Does High Customer Retention Make This Company More Attractive?

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West Corporation (NASDAQ: WSTC) provides technology-driven communication services, such as conferencing, emergency communications and automated call processing, to its clients globally.

Strong customer retention is a plus

West Corporation has increased its revenue every single year since 1986, including the 2000 through 2001 dot-com bust and the 2008 and 2009 global financial crisis. Its ability to retain customers is a key contributor to this revenue stability and there are a few factors driving that.

Firstly, it is easier to sell new products to old customers than winning new customers. A product/service bundling strategy works well for West Corporation, with 44% of its fiscal 2013 revenue generated from its clients who purchased multiple services. There is also inertia at play here, cancelling a suite of services from West Corporation and engaging individual call center and conferencing companies for the various communication services needed for the company.

Secondly, customer relationships are akin to marriages. There is a seven-year itch effect too, with longer-tenure customers more likely to stay with the same communication services provider. West Corporation has the upper hand here, given that its 10 largest customers for fiscal 2012 all have relationships with West Corporation spanning more than a decade. These customers are less likely to jump ship to a competitor.

Last but not least, imagine the damage if your conference call on a billion-dollar deal is disconnected halfway through because you chose to switch to a cheaper service provider. The relative low cost and the mission-critical nature of West Corporation’s communication services suggest that its customers are less likely to terminate contracts over minor price differences. This is reflected in West Corporation’s margin stability; its gross margins stayed within a narrow range of between 53% and 56% for the past 10 years.

Debt-laden balance sheet represents an opportunity rather than a risk

Many investors I know use gearing as one of the key screening criteria for potential investments and will not touch highly geared companies even with a 10-foot barge. My view is slightly different, as I think that the investment merits of a stock should be viewed holistically.

In West Corporation’s case, although it is highly geared with a net leverage of 4.8 times, there are several mitigating factors to consider. One of them is that it has limited refinancing risks, with the bulk of its debt maturing in 2018. Also, it enjoys recurring monthly revenue from many of the multi-year support and maintenance agreements.

Moreover, West Corporation has generated positive free cash flow in every single year since fiscal 2003. In addition to reducing its debt balance with excess cash flow, both accretive acquisitions and increased dividends are potential catalysts for the re-rating of the stock.

Future outlook

For the first quarter of fiscal 2013, West Corporation grew its consolidated revenue and free cash flow by 3% and 13%, respectively, year-on-year to $660.2 million and $65.1 million, respectively. Based on the lower end of management's guidance, West Corporation is expected to increase its full-year fiscal 2013 revenue and net income by 3% and 8%, respectively.

Organic growth prospects are muted, with upside possibly coming from accretive acquisitions. West Corporation has a good track record, having completed 23 acquisitions since 2005, which are largely financed with internal funds. Its most recent acquisition was HyperCube, a domestic provider of local and national tandem services to carriers, which enabled West Corporation to link up its voice application and service platforms with the major carriers in the country.

Peer comparison

West Corporation’s call center peers include Convergys (NYSE: CVG) and TeleTech (NASDAQ: TTEC).

Convergys is the leader in the North American fragmented call-center services market. It had about 7% market share in 2011, with operations globally serving more than half of the Fortune 50 companies and more than 4 billion customer contracts annually. It plans to maintain and grow revenue through closer client engagement and selective acquisitions. Results of such client engagement initiatives have been encouraging, with its program churn levels at less than half of 2010 levels.

It also acquired Datacom's Asia contact center operations in April, further enhancing its language capabilities and its geographical coverage. It recently revised its 2013 adjusted EPS guidance upward from $1.00 previously to $1.05, on the back of a 22% rise in quarterly EPS for the first quarter of 2013. I am negative on Convergys, given its significant exposure to telecommunications and cable clients, which accounted for 60% of 2012 revenue.

TeleTech’s revenue for the first quarter of 2013 fell by 1.5% year-on-year due to the company’s decision to exit under-performing businesses. Despite this, management guided for full-year fiscal 2013 revenue growth and operating margin expansion to be between 4.5% and 6.0% and in the range of 0.25% to 0.50%, respectively. While quarterly revenue of $288.4 million made up 23.7% of the lower end of its revenue guidance, new client programs and M&As will be critical in determining if TeleTech hits its revenue targets.

It is worth noting that TeleTech has recently announced an additional authorization of $25 million for future share repurchases, in addition to the remaining authorization of $15.6 million under a previous program. However, TeleTech’s CEO Kenneth Tuchman has a 60% interest in the company and there could be potential concerns over corporate governance.

Conclusion

Despite average industry growth prospects, West Corporation managed to grow its revenue and adjusted operating income by a 10-year CAGR of 12% and 17%, respectively. This was achieved through its high customer retention rates and accretive acquisitions. It is attractively valued at 7.8 times forward P/E and 8.2 times trailing-12 months EV/EBITDA, making it a buy in my book.

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