Outsize Performance from Outsourcers

The shares of companies that perform the vital behind-the-scenes tasks that keep Corporate America running have been gaining ground this year. After appreciation in the final few months of 2005, the S&P Data Processing & Outsourced Services sub-industry index has risen 6.9% year-to-date through Mar. 24, outpacing the 4.4% rise in the S&P 500 index.

Dylan Cathers, who follows some of the stocks in the group for Standard & Poor's Equity Research, says his two favorite names are Computer Sciences (CSC) and Automatic Data Processing (ADP).

Computer Sciences is attractively valued, trading at under 16 times projected earnings, vs. an average p-e in the mid-20s for its peers, Cathers says. The stock has been volatile. It shot up last October on rumors of a potential buyout and sold off a few weeks later when a deal wasn't reached.

This year the stock has rebounded, hovering a few points away from its 52-week high of $59.90. "It's well run, and we believe it is well positioned to win a large portion of government contracts that will be allocated over the next 6 to 18 months," Cathers says.

ADP offers a broad range of payroll services to companies of all sizes. Another plus for investors, says Cathers: The company pays a dividend, giving the shares a nice yield of 1.6%.

BusinessWeek Online's Karyn McCormack recently spoke with Cathers about these companies, and about the recent earnings reports from Paychex (PAYX) and Accenture (ACN) and industry trends. Edited excerpts of their conversation follow.

Note: Dylan Cathers is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

What's your outlook for data processor companies? What's driving the industry?

We have a positive outlook for these companies, which perform numerous noncore functions for their clients. The best example is payroll. When you receive a paycheck from your employer, there's a chance that it was not processed by your company but by one of these companies instead. ADP is the biggest processor, with roughly 30% of the market.

Driving the data processing industry and the IT outsourcing industry in general is the desire for companies to lower their costs and increase their focus on their core business.

Other reasons for outsourcing include gaining access to special expertise and new technologies, speeding up delivery, relieving resource constraints, and getting help maneuvering through increasingly complex legal regulations such as Sarbanes-Oxley. We believe this is a long-term trend and may continue regardless of the economic climate.

For the data processors in particular, their fortunes are closely tied to the level of unemployment. Unemployment was 6% in 2003, and it's been steadily falling since then. S&P is projecting an unemployment rate of 4.9% this year.

What are your favorite stocks in the group, and why?

We have a 5-STARS ranking on two stocks: Computer Sciences and Automatic Data Processing. We believe both companies have strong cash flows thanks to recurring revenue streams from long-term contracts. They also have in common high levels of cash on their balance sheets with modest debt-to-total-capital ratios.

We believe Computer Sciences stands to benefit from increased levels of outsourcing from the government. As federal, state, and local governments strive to balance budgets while improving services, they will need to use their tax receipts more efficiently, which often calls for outsourcing.

The government is loath to send citizens' tax receipts to overseas outsourcers, which decreases the pool of potential competitors. Computer Sciences and other domestic outsourcers should reap the rewards.

We like ADP as it offers a broad range of payroll outsourcing services to companies of all sizes. It also has different levels of outsourcing to accommodate a client's comfort level. Additionally, ADP is diversified, offering various other outsourcing services through its brokerage and dealer segments.

The brokerage segment handles transaction processing for the financial industry, while the dealer segment provides management systems to vehicle retailers and manufacturers. The company has also been aggressive in buying back stock, repurchasing more than 14 million shares in fiscal 2005 and more than 7 million in the first six months of fiscal 2006.

What do you think of Paychex? It reported quarterly results last week.

One of ADP's main competitors is Paychex. We like the company very much, as it has a strong, debt-free balance sheet, wide operating margins, and good revenue growth prospects.

Also, it tends to cater to smaller companies, which we believe is an area underserved by the market. Its earnings were in line with our expectations. It showed some seasonal weakness, but signs are positive, with retention rates rising and attrition levels declining.

We rank the stock 2 STARS (sell), however, as we believe that the current valuation, at a bit over 32 times our calendar 2006 estimate, is a bit lofty compared with the other companies in the sector.

Accenture also released earnings recently. What's your view of the company and stock?

Accenture is a consulting and outsourcing company with operations all over the world. The company's focus is on consulting, contributing roughly 60% of sales in 2005. Consulting tends to have higher margins than the company's outsourcing operation.

This week, Accenture reported that its contract with National Health Service in England is likely to see its cost outlays outstrip its future revenue stream. Accordingly, it recorded a $450 million provision for the expected future losses.

We believe this is an isolated, albeit quite expensive, incident. The remainder of the company's businesses have been growing at a brisk pace, and through the first six months of the fiscal year that ends in August, bookings were up 13% in local currencies.

We rank the company 4 STARS (buy) based on its strong balance sheet -- over $2 billion in cash and little debt -- diversified group of offerings, and good revenue growth prospects. We lowered our target price to $34 from $38 after the announcement, however, based on what we see as a slightly elevated level of risk due to the uncertainties surrounding the NHS contract.