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Firstsource Solutions IPO: Our view - Views on News from Equitymaster
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Firstsource Solutions IPO: Our view
Jan 29, 2007

Firstsource Solutions Ltd. (FSL), the erstwhile ICICI Onesource is issuing 60 m shares as part of its initial public offering (IPO), which opens today for subscription. The company has priced the issue in a range of Rs 54 to Rs 64 per share, thus expecting to raise Rs 3.7 bn to Rs 4.4 bn. For retail investors, minimum subscription for this issue is 100 shares. The issue will close on February 2, 2007.

Objects of the issue

Expenditure items (Rs m) Net Proceeds Estimated amount
Acquisitions 1,800
Setting up of new facilities (Break up is as follows): 463
a) Lease Deposit 34
b) Interior and Furnishing Cost 225
c) Technology and Equipment Cost 205
Repayment of loans of our company –
ICICI Bank External Commercial Borrowing
General Corporate Purposes (Balancing figure) 664
Total* 3,840
* Calculated at the higher end of the price band of Rs 64 per share, considering only the fresh issue part of 60 m shares

Company background
FSL was originally incorporated as ICICI Infotech Upstream Limited in December 2001, and embarked on an aggressive inorganic growth path soon after that. Within a period of five years it has acquired:
  1. CustomerAsset India Private Limited in 2002 to accelerate our entry into the Business Process Outsourcing (BPO) business

  2. First Ring Incorporation, a US company in 2003 to focus on customer acquisition and credit card services

  3. Holding stake in Pipal Research Corporation, a US company in 2004 to focus on research and analysis (R&A) capabilities.

  4. Account Solution Group (ASG) LLC, a US company in 2004 to capture the collections and receivables management market and

  5. RevIT Systems India Private Limited in 2005 to enter into the healthcare industry and transaction processing capabilities.

FSL is a leading provider of offshore BPO services to clients primarily in the BFSI (banking, financial services and insurance), telecommunications, media, and healthcare industries. It provides BPO services mostly to clients in the US and the UK. It had 61 clients as of September 30, 2006. Its five largest clients are BSkyB, CapitalOne, Lloyds TSB Plc, a large telecommunications company in the UK and a Fortune 500 telecommunications company. During the period between FY03 and FY06, FSL grew its net sales at a compounded annual rate of 95%.

FSL is promoted by ICICI Bank and a private equity fund, ICICI Strategic Investments Fund (SIF). SIF is managed by ICICI Venture Funds Management Company Limited. SIF has also made investments in other companies, including 3i Infotech Limited.

Reasons to apply
Fifth largest BPO player: FSL is the fifth-largest BPO provider in India, in terms of revenue for fiscal 2006. The company provides services to 74 clients, including six Fortune 500 banks, two Fortune 500 telecom companies and three Fortune 100 healthcare insurance companies, across a range of industries and geographies. Also, as an early mover in the BPO industry, the company has been able to achieve critical mass, attract senior and middle management talent, establish key client relationships and a track record of operational excellence as well as develop robust and scalable global delivery systems. In the past, FSL targeted the BFSI, telecom and media, and healthcare industries through a combination of organic growth and focused acquisitions, and is positioned to benefit from the attractive growth opportunities in these industries. It compounded annual growth in revenues of 95% during the period FY03 to FY06 has been one of the fastest in the Indian offshore outsourcing industry and we expect the growth momentum to be maintained in the future as well. During FY07, the company is expected to grow sales and net profits by around 35% YoY and 230% YoY respectively (considering annualised 9mFY07 numbers). FSL provides its services through 17 global delivery centers with 11 centers located in India, 3 in the US, 2 in the UK and 1 in Argentina with 1 under development in the Philippines.

FSL: Moving up the ladder
Rank FY04 FY05 FY06
1 WNS WNS Genpact
2 Wipro BPO Wipro BPO WNS
3 IBM Daksh HCL BPO Services Wipro BPO
4 Convergys IBM Daksh HCL BPO Services
5 HCL BPO Services ICICI Onesource* ICICI Onesource*
* “ICICI OneSource Limited was renamed “Firstsource Solutions Limited” on November 21, 2006

Diversified business model: The Company has a well-diversified business model and revenues are scattered across continents. Its customers based in the US and UK contributed 49.4% and 48.0% of its income from services in 2006, respectively, while clients in the BFSI, telecommunications and media, and healthcare industries, respectively, contributed for 63.5%, 25.0% and 5.7% of its income from services in 2006. The revenue from top five clients amounted to 50% of total revenue, and no single customer accounted for more than 16.0% of its income from services. Due to lower revenue concentration the company maintains its strength over its competitors.

Strategic tie-up with Metavante: FSL entered into a strategic partnership with Metavante in March 2006 (Metavante currently has a 24.1% shareholding in FSL). The latter is a financial technology subsidiary of the Marshall & Ilsley Corporation and the third-largest bank technology and payment processor in the US. FSL’s agreement with Metavante provides for combining the latter’s technology outsourcing capability and proven technology platform in the banking industry with the former’s process management expertise to offer banks and financial institutions a comprehensive outsourcing solution. This, combined with Metavante’s established business relationship with over 1,000 banks and financial institutions, gives the company a competitive advantage in the market, which is particularly relevant with regard to super-regional, regional and local banks and financial institutions that are beyond its traditional customer base of national and international banks and financial institutions. Also, as per the arrangement, Metavante has agreed to provide FSL with exclusive rights to perform any offshore BPO services that they or their clients require and the latter has agreed to market certain of its offshore BPO services to banks and financial institutions in North America exclusively through the former.

Strong relationships with leading global companies: FSL has maintained strong relationships with its clients and over a period of time has got repeat business from these clients. The repeat business income accounted for 74%, 76% and 87% of the company’s total income in 2004, 2005 and 2006 respectively. The company also has an onshore account management and relationship management teams, to get additional business for them and to understand their needs in a better way.

Reasons not to apply
Competition’s getting hotter: BPO businesses around the globe face the problem of relatively higher levels of attrition and absenteeism than their software services counterparts. FSL has been facing attrition rates (30% in 9mFY07), which are reportedly higher than its peers in the Indian BPO space of similar standing. This is a big cause of concern, as increased attrition rates result in higher hiring and training costs for new employees and also, the time taken to bring the skill levels of the employees up to scratch is higher.

Further, with competition set to intensify from MNC offshore BPO providers, BPO divisions of global IT companies and global ‘pure play’ BPO providers located in the US, and BPO divisions of IT companies located in India, such as Infosys and Wipro, challenges on the talent acquisition and retention will continue to plague the company in the future.

Maintaining data integrity of clients: BPO companies are required to manage confidential client data in connection with the services that they provide. Since the companies do not have insurance coverage for mismanagement or misappropriation of such information, they have to spend huge amounts on the security of the data, which they get in the discharge of service. Information security system has to be spot on. Inspite of all these, data security cannot be guaranteed. The occurrence of such events could have a negative impact on the reputation of FSL, which could negatively impact its business prospects.

Negative public reaction to offshore outsourcing: Offshoring is a very sensitive topic in the west, and new legislations are been enacted to stop offshore outsourcing of work to developing countries like India, China and the Middle East. In the US, legislation has been proposed that would require offshore service providers to identify where they are located. One more legislation could be adopted that would restrict the US private sector companies that have government contracts from outsourcing their services to offshore service providers.

Transfer of Undertakings (Protection of Employment) Regulations 2006, has been enacted in UK (from where FSL generates almost 50% of its revenue) and all these could act as a deterrent for companies to outsource work to India. If the clients in the UK and US are restricted from outsourcing work to India and other emerging offshore destinations, companies like FSL could be faced with significant liabilities or could lose income, both of which would have a material adverse effect on their growth prospects.

Comparative valuations and comments
At the higher price of Rs 64, FSL’s issue is priced at 31.7 times its trailing 12-month earnings. While there are no pure play listed BPO companies in India, we compare FSL’s key financial numbers with a couple of MNC BPO providers like WNS and EXL Services as also a mid-size Indian IT and BPO company – Mphasis.

Comparative evaluation
Particulars (FY06) FSL* WNS EXL# Mphasis
Sales (US$ m) 122 203 74 209
PAT (US$ m) 5 18 7 33
EBIDTA margins 14.5% 15.4% 15.9% 21.2%
Net profit margins 4.4% 9.0% 9.5% 15.9%
Return on equity 5.6% 23.4% 22.8% 23.0%
Employees (Nos.) 10,717 10,433 5,799 12,535
Revenue per employee (US$) 11,378 19,439 12,753 16,666
Valuations (Trailing 12-months)        
Price to earnings 31.7 60.6 49.0 40.1
Price to sales 3.8 5.3 6.5 4.4
EV/EBIDTA 19.9 31.5 NA NA
* For FSL, higher price of Rs 64 is considered # Data for EXL is for year ended December 2005; March 2006 for others

As seen from the above table, while FSL is a relatively smaller player of the lot, it also underperforms others on the profitability (EBIDTA and net profit margins) and return on equity fronts. As for valuations, the issue looks relatively cheaper on a trailing 12-month performance basis. But this needs to be understood in respect of the company’s relatively smaller size and subdued financial performance. While the company shall provide opportunity in terms of the only listed ‘pure play’ BPO in the company, one needs to understand that benefits of the offshore outsourcing opportunity can be availed of in a better way by investing in the already listed IT services players (Tier-I and Tier-II) that have integrated business models of providing both IT and BPO services.

Overall, while investors willing to take high risks can consider applying to the issue, for the defensive lot, there already are much better long-term opportunities available in the integrated IT-BPO space.

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