Keane: Connecting the dots

My friend asked me why am I still holding on to Keane (I use to work in Keane) stock. I was in New York and on cell phone, still I talked for about an hour (we also discussed google). I am personally excited about Keane. I don't believe that it will ever give 30% growth rates like Indian firms - WIPRO, Infosys (I use to work for infosys) or TCS. With 25% insider ownership, I am sure it is not an acquisition target. So, am I crazy? Well here is my theory on Keane

Let's go in history. Keane had a decentralized consulting model. In effect, it was a holding company with 50 small firms (offices) all over US. Each office took care of it's own hiring, training and local clients. They did have some national cost centers, but most of the business was at a local level. This worked very well during and before Y2K. Billing rates were high so the local office overhead as a percentage of total revenue was less. Clients liked personal attention during Y2K scare and employees didn't have to travel and still enjoy almost consulting lifestyle and pay.

After Y2K, Keane was not able to convert most of it's clients from Y2K projects to other high billing projects. This was due to two reasons. Due to depression, firms had liquidity crises and cut IT spending. On the other hand, Indian firms had shown the success of their model and were able to attract the clients by undercutting US firms like Keane. In this situation, accenture opened an Indian division, KPMG opened an office in China and years later India, while Keane stayed put with it's model. So, Accenture made most out of it and Keane fell back further.

They did acquire an Indian firm to start an indian operation, but it was never same. The indian operation became a cost center and they worked with US offices to get projects. US offices with revenue targets wanted to most of the work within their office. I still remember how in each quarterly meeting we should focus on our branch position based on revenue.

To be fair, inflexibility has also something to do with kind of people Keane hired, but that's another big discussion. So, with lowered revenue, these headoffices became a larger % of revenue resulting in Keane's profit margin falling to -3% to 3% range and revenue dropping from more than a billion to 6-700 million range.

Recently I read a news that Brian Keane mentioned during this trip to India that Keane plans to hire 5000 people in India. I also heard that in 2005, Keane hired WIPRO Senior executive Richard Garnick. Also, I saw some news about Keane merging their branches and cutting support staff. Also, there is indication that US and Indian staff are bidding on the project jointly, thus throwing the revenue based performance out of the window. Now when I connect these pieces of information, I think Keane is moving to the accenture model. Their operating margins will increase. It has been increasing recently. Please note any additional saving in cost is directly passed over to the net income after tax. When you compare with accenture Keane has higher revenue growth, slightly higher gross margin (2-3%) , but almost half operating margin (5% against 10%). This is the effect of all those local branch overheads and mostly US workforce. Now if the save any cost by using their India unit effectively and merging local branch offices, it will fall directly to bottomline.

As an example, if they improve their operating margins from 5 to 7.5. This 50% improvement will have a 50% improvement in net income so assuming same P/E(growth rate) 50% increase in revenue. If they cam come to 10% as accenture, their stock price should double.

So, why havn't analyst caught this. First, I am not sure how many analysts actively follow Keane. It's a boring firm. Also, Brian Keane's announcement was in India. Finally, after 5 years of bad management analyst don't believe that Brian gets up one day and decides that he will stop acting as a leech and work to improve performance. So, they are discounting this news. I believe otherwise. Next two quarter are expected to be key for Keane. I will closely monitor the performance and if there is no action, I will get out of the stock. sometime before June/July.

Recommendation: Buy under 12 for a pop to 18-20 in under a year.