Summary

I recommend a long position in Sykes Enterprises, a Business Process Outsourcing (BPO) or call-center business.  Having recently completed the cash and stock acquisition of ICT Group, Sykes is poised to accelerate earnings growth and is trading at around 7x estimated Q4 2010 run-rate earnings and 3x EBITDA.  With a net cash balance sheet and a long track record of organic growth and profitability, Sykes is a quality operator now trading at a highly attractive valuation (after falling 50% from its 52 week high).  There is nothing too complicated about the situation, just a growth company that has had a minor stumble and has fallen into deep value territory due to market over-reaction.  SYKE was previously written up on VIC, but none more recently than 4 years ago.  Paddy had a couple of great calls going long at 4x EBITDA and short at 10x EBITDA 2 years later.

Industry

The growth of the call center industry has been driven by the combination of improved telephony equipment and infrastructure, and customers' willingness to outsource non-core functions such as call centers in their drive to increase both profits and service levels.  While many think of India as the location of choice for call centers, the industry is actually much more global and diversified.  Sykes, for example, operates 70 call centers in 24 countries, with over 50,000 employees.  Call center companies are paid in one of three ways:  time and materials, per call, or per minute.  Contracts typically include bonuses and penalties based upon various service level metrics that are closely monitored (such as average hold time or customer feedback data).

Expected Industry Trends

• Continued modest industry growth, as less than 30% of the potential market is currently outsourced. Sykes cites an industry study predicting a 2.4% topline CAGR through 2013.
• Continued move from servicing US clients onshore to offshore, in an effort to reduce costs.
• Continued consolidation, as large clients increasingly prefer vendors with ability to service accounts from variety of geographic locations. Also, vendors such as Sykes need to avoid significant client concentration in order to reduce risk and enhance bargaining position.
• Pricing. I expect flattish pricing on shore, slightly pressured pricing offshore as the currently higher margins likely will be competed lower over the long term, and a negative mix impact to pricing (as continued offshoring leads to lower revenues per minute).

Company Overview

• Sykes was founded in 1977, began focusing on the call center business in the early 1990s, and has been public since 1996.
• Pro forma for the ICT acquisition this year, Sykes' 2009 revenues were around $1.25 billion and 2009 EBITDA was $160 million (including estimated cost synergies of $24 million).
• Sykes has one large client (AT&T at around 14% of revenues), beyond that client customer concentration is minimal (next largest is 4%). The ATT business is comprised of 3 separate programs, lessening the concentration risk.
• Top verticals include Communications (36%), Technology (22%) and Financial Services (21%).
• Focus on inbound customer service calls (97%) which are more stable than outbound telemarketing (3%).
• 85% of business is voice, with small amounts of email and chat support.
• 80% of business supports services, rather than products (product-based call demand tends to be lumpier as it is driven by new product sales, whereas call demand for services such as credit cards tends to be more stable).
• Sykes determines its business segments based upon the location of the customer, rather than the "delivery location". I believe this is done in order to purposely obscure offshore margins for competitive reasons. In general, the offshore segment is likely to have materially higher margins than onshore.
• Acquired the publicly-traded ICT Group for $225 million in a 50% cash/50% stock deal (stock issued much higher at $24 per SYKE share). This represented 6.7x 2009 EBITDA of $33mm and 3.9x 2009 EBITDA if adjusted for $24mm of cost synergies. The acquisition appears to be a good fit based on minimal client overlap, strong market share of the financial services vertical, and the benefits of additional scale.

Financials

• 13% topline organic CAGR since 2004. Over half of the growth was from new program wins from existing customers (as opposed to new customers).
• Stable gross margins in the 32-33% range. The stability of gross margins indicates that although pricing pressure exists, it has been very manageable historically.
• Operating margins gradually expanding from the 5% range to the 8-9% range over the past 5 years, as Sykes was able to leverage its G&A costs. EBITDA margins have expanded similarly, and were 12% in 2009.
• ROEs in the 10-16% range, despite a conservative balance sheet (net cash) and the near-term margin hits from the constant launch of new facilities for growth.
• Strong Free Cash Flow.  Total capex (including significant growth capex as the topline almost doubled from 2004 to 2009), has averaged around 35% of EBITDA.  Maintenance capex is estimated to be around half of total capex, so Sykes generates good Free Cash Flow.  In 2010, Sykes should generate around $140mm of EBITDA (including ICT for 11 months), and has estimated maintenance capex of $25mm (18% of EBITDA) and growth capex of $20mm.

 

Management.  The CEO is Charles Sykes, who is the son of the founder John Sykes.  Charles has worked at the company since 1986, has been CEO since 2004, and I consider him to be a strong operator based upon his analytical answers to conference call questions and his company's track record of execution.  Charles' stock holdings are less than 1%, but his father continues to own approximately 13% of the company which presumably aligns his interest.

SYKE performs well and generates expected Q4 run-rate earnings, highlighting extreme valuation.

SYKE pays down $75mm term loan and/or repurchases shares.