For Wage Inflation Press 1

I enrolled in graduate school during the tech bubble. With the Nasdaq up over 80% in 1999 and the portfolio I was managing down -8%, my career in investing appeared to be over. As such, I thought I might as well go back to school and try to figure out what I was going to do next. As luck would have it, shortly after I enrolled, the tech bubble popped and I kept my job! I wasn’t thrilled about going back to school while working, but in hindsight I’m thankful Greenspan’s “New Economy” forced me into getting my MBA.

While I had some very good classes, one of the things I remember most was all of the new terminology I acquired. Some examples include: mission critical, thought leader, paradigm shift, scalability, footprint, SWOT, and [insert anything] followed by solutions. It’s all about those solutions!

Although “sound smart” business terminology isn’t very useful in investing, it can be helpful when translating business lingo. For example, Sykes Enterprises (SYKE) is a market leading provider of comprehensive customer contract management solutions in the business process outsourcing industry. Sounds impressive, but what in the world do they do? MBA translation: operator of call centers.

Sykes is on my possible buy list, along with its competitor Convergys (CVG). The call center industry is a pretty boring business, but the market leaders can generate attractive free cash flow. Operating margins average around 8-10%. Margins fluctuate with capacity utilization and changes to client programs (new products, marketing, decision to take call centers in-house or outsource, etc). Industry growth is similar to nominal GDP (around 3%). The market leaders have benefited from their clients’ desire to consolidate service providers. Automation and technology present risks and opportunities. In my opinion, the call centers are not great, but good businesses (assuming you’re a market leader).

I’ve owned Sykes and Convergys in the past. With the stock of Convergys in decline and becoming more attractively priced, I’m currently getting up to speed on both companies. As I worked on their businesses this week, I bumped into something I’m noticing more frequently in recent earnings reports and conference calls – inflation. Specifically, Sykes and Convergys both mentioned growing wage pressures within their industry.

Sykes did a particularly good job of explaining rising labor costs on their conference call. Their CEO, Charles (Chuck) Sykes, has historically gone out of his way to help investors understand the industry and operating environment. His commentary is usually long, but often very worthwhile. I selected and highlighted several of his comments related to labor costs.

Sykes is noticing wage inflation in local markets and is having to spend more to engage employees.

“Given the headline improvement in employment trends in the US, where the unemployment rate has been hovering around 4.8%, there is some concern about limited slack in the labor market and wage pressures, although there have been pockets of labor tightness in some cities and states, the broader picture across the markets in which we operate remains manageable. Still with labor slack dictated more by local market conditions, we are having to employ monetary and non-monetary levers to optimize employee engagement. Specifically we are adjusting strategies and tactics around talent management with a focus on improving attrition and absenteeism.”

Wage inflation remains manageable, but if it tightens further, more will need to be done.

“All told, the supply of labor doesn’t appear to have reached that tipping point where it is impacting our long-term margin targets but if the economy picks up steam rapidly and as a broad spectrum of industries use wages to access labor markets, we will have to work with our clients to help them evaluate the best trade-offs between wage and price against our service strategies.

Discovering and monitoring wage inflation is a process – there’s not an immediate notification.

“To answer your question, you know, it took us a little bit to really start suspecting things around the wages. I mean normally, and I think this is probably true for most anyone in our industry, you know, the symptoms are looking at your application rates. You know, a number of people that are showing up at your door to want to get a job and you start looking at your recruiting or once you hire the folks, a number of people that show up or once they show up, the number of people that, you know, what the absenteeism rate is and then once times going on, you know what that attrition level is. These are normal drivers that have been around for many, many years but normally when you start suffering in one of those, candidly I would say most of the time it’s kind of operationally driven.”

Initially management thought labor pressures were a result of normal fluctuations in business activity, but eventually concluded it may be something more.

“But once we worked on this for a while during the ramps and we just weren’t moving the needles enough and then just all the commentary that we’re all reading in the papers about minimum wage pressures. Keep in mind now, you know, we’ve had 22 states in our country that have raised minimum wage. You know, as we look at those things, those are things that we’re starting to avalanche our head and say I think maybe we’ve got some challenges here on the wage side.

Sykes is early in the process of addressing labor challenges, but they plan to move ahead – other clients and industries have already announced wage increases.

“Again, what’s encouraging is I believe this is something that in the beginning it’s going to be a little tight because I don’t know if our competitors are all moving at the same time that we are. I would say probably not. That’s going to create a bit of unevenness, if you will, and maybe when you’re chatting with other colleagues of ours, our competitors, how they speak about it. But I do think we are starting to see, we’ve already seen some of our big clients, particularly in banking industries, they on their own have announced wage increases. I believe it’s real and I believe the industry will adjust.

How quickly the labor cost trend increases remains uncertain.

“The challenging news is I just don’t know how fast. And again for our group of customers and conversations we’re having, we’re anticipating more of the second half of the year to get some of those things resolved. It’s a long answer to your question but it’s a complicated thing in just trying to give total context to it.”

Thank you Sykes for the very informative and productive discussion on labor inflation. As the Federal Reserve debates whether to raise the fed funds rate 25 basis points to 0.75%, the real world isn’t waiting around to respond to the changing price and cost environment. For Fed members voicing their concerns about falling behind the inflation curve, it might be time to call their favorite customer service center and start measuring wait times! Your call is very important to us…

Have a great weekend!