The slowdown triggered by the global financial crisis continued to adversely impact the BPO industry as clients tightened their discretionary spending resulting in flat volume growth. However, the qoq Rupee depreciation by ~4.8% vis-à-vis the US dollar, and the integration of past quarter acquisitions, has softened the adverse impact. Despite this, EBIT margins have suffered largely because of wage inflation.

Valuations have been declining and we expect them to go down further, as we think that the complete impact of the current crisis has not been factored in yet. At the same time, we also believe that valuations will become increasingly relevant as the bankruptcies and financial turmoil in financial services will accelerate consolidation in the BPO industry. We feel that the Merrill Lynch takeover by Bank of America may trigger further consolidation. We largely expect this trend to benefit the BPO industry, as integration processes typically seek to drive operational synergies through centralized outsourced units. Nevertheless, we expect BPOs to hedge against the bleak environment by limiting exposure to financial services in general and the US in particular and actively increase exposure to defensive sectors and domestic business.

 

Key figures of quarter end results

 
*Total revenue of HOV Services excludes other income of $8.4m (Mar 08) and $0.1m (Jun 08) 
Source: Company filings, ValueNotes Research

Firstsource (NSE: FSL)

The top-line grew 4.1% qoq, largely contributed by strong momentum in domestic business (Airtel and Vodafone Essar ramp ups) and full quarter revenues from the MedAssist acquisition and the Barclays contract.

FSL recorded a foreign exchange loss of $18.3m on account of restating the FCCB (Foreign Currency Convertible Bonds) liabilities, which was the primary contributor for the loss before interest and tax of $9.2m. The management claims that other factors responsible for the loss were increase in cost of growth (Airtel account), seasonal fall off on collections and wage inflation. However, the management expects margins to improve by ~150-200 bps in the coming quarters when productivity improvement measures and integration synergies resulting from the MedAssist acquisition start delivering results.

984 employees (5% of the current workforce) were added during the quarter, but attrition remained high at 38.7% (despite marginally falling from 38.9% in 4Q08).

The management has retained its guidance of 33-38% revenue growth for FY09. However, sluggish growth in the current quarter will put pressure to achieve higher growth in subsequent quarters, if they have to meet the revenue guidance. Given the current market conditions, we are skeptical of the company achieving its guidance.

 

Source: ValueNotes Research

WNS holdings (NASDAQ: WNS)     

The top line growth of 6% qoq was driven primarily by inorganic growth (acquisition of Call 24X7 and BizAps, and integration of the Aviva Global Services business).

However, operating costs increased by 6.6% qoq primarily due to higher depreciation and amortisation costs arising from the setting up of four new operating centers and acquisition of intangible assets such as Marketics, Flovate, Call 24X7 and BizAps. WNS recorded other operating loss of $1.5m as against an income of $2.2m in the previous quarter primarily on account of foreign exchange losses in the current quarter. The combined effect has been a decrease in EBIT margins by 360 bps.

The management claims to be immune to near term economic fluctuations due to two reasons. First, WNS only has a 5% exposure to the mortgage and banking sector. Second, revenues are not dependent on clients’ discretionary spending as WNS has signed long-term contracts tied to clients’ operating budgets. Consequently, management has retained full year revenue guidance of $425-435m.     

EXL Services (NASDAQ: EXLS)

Depreciation of the Philippines Peso and the Indian Rupee against the US dollar helped boost revenues by 5.6% qoq.

Forex losses of $143m reduced the EBIT margins by 4%. However, excluding the Forex loss, the EBIT margins were relatively stable at ~9.8% qoq.
 
The company has re-organized its business into two main segments: Outsourcing services (comprising the BPO segment excluding process advisory services) and Transformation services (comprising research and analytics, advisory, and process advisory services). 

The company has lowered its forecasts for FY08, from its initial revenue guidance of $205 - $210m to $200 - $205m,  because of lower volumes expected from select clients.

Genpact (NYSE: G)
                     
Quarterly revenue increased 8% qoq and crossed the $250m mark. The management claims that improved pricing for higher value work is a key factor that has positively impacted its top line. Genpact’s ability to command premium pricing is reflected in its average-revenue-by-employee, which is the highest among all the companies covered in this report. Although the company currently has high exposure to a single client, GE, which contributes ~50% of the revenues, this acts as a hedge in a scenario of unpredictable volumes from other clients.

The increased contribution from high margin business (re-engineering services), improved employee efficiencies and better operational cost control (total operational expenses reduced by ~2% qoq) resulted in a marginally higher EBIT margin in the last quarter.

Attrition rates dropped from 30% to 25% in Q2 FY08. Genpact has the lowest attrition rate compared to its listed peers. 

HOV Services (NSE: HOVS)                                   

The company has reported a marginal qoq revenue growth of 2.2% and has retained its revenue guidance of $230-237m for FY09.

EBIT margins increased by 1.4% qoq. Rationalization and integration of global operations has given rise to operational leverage (other operating expenses reduced by ~17% qoq). This has helped to defray increases in staff costs in India. The management believes that expansion into Tier II cities in India will further reduce the wage bill and help to keep costs under control.

Valuations continue to be high despite business uncertainties

The PE ratios of the BPO companies under review in this report (except for WNS) have fallen this quarter. However, flat volume growth and low pricing power are already impacting the operating dynamics of companies. Further, the overall business environment continues to be uncertain because of which we believe the stocks are still over-priced.  

Since wage inflation and rupee appreciation directly undermine the cost arbitrage advantage, which offshore BPOs enjoy, any adverse movements in these two factors will also significantly dent the operating business model. However, the global financial crisis is seeing a lot of shake-outs in the captive segment of the BPO industry and we believe there is more to come, given the near-collapse of Lehman brothers and other imminent failures. We are of the opinion that a lot of labor from this segment should flow into domestic third-party BPO services, significantly easing labor supply concerns. Further, scale advantages (for Genpact, WNS, EXL primarily) and a slowing economy should translate into milder wage inflation this year.

  *FSL had a negative EPS of 0.04 for the quarter.
**Represents EV/EBIT as EBITDA is not available
+based on trailing twelve month (ttm) performance
Source: Yahoo finance, Money control, Company web site