receivables with little to no collection risk.  When viewed under the most distressed of scenarios, if we were to include the total undiscounted future operating lease obligations ($32.7MM) on the balance sheet, where all that's left is four owned facilities and their net working capital, Startek would still have $5.55/share in tangible book value.  Of the Company's net PP&E carrying value of $55.9 million, we estimate that ~30% is attributable to their recently constructed, highly desirable, state of the art facilities located in the Philippines and Costa Rica.  Put another way, Startek's enterprise value per seat (EV/seat) of approximately $4k is well below industry replacement cost estimates of between $8-$12k, as well as their peer group's average EV/seat of $29k.  History tells us that it is extremely rare for companies within the call center industry to trade at such steep discounts to replacement value over long periods of time.  The two most recent examples include former competitors ICT Group and PeopleSupport.  ICT Group was trading for an EV/Seat of $9.7k in early October '09 before being taken out by Sykes at an initial implied value of $16.9k/seat, while PeopleSupport was being valued at roughly $9.8k/seat in late July '08 before Aegis announced its intention to acquire the company at an implied EV/seat value of $15.8k.  At its current depressed valuation, we believe Startek could become a target of some of its larger peers. 

 Peer Group Review:  clearly SRT is cheapest on most metrics.  Below, we offer some ideas as to why the dislocation exists, why some concerns appear to be overblown and more than priced in, and what the company is doing to eliminate it.

Customer & Vertical Concentration: 

Startek has historically traded for a 20-40% discount to the peer group due to the Company's significant vertical and customer concentration.  Approximately 95% of the company's revenue is derived from the telecommunications industry.  AT&T represented 64% of the Company's consolidated revenue in 2009, with T-Mobile representing another 22%.  While we agree that a discount to the peer group is warranted due to its industry and customer concentration, we would argue that trading at working capital with no long term debt more than compensates investors for any client degradation.  With regard to the AT&T relationship, Startek's services cover over 10 distinct programs within the consumer, business, and wireless departments of AT&T, which helps to mitigate the risk of total loss for this specific client.  To further quell any fears related to AT&T concentration risk, we view AT&T's decision to award Startek's offshore segment up to 850 incremental seats, with the potential for more behind it, to be a positive sign with regard to the relationship.  Management continues to reiterate how strong their relationship is with both parties, and they view the likelihood of any loss related to these concentrated parties as minimal. 

One of Startek's top priorities is to diversify their client base away from AT&T and T-Mobile.  To achieve this, they have recently announced their intention to enter the healthcare and insurance verticals.  While expansion into new verticals will take some time to gain traction, we view this initiative as a step in the right direction. 

Execution Risk:

This risk is relatively straightforward.  The offshore expansion efforts currently underway inherently introduce execution risk.  Startek has approximately $10MM of capex remaining on the build out of their three off shore facilities, which by year end will be fully funded and operational.  Cash burn for the remainder of the year is expected to be approximately $5MM, leaving Startek with approximately $22MM of net cash on the balance sheet inclusive of internally generated cash flow expectations for 2010.  Maintenance capex will be approximately $8MM/yr for the Company going forward.  We have adjusted our net cash balance for the anticipated burn of $5MM in 2010 in the earnings power model above.  Should execution match expectations, we believe Startek offers substantial upside potential.

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