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Outsourcing's Newest Niche

By Stephanie Crane Business-process outsourcing (BPO) has become a hot area for the leading players in information technology services and payroll processors, as they jockey for market share within the increasingly competitive outsourcing arena. Among the outsourcing and consulting service providers, we see Affiliated Computer Services (ACS); 5 STARS, or buy; recent price: $50), Computer Sciences Corporation (CSC

; 4 STARS, or accumulate; $43), Accenture (ACN); 3 STARS, or hold; $25), and Electronic Data Services (EDS

; 3 STARS; $17) staking their claims by leveraging expertise with network systems and software to manage data.

Among the payroll processors, we expect Automatic Data Processing (ADP

; 5 STARS; $45), Ceridian (CEN

; 4 STARS; $23), and Hewitt Associates (HEW

; 3 STARS; $30) to benefit from the growth in demand for BPO. We're also seeing Hewlett-Packard (HPQ

; 4 STARS; $22) and IBM (IBM

; 5 STARS; $90) flexing their influence to secure contracts.

PRODUCTIVITY GAINS. In addition, the leading outsourcing companies in India -- Infosys (INFY

; not ranked by S&P; $84), Wipro (WIT); not ranked; $44), and Satyam Computer Services (SAY

; not ranked; $18) -- have begun to focus attention on this area as they seek to climb the value chain. However, any competitive pressure from them in BPO is not likely to be a risk for some time to come, in our opinion.

Worldwide spending for IT services and outsourcing is expected to grow in the high single digits through 2008, as corporations and governments recognize the need to update their IT and communications networks, lower operating costs, and increase margins. Added to this is the push to squeeze greater productivity out of operations, forcing companies to seek technology that enables efficient and cost-conscious operating processes.

As a result, a growing and evolving niche market within outsourcing is BPO, which offers clients the opportunity to have all their business processes handled by a third party, leaving them to focus on their core operations. BPO includes a broad array of back-office functions, including human resources, supplies procurement, finance and accounting, customer care, supply-chain logistics, engineering and research and development, sales and marketing, facilities operations, and management and training. Growth in this area is estimated at around 11% over the next five years, with spending projected to reach $200 billion by 2008, a little over one-quarter of total estimated spending in the IT services market, according to researcher International Data Corporation.

In the human resources area, IDC figures that spending on BPO could grow as much as 20% over the next five years in the U.S. alone, as corporations focus on trimming costs and boosting efficiencies related to payroll processing, health and welfare benefits, and retirement benefits. Functions that were once paper-based, labor intensive, and subject to the complexities and changes in government legislation, are now being transferred to data banks and call centers, offering employees greater flexibility. Employees can access an Intranet site to select options, using interactive software to change tax information, 401(k) contribution levels, health-insurance options, and even COBRA elections, all of which reduces corporate expenses.

DAUNTING INVESTMENTS. In our view, BPO benefits both the customer and service provider. We think BPO offers greater savings -- ranging anywhere from 15% to 85% -- to end customers. Offshore labor offers an estimated 25% to 30% cost benefit. About 25% of the savings is due to efficiencies gleaned from proprietary products, and between 10% and 30% of the savings due to consolidated operations. By contrast, traditional IT service contracts likely offer a client cost savings ranging from 10% to 15%.

For the BPO service providers, BPO contracts typically carry higher profit margins than traditional IT services contracts. This is largely because, in any given BPO contract, 60% to 70% of the cost-cutting opportunity generally comes from labor (which is cheaper offshore), and the service provider also benefits from using externally situated proprietary systems and software. Traditional IT service providers tend to come onsite and generally must make a large upfront investment in IT infrastructure to be able to cut even 20% of a client's cost-reduction plan.

Among the companies we follow, Affiliated Computer Services (ACS) has made BPO its main strategy for growth, transitioning away from more traditional IT services in favor of offering BPO services to midmarket businesses and state and local governments. Currently, more than 75% of ACS's revenue ($4 billion expected in fiscal year 2004, ending June) comes from BPO contracts.

OFFSHORE ADVANTAGE. Furthermore, half of ACS's commercial revenue (not including those from government entities) comes from BPO contracts, enabling this segment to see internal growth estimated at 20% and offer what we view as solid gross margins. In comparison, the company's more traditional IT services business is faced with some pricing pressure due to greater competition.

We believe ACS can leverage its wide global reach to provide customers with BPO at lower costs, using operations in Mexico, India, and even the U.S. It also employs its own proprietary technology to bolster its presence in BPO and differentiate its offerings from those of competitors.

We expect revenue at ACS to grow 17%, to $4.9 billion, in fiscal year 2005, with earnings per share rising 19%, to $3.16. Our estimates include the company's recurring revenue stream, which contributes more than 90% of its revenue, offering visibility as well as a low risk of volatility.

We recommend buying shares of ACS, and we have a 12-month target price of $67, which is a significant premium to the current stock price. We used a discounted cash-flow model as well as a price/earnings-to-growth multiple to derive our target price. Risks to our opinion and target price include increased competition in BPO, which could affect pricing of contracts and hurt gross margins.

Note: Stephanie Crane has no stock ownership or financial interest in any of the companies in her coverage area. She's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received non-investment banking compensation from Affiliated Computer Services, Computer Sciences Corporation , Electronic Data Services, Automatic Data Processing, Ceridian, and Hewlett-Packard during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at Analyst Crane follows IT consulting and services companies for Standard & Poor's Equity Research

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