By Richard Stice, CFA
Given the uncertainty surrounding the current market -- including questions regarding earnings quality, the validity of long-term growth rates, and questions about when corporate information-technology (IT) spending will improve -- we at S&P favor companies that have good visibility and a track record of consistent revenue and earnings growth. Given these criteria, we recently upgraded Affiliated Computer Services (ACS ) to 5 STARS (buy), S&P's highest investment ranking.
ACS provides a full range of IT services to clients with time-critical, transaction-intensive data processing needs. It has a diversified customer base (its top five represent only 12% of total revenues), a 98% client-retention rate, and over 90% of revenues are recurring. Services include business-process outsourcing, which provided 47% of fiscal 2001 (ended June) revenues, systems integration (32% of revenues), and technology outsourcing (21%).
ACS serves two primary markets: The commercial sector (64% of 2001 revenues) and the federal government (36%).
MOVING AND STORING DATA.
In the commercial segment, business-process outsourcing focuses on administration and customer care. Services include processing health-care claims for insurance companies, accounts-payable processing, document management, billing, and customer service. Using image transmission, storage, and retrieval technology, ACS digitizes, processes, and transmits millions of information records for its clients. In many instances, it performs quality-assurance functions and stores data for clients on a long-term basis.
Systems integration services include application development and implementation, applications outsourcing, technical support and training, as well as network design and installation services. Technology outsourcing involves designing, implementing, and operating information systems. This would apply to data-center services, applications outsourcing, desktop management services, and e-businesses services.
In the federal government sector, civilian-agency clients account for about half of revenues, while Defense Dept. agencies represent the remaining half. Within this market, business-process outsourcing services consist primarily of loan servicing for federal agencies. This includes billing, secure payment processing, related accounting and reconciliation, and client call-center and Web-site operations.
The largest contract is with the Education Dept.'s Direct Student Loan program. ACS provides loan servicing to over 5.2 million borrowers for loans valued at $79 billion. For systems integration services, the federal government contracts either directly with ACS, or it hires ACS through the General Services Administration, which performs procurement functions for many civilian and Defense agencies.
We believe ACS is well positioned to take advantage of the growing outsourcing trend. Many companies are attempting to offload noncritical business functions to streamline operations and compete more effectively. For example, Procter & Gamble (PG ) is considering an outsourcing deal that would be one of the largest-ever, amounting to an estimated $8 billion over 10 years. ACS is competing for this contract.
The quality of ACS's earnings has been admirable. In fiscal 2001, under SFAS 123 (a disclosure required in annual report footnotes), stock-based compensation (or options) expense would have had a minimal impact on results, with earnings per share decreasing only 4%. This impact is smaller than that of major competitors.
For fiscal 2003 (ending June), we expect revenues of $3.79 billion and EPS of $2.20 -- both increases of about 24% over our fiscal 2002 projections of $3.07 billion and $1.77, respectively.
ACS shares were recently trading at $37 -- about 17 times our 2003 earnings estimate -- and at a discount to their historical average. Moreover, its price-earnings-to-growth rate of 0.8 is well below that of the S&P 500.
We use three different measures to arrive at a 6- to 12-month target price. Over the last seven years, ACS's average monthly p-e has been 27. Applying this value to our 2003 estimate of $2.20 equates to a share price of $59.
To calculate an appropriate valuation using p-e-to-growth, we use the S&P 500's current rate of 1.4 as a target. With ACS's projected 5-year growth rate at 20%, this produces a stock price of approximately $62.
Finally, we've estimated ACS's intrinsic value via discounted cash-flow analysis of $55. Averaging the three results implies a price target of $59, or 59% above the recent price.
Given its steady revenue stream, potential new contracts, solid earnings quality, and favorable valuation, we expect the stock to outperform the broader market over the next 6 to 12 months.
Analyst Stice follows IT consulting and services stocks for Standard & Poor's