Firstsource Solutions - Initiating Coverage - Overseas growth opportunities could surprise positively

Firstsource Solutions - Initiating Coverage - Overseas growth opportunities could surprise positively

Rating: Buy; Target Price: Rs52; CMP: Rs41.3; Upside: 26.7%



Overseas growth opportunities could surprise positively



We initiate coverage on Firstsource with a Buy rating and a TP of Rs52
based on 9x Sep-16E EPS. While revenue growth has been unimpressive at
first glance, growth potential is masked as growth in overseas
business was countered by an exit from unprofitable domestic accounts.
We expect this trend to continue over FY15E/FY16E along with
operational improvements that help bring further margin expansion. We
think our revenue growth estimates could prove conservative if
Firstsource gains traction in the Healthcare segment that has
significant potential. If healthcare does grow significantly, we think
margins could also improve ahead of current estimates with scale gains
in Philippines.

$ Margin expansion from cost management and international revenue
growth: Though employee costs put pressure on margins by 104bps over
FY12-FY14, prudent cost containment in other areas such as
Connectivity charges, Rent, Repairs and Maintenance, Traveling &
Conveyance helped deliver a credible EBITDA margin improvement of
345bps. While some of the cost savings came from the decision to
purchase a leased facility in the US, other cost savings reflect a
change in attitude towards cost management and we believe that further
cost savings are likely over FY15E and FY16E. We think that cost
savings have also come from increasing onsite seat utilisation and
that there is still some headroom left.

$ Revenue growth has potential ahead of current expectations: While
overall revenue growth over FY14 was affected by exits from
unprofitable domestic accounts, international revenue saw excellent
growth over FY13. Despite headwinds such as softness in the
collections business and the decision of a US banking client to
in-source some operations, the international business has shown a YoY
growth of 3.9% over 1QFY15. With deal ramp-ups expected this October,
we expect seat utilisation to improve in the near-term from the recent
low of 73.4% in 1QFY15, but we do not expect significant capex for
additional seats as our conservative revenue growth projections assume
only a high of 80% seat fill factor (in 3QFY17). We think our current
revenue estimates are conservative.

$ Growing US revenues and gaining scale in Philippines offer
opportunities: We note that Firstsource’s international revenue growth
was driven mostly by UK with the US contributing little even after
MedAssist acquisition. With the industry moving away from
voice-centred operations for customer management to a multi-channel
approach that combines chat, e-mail and self-service, Firstsource’s
lack of scale in Philippines is less of a handicap. But with
Philippines growing faster than India as a fulfilment center for North
America, and also being a proven destination for clinical process
outsourcing with a large pool of US-certified nurses, increasing
presence here would help long-term growth prospects in the US.

$ Valuation and key risks: We initiate coverage with a Buy
recommendation and a TP of Rs52 based on 9x Sep-16E EPS. With an
expected PAT CAGR of 28.3% over FY14-FY17E, we think Firstsource is an
attractive investment at current levels. Much of the profit growth is
expected to come from margin expansion and lower interest cost burden.
While we think that our revenue assumptions could prove conservative,
we await results of the recent focus on growing the international
customer management and healthcare segments. With long sales cycles,
we may need to wait till FY16E to see any significant uptick in growth
trajectory. Key downside risks include loss of key clients, continued
slowness in the collections business and significant rupee
appreciation.