Strategy - Carlyle’s Investment In Allsec Technologies

Options for Carlyle: Al sec Technologies InvestmentAuthor: Jaideep MirchandaniAugust 2009Executive SummaryAl sec Technologies plays in a rapidly changing market, one which wil continue to chal enge its survival and profitable growth. These changes include (1) The move to bundled outsourcing, combining BPO with other services (2) Consolidation of the BPO space to favor large players with scale and pricing power (3) Disruptive competition by the IT majors who are gaining in vertical knowledge and are using the scale they built for IT outsourcing to provide deeper, cheaper and more innovative BPO (4) The increasing importance of Intel ectual Property as a means to fuel innovation. We don't see a niche where Al sec has scale, intel ectual property or any other comparative advantage to thwart these strategic threats in the long term (12-18 months). These factors point against a strong financial return from Al sec even as it continues to lag the BPO industry in profitability and growth. We thus recommend that Carlyle consider either minimizing its long-term losses by exiting the Al sec investment or working with Al sec Management to package the company for an exit at a premium to market.Financial PerformanceLimited positives, no breakthroughs: The Q1 report, issued on July 31 2009, shows some progress.The largest accomplishment was the reduced dependence on its top client. Other positives included YoY revenue improvement. But fundamental y, Al sec is stil operating at a loss with continued cash col ection problems (Rs. 150.07M (Rs. 159.38M in Q4’09) are identified as “substantial y overdue” by the auditors). Overal , we don't see the data to indicate breakthrough growth to beat the industry either in the medium (6-12 months) or long term (1 year+). A core assumption of the rest of this report is that Carlyle would want Al sec to at least outperform the BPO industry on average.Reduced dependence on the top client from 23% to 21% (QoQ; 42% to 21% YoY): This is positive, but the top-5 concentration barely dropped from 62% to 60% QoQ. The underlying exposure has not been reduced meaningful y. Its larger competitors don't typical y have this kind of exposure. We don't believe this exposure is consistent with an ability to significantly grow its business. A minor accomplishment was improved YoY Q1 income performance (up 26.5% - Rs. 3125L vs. Rs. 2471L). While positive, the YoY revenue increase is one data point after an especial y dif icult FY 2009 when it severely lagged the Indian BPO Industry. Plus, Al sec stil made an operating loss in Q1.Growth in India HR BPO - Positive but not EnoughWhile Al sec's becoming India's No. 2 HR BPO vendor is notable, this segment wil not be suf icient to enable Al sec to grow beyond industry rates. HR represented 10% of Al sec's revenues, or about 300L whereas Al sec lost 469L after taxes in Q1'10. It is highly unlikely that HR BPO wil be able to transform Al sec's fortunes in 12-18 months. Market conditions also indicate a tough path for Al sec. According to a recent Economic Times report, the Indian BPO market is witnessing renewed pricing pressure, perhaps as much as 3-5%. This is in addition to the inherent fact that India's BPO business wil not command the same margins as a US or EMEA contract. Given Al sec's lack of comparative advantage due to scale, Al sec wil not be able to leverage its Indian HR BPO success to drive company-wide profitable growth in order to generate industry-beating returns. Allsec Technologies Investment – CarlyleJaideep MirchandaniLack of Innovation Al sec is handicapped by its lack of Intel ectual Property advantage. At a time when many vendors have aggressively launched new business models and new software IP to gain comparative advantage, Al sec has not emerged as a leading innovator. Two examples reveal where the Industry Leaders and Customers are taking the BPO Industry: 1. Genpact LeanDesk - IT Outsourcing crucial y requires predicability and the ability to securely manage the complexity of user IT environments. LeanDesk - a set of software tools and al ied process - al ows Genpact to reduce the cost of IT Infrastructure outsourcing, 17% of Genpact's business. This IP gives them a unique advantage. Over time, Genpact can leverage col ective user learning to improve the consistency and value of its IT Outsourcing of erings. 2. Infosys - HRO Platform for Business Model and Technology Innovation - Infosys has developed the technology and business model to deliver a purely subscription-based HRO. This al ows customers to focus on "hire to retire" atop Infosys's already-instal ed systems using Infosys's already-trained platform operators. The only ramp-up wil be in client-specific process areas. The rest wil be encoded in a platform. In contrast, a company that doesn't encode its process and learning in a platform continual y finds itself dependent on individuals and documentation to gain domain knowledge. But nothing wil require al personnel to execute BPO in a common way without technology and a platform to demand and audit it. Infosys now has an opportunity to teach its customers about HRO best practices as multiple customers use its platforms.From past performance it is not clear that Al sec has the wherewithal to match this innovation. In our view, this shortcoming is the main reason that Al sec's long-term prospects are dim. We haven't seen compel ing evidence that Al sec has beaten the industry in process or human resource productivity gains. Even if it had, experience from the IT outsourcing industry has shown that a linear, headcount-fueled growth model is not sustainable as markets become more competitive. It is crucial to innovate deeply in the business model and via technology. This essential y is the route that majors like TCS, Infosys and HCL have taken by moving away from "Time and Materials" models to shared risk and even pay-per-use contracts. Final y, even if we ignore innovation, Al sec lacks the scale to compete in size: the largest players have 7-10X the number of employees in pure-play BPO services alone (e.g. Genpact has approximately 37,400). Strategic Outlook and AnalysisWe use Porter's 5 forces as a framework to consider Al sec's position. In sum, Al sec’s position appears to be weak.Competitors: With around 5500 employees, Al sec does not appear in NASSCOM's top-20 by revenue or employee strength. It is at best a mid-tier vendor. Given Al sec's size, finding a niche is crucial if it is to compete with larger players. It has vast competition at the top including Genpact, IBM, Accenture, TCS and even smal er competitors, some of whom have been more successful in building niche skil s and domain knowledge. Tricom is one example. Tricom has focussed more on non-voice services and has fashioned its marketing message around a set of precise services in Healthcare, Legal Process Outsourcing and Indexing, many of which are considered higher value add than elementary customer service or voice BPO. Furthermore, for Health Care, Tricom acquired Godrej's BPO practice, hence acquiring domain knowledge and credibility in that sector. They were also able to fashion precise of ers. For instance, they of er the fol owing for patients and providers: Patient Scheduling, Patient Enrol ment, Pre-authorization/certification, Eligibility and Verification. It is not clear that Al sec, for instance, has been able to carve and market this level of specificity into their of erings. Allsec Technologies Investment – CarlyleJaideep MirchandaniRise of the IT Majors in BPO: In addition to Wipro, Infosys and TCS, of late, players like Cognizant have rapidly grown their BPO of erings, often in conjunction with core IT Services. Their bundling of IT Services with BPO means that Al sec's "pure BPO" of erings are threatened by ful er bundles which may include ADM and IT Outsourcing in addition to BPO. In such a scenario, Al sec is threatened not just by size, but also by the greater technological prowess of the IT vendors. For instance, Infosys has already combined its technical and business model advantage to of er new, less capital intensive options for customers such as with HRO.In sum, Al sec faces a fiercely competitive environment in which it faces threats from the larger and mid-tier rivals. Crucial y, it is also at an innovation disadvantage, both in terms of of ering new business models and for creating comparative advantage via technology. These issues also hold for other, smal er BPO players (e.g. Sparsh) who face the same threats.Suppliers: Do not appear material to shaping Al sec's business environment. Al sec's major resource - employees and location - is control ed internal y. Substitutes: Substitutes from another industry do not appear relevant to shaping Al sec's business environment. However, the at ack by IT majors means that a buyer may choose a "BPO+" of ering instead of BPO alone.Buyers: On the one hand, Al sec’s export base is exposed due to the downturn and regulatory changes (pg. 28, Annual Report, March 2009). On the other hand, BPO customers - like IT customers - have continued to demanded price reductions and risk sharing. Al sec wil not be immune to these demands. Large vendors have responded wel to this crisis both because of greater financial resilience and because they are more accustomed to these deals from their experience in IT outsourcing. In sum, the health of Al sec's key customers – as wel as the stronger buying power of prospects - wil continue to pose a major risk to Al sec's continued ability to ward of competitors and grow revenue.New Entrants: For Al sec, this poses a threat due to the weak barriers to entry it poses1. Al sec's inability to build major comparative advantage and its relatively smal scale mean that its customers are ripe targets for smal , more innovative new entrants. 2. Price driven by scale - Al sec's competitors - including Accenture, IBM, Wipro, Infosys, Genpact, have acquired a scale that gives them a price advantage in the market. However, as discussed above, Al sec lacks the required scale to compete credibly on price and stil grow profitably. A new entrant could enter via acquisition or build out BPO capabilities to match Al sec's scale of around 2000 employees. Precisely such an entrant could benefit the market by acquiring Al sec or some other competitor. Our conclusion is that Al sec's strategic position is weak. It is unlikely to generate returns that beat its industry. Given its string of recent losses, it is at a real risk of being unable to generate profits at al if some of the above threats materialize. Al sec reported a Q4'09 customer acquisition which caused Q1 '10 rampup. Al sec also predicted that revenues from a strong Q1 win are expected to flow in from Q2 onwards. These are positive, short-term events, but the underlying issues clearly hold. In the best case, Al sec wil ride a market bounce in world markets and customer mood to gain some breathing room, possibly stemming its losses and turning a profit (1-3 quarters). It may wel hold on to some of its key customers though Q1 already indicated spending pressures from its international customer base. In the 12-18 month timeframe, we believe strategic threats wil cause it to begin "rusting", a gradual but irreversible decline due to the loss of operating margins either by losing revenues from current customers (already seen in declining Q1 exports) or by losing customers outright.Allsec Technologies Investment – CarlyleJaideep MirchandaniOptions and Recommendations for CarlyleGiven Al sec's performance since 2007 as wel as its fundamental strategic position, we believe Al sec is no longer a viable long-term investment capable of generating suitable returns for Carlyle compared with the BPO industry at large or the India equity market. We thus consider two options. Ultimately, Carlyle’s investment goals wil drive the decision.OptionKey ImplicationsProsConsExit InvestmentFul or majority exit from Quick, ef icient exit to (As always) No going back investment with Al sec al ow Carlyle’s capital to on booked lossesessential y as-isbe redeployed rapidlyPackage Al sec for exit Acquisition or other 1. Possibility of 1. Wil require work and at a premiumchange of control which commanding a premium possible additional al ows Carlyle to sel its over current priceinvestment in the stake at a premium to operations. We expect this Al sec’s current market 2. At ractive overal to entail repackaging and price. We see three types market improves odds of repositioning of the of possible BPO acquirers securing a premium - The company. This may whether or not they may BPO market is predicted require an investment to be financed by other by NASSCOM to grow in shore up areas of extreme investors. Acquirer types 2010 and beyond. The weakness (e.g. lack of listed below.addressable BPO market utilization in Philippines is estimated at least USD from Q1’10 report) and 120-150B, making this an time – perhaps 4-6 months at ractive business with of paral el ef ort - to ensure room for growth. This Al sec is portraying its could at ract a reasonable capabilities and niche premium for Al sec at ractively and precisely.provided Al sec is seen as a front-runner in a wel -2. Wil require the buy-in of defined niche, and is able Al sec’s management and to precisely articulate its shareholdersof erings and message. Three possible acquirers:a. New Entrant – Al sec of ers a fast way to get into the BPO market for a player prepared to make the required investments to grow and innovate beyond Al sec’s current size and capabilities.b. Existing Player - May see this as a quick way to add 5000+ employees and perhaps a few customers at an at ractive price.c. Smal er, Aggressive Player - A smal er player may want to acquire Al sec's scale, HR brand and customer book to add credibility, especial y when competing with larger players for the larger, transformative deals. Given the dif iculties faced by other smal players like Sparsh, this could be part of a “mop-up” strategy to consolidate smal players to col ect critical mass.Allsec Technologies Investment – CarlyleJaideep Mirchandani