Description

I am recommending the purchase of Sykes Enterprises common (SYKE) based on a very attractive risk/reward proposition with up to 60-100% upside from current levels in the next 12-18 months and in my judgment no more than 20% downside risk. Sykes is one of the largest providers of customer contact management solutions; in plain English, SYKE manages customer call centers on an outsourced basis for large customers in communications (43% of 2003 revenues), technology/consumer (33%), financial services (6%), healthcare (6%), and transportation/leisure (5%). SBC represented 16.9% of revenues in 2003 and Microsoft 12.1%. SYKE’s top ten customers generated 59% of 2003 revenues so there is some customer concentration risk inherent in the business. Good public comparables include Teletech (TTEC), West Corp (WSTC), and APAC Customer Services (APAC). Sykes has good descriptive information on its business on its website (sykes.com) as well as access to its public filings and a recent earnings call so I will not belabor the facts here. Peter315 first wrote-up SYKE at $3.18 in December 2002; though more expensive now, SYKE is better positioned today and has substantially better momentum in a much better economic environment.

SYKE was a high flyer in the late Nineties as the pace of outsourcing accelerated, particularly among technology and dot com companies that were SYKE’s focus, representing 62% of the business in 2000 versus 43% today. Since then, the Company has endured a painful retrenching driven by several developments, including: the substantial cyclical (and in the case of the dot coms, a permanent) reduction of technology business; the virtual elimination of outbound calling volumes in the US (outbound to SYKE; these are the annoying calls you get at home that the Do Not Call list is eradicating); and the migration of call centers to cheaper offshore locations, which has received much attention in the press recently (indeed, SYKE was the subject of a front-page article in the Journal recently). All of this dislocation drove the stock from over $51 at its peak in early 2000 to under $3 in late 2002. To its credit, SYKE has substantially restructured the business, and it appears to be slowly turning. Moreover, all the aforementioned bad news is essentially in the numbers and the stock, but after all the pain and suffering in this name, I believe the market does not appreciate the turnaround underway nor the value in the stock at today’s levels. Before discussing these issues, a few numbers (all are for 2003):

Revenues $480.4
EBITDA 39.3
EBIT 11.4
Net Income 9.3
EPS (adj.) 0.18
Capex 29.3

Market Cap 252
Ent. Value 160
EV/EBITDA 4.1x
Tangible BV $4.84/share

Based on customer demand (including specifically from SBC, its largest customer), SYKE has been migrating increasing portions of its business offshore, where operating costs are substantially lower. SYKE currently operates 42 call centers, 17 in its European segment (which also includes the Middle East and Africa), 13 in the US, 3 in Canada and 9 offshore (China, Philippines, India, Costa Rica and El Salvador). The Americas represents about two-thirds of revenues; however, 42% of Americas’ transactions are now handled offshore, and this figure should approach 50% by year-end as SYKE continues to close centers in the US (and for that matter Europe, which continues to be weak) and add capacity offshore. This migration is costly as SYKE incurs duplicative and one-time expenses as it ramps up new call centers offshore. Moreover, as business has migrated offshore, the Company has had to spend capex just to maintain profitability (ie moving capacity), which obviously is a poor, albeit largely unavoidable, use of capital. Again, this level of expenses and capital spend is in the stock, and importantly, is nearing an end. According to management, the offshore migration underway the past few years should largely be “complete” in 2004 whereupon any change in mix will be more gradual, with correspondingly less impact on expenses and cash flows in the second half of 2004 and into 2005. Indeed, capex spend should peak in the first quarter of 2004 at $15-17mm, with spending in the subsequent three quarters no more than this amount in total. Importantly, I expect capex to decline substantially in 2005 absent a material pick-up in revenues.

This inflection point in cash consumption and duplicative expenses is corresponding to a gradual recovery in demand. SYKE has increased revenues sequentially for five consecutive quarters, and year-over-year growth accelerated through 2003 during which time it has largely met or exceeded its guidance. This is important for returning to more normalized margin levels as there is significant operating leverage in the business, which continues to suffer from overcapacity in the US and Europe. Moreover, sales cycles tend to shorten during an economic recovery, which is consistent with the Company’s indication recently that its sales pipeline is firming.

Given the continued investment levels in the first quarter of 2004 and duplicative expenses, I have relatively low expectations for Q1, which may provide a window of opportunity for accumulating the stock, which has traded down to the $6 range from nearly $10 in January based in part on management’s sober outlook for Q1 and the lack of full year 2004 guidance. (Frankly, the stock had gotten ahead of itself at those levels anyway.)

One last point: management, namely the founder and CEO, who owns 36% of the Company, is incented to drive the stock higher by year-end. He announced in December implementation of a Rule 10b5-1 plan (the “Plan”) to sell up to 1.5mm shares, 1.15mm of which he nominally sold forward at $8.36/share. The amount of stock he actually needs to deliver in December 2004 under the forward sale will be dictated by the market price at that time. This just smells like a situation where costs and investments are being front-loaded in the year and expectations being set low so that the Company can under-promise and over-deliver, hopefully driving the shares up as a result. This is merely a hunch of course, and not a reason by itself to buy the stock.

On valuation, I estimate $48-50mm of EBITDA this year as revenues and margins improve in the second half particularly, which is lower than the $57mm of EBITDA CSFB (the only major firm covering SYKE) estimates. Thus, SYKE is trading at roughly 4x trailing EBITDA and 3.25x 2004E EBITDA. These levels are generally low, but key for me is an expectation that capex will moderate with the offshore migration leveling off (of course, if growth accelerates, at some point there may be increased spend for capacity but also higher earnings and cash flows). Moreover, the stock is trading at 1.3x tangible book value, nearly half of which consists of cash. The Company owns all of its call centers in the US and generally has been booking gains when it closes and sells these centers, which confirms for me that book value is meaningful in this case. This should provide a good floor for the stock.

Although I am not particularly enamored of the call center business given its relatively low ROIC, the business has a reason to exist as outsourcing is here to stay and is growing. This situation provides meaningful upside in an economic recovery and an attractive risk/return proposition as the Company benefits from a cyclical rebound in its business and its offshore investments and strategic repositioning of the past few years.

Catalyst

Accelerating revenues, earnings and cash flow through 2004
Share repurchases