Outsourcing gains

The Indian outsourcing story has been riding high on a cost arbitrage model. Will the scene change as the rupee appreciates?

The unprecedented rise in the rupee witnessed in recent weeks has been a major source of nervousness among stock market players.

Since the beginning of the year, the Indian currency has appreciated from Rs 44.24 to a dollar to Rs 40.86, a gain of 8.27 per cent. Compared to the low of Rs 46.99 per dollar in July 2006, today the local currency is trading 15 per cent higher.

Although it suggests that the economy is more robust than what one thought it to be, it is an irony of sorts that the rise of the rupee threatens the profitability, if not the survival, of the very businesses which give the country this strength to begin with.

After celebrating the success of software service providers for several years, and recognising the potential of other outsourcing businesses like textiles, auto ancillaries and, more recently, pharmaceuticals, the stock market now seems confused.

Will these businesses continue to be competitive and deliver the growth projected earlier? 
 

TECH TRICKS
Rs crore	Firstsource Solutions			HOV Services
	FY07	FY08E	% chg	FY07E	FY08E	% chg
Revenues	829.80	1245.00	50.04	867.70	1120.00	29.08
Operating Profit	164.40	255.23	55.25	86.10	147.00	70.73
OPM (%)	19.81	20.50	-	9.92	13.13	-
Net Profit	97.30	149.50	53.65	33.10	62.30	88.22
NPM (%)	11.73	12.01	-	3.81	5.56	-
EPS (Rs)	2.50	3.84	53.60	36.40	68.50	88.19
P/E (x)	35.76	23.28	-	5.69	3.02	-
Source: Analysts' estimates, company guidances

The Smart Investor finds out that the India outsourcing theme is still on a firm footing, thanks to the significant cost advantages and competency in areas of research and engineering.

But the good news is that local forex experts feel that the rupee would come off the high level sooner than later.

"Although the strength of the rupee against the dollar appears to be continuing, we see the exchange rate stabilising at Rs 43 over the next three-four months," says Anis Sheikh, manager, risk management advisory, Mecklai Financial.

On the business side, too, outsourcing is still lucrative thanks to the hefty cost savings.

While there are doubts about the ability of textile companies to withstand competition from other cheap producers like China and Bangladesh, analysts are confident about the prospects of drug-makers engaged in contract research and manufacturing (Crams), auto ancillary manufacturers, and IT-enabled service providers.

Sample this: According to domestic brokerage Enam, in the case of pharmaceuticals, setting up a US FDA approved plant in India would cost 30 per cent lesser than in the US; running the same plant would be about 45 per cent cheaper; the cost of labour would be only 7 per cent of that in the US; and manufacturing cost in the country would be 35-40 per cent cheaper compared to the US and 25-30 per cent compared to Europe.

Given the unbeatable economics, India should be able to garner a lion's share of the global contract research revenues, estimated at $13 billion in 2005 and projected to grow at 14 per cent per annum through 2009.

"In India, this segment is still at a nascent stage, worth hardly about $700 million. Since the base is small, it is not difficult for this industry to register high growth in the initial years," says Sarabjit Kour Nangra, vice president "� research, Angel Broking.

Players like Nicholas Piramal, Jubilant Organosys, Dishman Pharma, Divi's Laboratories, Shasun Chemicals and Suven Life Sciences have a fairly large part of their revenues coming from Crams.

The story of auto ancillaries is also similar. Says Mahantesh Sabarad, analyst, Prabhudas Lilladher, "Indian auto component products provide a huge arbitrage opportunity to foreign OEMs as Indian products are 20-30 per cent cheaper."

High costs have resulted in the shutting down of plants in the developed markets. Riding on India's cost competitiveness especially in terms of labour costs and the consequent price differential, an ACMA-McKinsey study expects India's component exports to jump from $1.8 billion in FY06 to $20-25 billion by FY15.

Additionally, the robust growth rate will be fuelled further by the increasing demand in the domestic market especially passenger cars as Indians upgrade themselves from two-wheelers to cars, says a report from a foreign investment bank.

While the business opportunity for ITES is huge and India dominates the space with a 46 per cent share in the world, the advantages go far beyond labour cost to the time advantages and language skills.

The offshore BPO market is estimated to grow at a compound annual rate of 37 per cent, amounting to $55 billion by 2010, according to a NASSCOM-McKinsey study. Indian companies in this segment are expected to earn revenues of $25 billion by 2010.

While the long term looks secure, it needs to be emphasised that companies will not be able to escape a dent in margins due to adverse currency movements even though they might try to hedge their positions. It is here that companies with a diversified revenue stream across geographies can help.

Auto ancillaries, for instance, derives about 25 per cent revenues from the US and 35 per cent from Europe. But again, the rupee has appreciated six per cent against the euro this year till date and hence companies may not be able to emerge unscathed.

Here we shortlist a few companies engaged in outsourcing which promise strong earnings growth in spite of concerns over an appreciating rupee and a global slowdown. Investors can use any correction in these stocks to accumulate them for the long term.

Firstsource Solutions
Figuring among the top three Indian pure-play BPOs, Firstsource Solutions is a fast growing company with an attractive clientele, which includes six Fortune 500 banks, two Fortune 500 telecommunications companies and three Fortune 100 healthcare companies.

Further, this clientele is well diversified across geographies, namely, the US and the UK, thus giving the company a natural hedge to protect the company from the forex volatility. It has over 14,000 employees spread across 24 global delivery centres located in India, the US, the UK, Argentina, and the Philippines (under development).

For FY07, the company delivered a 50 per cent plus growth in its top line, and its operating profit margins too have improved continually from 11.5 per cent in FY04 to over 20 per cent in FY07.

The management is confident of repeating the feat, even amidst speculations of a slowdown in the US: "We may see a shrinkage in the sizes of outsourcing deals that take place. However, volume growth in terms of number of deals will remain intact," claims Ananda Mukerjee, chief executive officer. The stock, however, is a tad expensive trading at over 23 times its estimated FY08 earnings.

"For a mid-cap company, these valuations are fairly high when one can find similar IT companies for lower valuations. However, the growth potential for this company is robust, which may make investors to look beyond traditional parameters," suggests an analyst.

HOV Services
Until last year, HOV Services was just another BPO outfit lugging about Rs 165 crore in revenues, providing services to banking, financial services and insurance (BFSI), enterprise management solutions and accounts receivables management (ARM).

In FY06, the company acquired Lason Inc of the US, another BPO outfit about four times larger than itself, adding significant momentum to its growth.

Armed with a high profile clientele, HOV expects to clock revenues in excess of Rs 865 crore for FY07, and continue growing its top line at nearly 30 per cent per annum. On the profitability front, it needs to improve margins from the existing 13-14 per cent level to match up with its peers.

Suresh Yannamani, president and chief operating officer, BPO services of HOV claims, "We expect to realise significant synergies once we consolidate the business of HOV and Lason which compliment each other. This would enhance our profitability."

Now, the company has presence in six key verticals such as healthcare, BFSI, finance and accounting, e-publishing, transaction management and government.

"We have a clientele which comprises 50 of the Fortune 100 companies. Therefore, rather than increasing the number of clients, the focus would now be on mining our existing clients to get higher value-added processes outsourced from them," says Sunil Rajadhyaksha, executive director, HOV Services.

The company has not yet published its FY07 results. Considering the company's projections of earning a top line of Rs 868 crore in FY07 and Rs 1120 crore in FY08, the stock appears undervalued, offering plenty of upside potential.

Considering that the management should be able to pull off an effective integration of the two businesses, which does not seem difficult over the next few quarters, investors can place their bet.

Dishman Pharma
One of the fastest growing companies in the Crams space, Dishman Pharma has emerged as a strong contender in contract research after it acquired a Swiss research-based company Carbogen Amcis with three production facilities in Switzerland.

In the contract manufacturing space, it has supply relationships with pharma majors like GlaxoSmithKline, Merck and Sanofi Aventis. Further, it is also foraying into specialty chemicals, with manufacturing of electrolyte quaternary compounds (QUATs) and reagents.

In FY07, Dishman is expected to double its top line as it consolidates the acquired entity, and grows its business verticals. However, the profitability is expected to remain under pressure due to the high-cost structure of its Swiss manufacturing facilities.

The stock trades at around 22 times and 14 times its estimated FY07 and FY08 earnings, respectively, which is reasonable, considering the strong business model.

Nicholas Piramal
Nicholas Piramal has been growing by leaps and bounds both in the domestic and export markets.

Over the past couple of years, the company has significantly scaled up its Crams business through organic as well as inorganic initiatives. It acquired UK's Avecia Pharmaceuticals and Pfizer Inc's manufacturing facility in the UK to strengthen its foray in the Crams space.

"Today, we are working in four major areas, namely, oncology, inflammation, diabetes and metabolic disorders, and anti-infectives, and have 13 different molecules in different stages of research," says Ajay Piramal, chairman, Nicholas Piramal.

Currently, the company spends 5 per cent of its revenues toward research and development (R&D).

Nicholas Piramal recorded a robust 55 per cent growth in its revenues in FY07, while its operating margins after R&D expenses were stable at 15.5 per cent.

The company expects to grow its business at the rate of 25 per cent and maintain similar levels of profitability over the next fiscal year. The stock priced at about 16 times its estimated FY08 earnings, looks reasonable considering the company has significant potential to scale up its business both in India and abroad. 
 

BOOSTER SHOTS
Rs crore	Nicholas Piramal			Dishman Pharma			Suven Life Sciences
	FY07	FY08E	% chg	FY07E	FY08E	% chg	FY07	FY08E	% chg
Revenues	2472.00	3090.00	25.00	558.10	872.20	56.28	114.60	148.90	29.93
Operating Profit	383.50	479.00	24.90	140.10	209.30	49.39	16.80	37.20	121.43
OPM (%)	15.51	15.50	-	25.10	24.00	-	14.66	24.98	-
Net Profit	221.80	278.10	25.38	89.30	136.30	52.63	11.20	15.60	39.29
NPM (%)	8.97	9.00		16.00	15.63	-	9.77	10.48	-
EPS (Rs)	10.50	15.80	50.48	11.00	16.80	52.73	4.27	6.20	45.20
P/E (x)	24.42	16.23	-	21.91	14.35	-	9.43	6.49	-
Source: Analysts' estimates, company guidances

Suven Life Sciences
Suven Life Sciences derives almost 90 per cent of its revenues from Crams, and has the least dependence on other volatile revenue-streams like bulk drugs and generics.

The company has tie-ups with leading drug majors globally for collaborative research, and the earnings from its Crams business are expected to grow at nearly 30 per cent over FY08.

In FY06, the company spent 22 per cent of its sales on R&D, and it is still growing.

The company is planning research for a drug on Alzheimer's disease, which could result into a prospective out-licensing deal. If this comes through, it would translate into a strong revenue stream, going forward. The stock trades at a discount to its peers, at about 9.5 times and 6.5 times its estimated FY07 and FY08 earnings. 
 

GAIN ABROAD
Export/Net sales in FY06	(%)
Bharat Forge	41.80
Amtek Auto	30.98
Amtek India	14.00
ANG Auto	54.40

Bharat Forge
According to a report by Edelweiss Securities, Bharat Forge, the forgings manufacturer, is poised to ride the current wave of auto component outsourcing due to its scale, efficiencies, and state-of-the-art facilities.

"Its current customer base includes virtually every global automotive OEM and Tier-I supplier," says the report.

In addition to organic and inorganic growth, the company's de-risking strategy of diversifying its user industries by manufacturing forgings and machined components for the aerospace, marine, rail and locomotive, mining and construction sectors appears sound.

Besides, its capex spree will help the company to rationalise costs and improve margins in the long run. The stock trades at about 26 times and 20 times its estimated earnings for FY07 and FY08 respectively. 
 

ZIPPING FAST
Financials (Rs crore)	Bharat Forge (Cons)			Amtek Auto (cons)			Amtek India (cons)			ANG Auto
	FY07E	FY08E	% chg	FY07E*	FY08E*	% chg	FY07E*	FY08E*	% chg	FY07	FY08E	% chg
Net sales	4150	4800	15.7	4254.2	5056.3	18.9	752.5	1121.6	49.1	114.5	300	162
Operating profit	670	860	28.4	840.4	1037	23.4	200	360	80	30.8	NA	-
OPM  (%)	16.1	17.9	177.2	19.8	20.5	75.5	26.6	32.1	551.7	26.9	-	-
Net Profit	300	400	33.3	406.8	521.2	28.1	110	166.7	51.5	22.7	35	54.2
NPM (%)	7.2	8.3	110.4	9.6	10.3	74.6	14.6	14.9	23.9	19.8	11.7	-815.9
EPS	13	16.5	26.9	24.9	31.8	28	9	13.6	52	20	30	50
P/E	25.6	20	-	15.6	12.2	-	18.4	12.1	-	14	8.7	-
* Year ended June, OPM, NPM % chg is in Basis Points Source: Analysts' estimates

Amtek Auto
Amtek Auto recently announced a 50:50 joint venture with £149 million Belgium-based VCST Industrial Product to set up a facility for powertrain components in India. VCST mainly caters to passenger cars and commercial vehicles.

According to Emkay Shares and Stock Brokers, the alliance between the company and VCST would bring integrated value chain and advanced machining technology necessary to compete in the world market.

Amtek Auto is a low cost producer and has an established base in domestic market and also enjoys strong relationships with both domestic and global OEMs.

The company has made series of acquisitions in the past in order to grow inorganically besides expansion of own units. The Emkay report also says that Amtek Auto's huge cash balance of Rs 1,490 crore (Rs 107 per share) will enable the company for further inorganic growth and expansion opportunities.

The company reported robust growth in March 2007 quarter. Net sales rose 36 per cent to Rs 315 crore. Though operating profit grew at lower 22 per cent, net profit jumped 48 per cent thanks to a four fold rise in other income. The stock trades at a reasonable valuation of 15.6 times and 12.2 times its estimated FY07 and FY08 earnings, respectively.

Amtek India
The other listed company from the Amtek group also reported robust growth in the March 2007 quarter. Both net sales and operating profit rose 71 per cent each at Rs 211 crore and Rs 55 crore respectively.

Moreover, net profit rose at an even higher rate of 97 per cent to Rs 34 crore as other income more than tripled. Interest and depreciation grew in the range of 35-40 per cent.

The company's capacity expansion programme for its foundry and components divisions is well on track. It has already increased the capacity of its machining components division by 67 per cent to 12.5 million pieces per annum and more than doubled its capacity of foundry division to 70,000 tonne per annum.

The management has expressed its intention of a merger of the two companies, Amtek Auto and Amtek India, sometime in the future, which would be a positive trigger for both the stocks. Amtek India trades at 18.5 times for FY07 (higher than Amtek Auto's valuation) and 12 times for FY08 (almost similar to Amtek Auto) estimated earnings.

ANG Auto
ANG Auto is a small-sized manufacturer and exporter of auto parts for the heavy commercial vehicle segment. It primarily makes trailer axles, air brake component and transmission components.

The company recently merged its 75 per cent subsidiary, ANG Auto Tech, which manufactures tractor trailers, with itself.

Analysts expect the merger to be earnings accretive for the company due to better synergies, resource mobilisation and lesser overheads. Besides, it will help the company in achieving scale, size, integration, and enhanced financial strength.

Its year ending results for FY07 has been better than expectations. While net sales doubled to Rs 114.5 crore, operating profit and net profit more than doubled to Rs 31 crore and Rs 23 crore respectively.

Though the stock trades at 14 times its estimated FY07 earnings, its estimated FY08 P/E multiple is lower at 8.7 times.