28 June 2011

Indian BPO Industry - Missed Call; No More :: Citi

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Indian BPO Industry
Missed Call; No More
 Circa 8-10 years back and BPO blue-sky scenarios — It's not quite played out –
BPO growth has lagged IT, has suffered from the global meltdown and has fallen off
the investor radar. So has India missed  the BPO call? We think not, though the
market penetration remains low (<10% of $172bn in 2010), execution/business
models have improved and the fundamental value proposition remains intact. While
stabilization in global macro and employment in the developed world is needed to
kick-start the business, investors should start dialing in.
 We see value building in — (a) Integrated models (IT+BPO with BPO at ~5-10%
of current revenues) – HCLT/Wipro preferred plays. (b) We believe standalone
BPOs can co-exist – EXLS favored play. (c) Structurally, prefer integrated models –
scale, cross-selling and single-provider benefits. (d) BPOs will deliver growth and
returns – but unlikely to be primary stock  driver for integrated players. (e) Rising
M&A activity to put spotlight on BPOs and may raise transaction multiples.
 Why is BPO not ‘IT’? — We expect BPO sector to scale up faster, become more
visible and be better valued; but is likely to continue to play second fiddle to IT. This
is because it is still growing a tad slower (~24% vs. ~26% IT CAGR), lags in
margins (10-15% vs. 25-30% for IT), has greater people challenges (35-40%
attrition vs. 15-20%) and faces greater regulatory challenges. BPO space will not be
the next IT, but it should still give growth and returns.
 How do valuations stack up? — Standalone BPOs trade at ~18-20x CY11E PE, a
20-30% discount to comparable integrated plays (CTSH). On an EV/Sales basis,
the discount is ~40-50% with CTSH and ~60% to the Indian integrated stocks. The
recent M&A deals were struck at current valuations. As BPOs scale up in future they
will likely warrant better multiples.

Management interaction highlights

Presented below are the key highlights from our interaction with management.
 Demand continues to be good on an overall basis. Europe and emerging markets
are strong, while there has been some softness in the US due to the recent weak
economic data (on the retail banking/mortgage side).
 Pricing is starting to stabilize. It is competitive for new deals but the deal
renewals are happening at favorable rates. Competition is rational.
 The strength of Genpact lies in the breadth and depth of the services that it offers
and the strong process culture, courtesy of the GE parentage.
 Smart Decision Services (Risk, Analytics and Re-engineering) is seeing strong
 The company invests a lot in IP and has a dedicated team for new product
 People issues are there, though the attrition in the higher end services is not very
different from IT. The company is planning for wage hikes of ~7-9% and is laying
more emphasis on training and the career paths of employees.
 Future direction – management looks at a particular vertical and tries to ascertain
what is needed to drive growth. The Headstrong acquisition in the Capital
Markets space was a result of similar introspection.
 Future investments would be in the area of front-end teams (within key verticals),
other sales & marketing initiatives and expansion into newer geographies.
 F&A is the fastest growing process, with a lot of activity across industries. This
gives the vendor a voice with the CFO, which can be used to push offerings
 Haven't seen many large deals in the space over the last two years, however,
now seeing some deals in the $8-10m range.
 US more active than UK/Europe. APAC/Middle East doing well.
 Seen some traction in KPO in the last six months. This is more discretionary and
gets cut off first in a recession. Offers a great cross-sell opportunity.
 Talent is available; issue remains that of employability – working with universities
to address it.
 Attrition is a challenge – can be lowered to 25-30% (which is manageable).
 Vendors have been rational regarding pricing.
 Making investments in developing additional platforms and expanding
geographically (both, in India and onshore locations).
 BPOs need to leverage technology better

EXL Services
 Unlike IT Services, clients typically start with one BPO vendor. Only when the
vendor ramps up to $20-40m, do they look for another as a risk diversification
 BPO deals are more longer-term in nature (3-7 years). Expect BPO industry to
outperform the IT Services industry over the next 3-5 years.
 Deal sizes continue to remain small – clients start with pilots and then ramp-up
as comfort increases.
 North America doing well; UK better than Continental Europe; APAC not really an
area of focus.
 Supply of talent is much larger for BPO, though voice skills are still an issue.
 Attrition continues to run high as a lot of work is done at night (real-time); don't
expect it to change.
Infosys BPO
 Decision cycles are longer (6-12 months); 25 large deals in the pipeline (>$25m).
 Clients start small and then ramp-up (deal size is recouped over 18-36 months).
 F&A and Sourcing & Procurement seeing good growth. Now, there is good
demand for industry specific processes which tackles the COGS line in the P&L
(BPO was used to largely address the SG&A expenses previously).
 Company has six platform BPOs and is seeing good traction. The McCamish
platform has helped in a landmark deal in the Life & Annuity space and has also
helped in opening the Canadian market.
 Pricing is aggressive in the industry for the commoditized services.
 Industry is converging with technology becoming an important piece – Infosys' IT
capabilities helps in this regard.
 Supply of talent is an issue at the mid-management level, not at entry level;
attrition currently at ~30% annualized and it is expected this can be brought down
to ~25%.
 Making investments in platforms, technology solutions (it has 25 point solutions
now; another 28 in the pipeline), process consulting, expansion of global centers
(e.g. Manila, Poland) and front-end sales

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