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Home > Articles > Outsourcing > ArticleItem
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1/24/2006 7:28:32 AM
Pearl Wang, Insight From Standard & Poors
The Ongoing Allure of Outsourcing
 Amid a general upturn in M&A activity, companies in the data-processing & outsourced-services subindustry have recently been at the center of media speculation about potential buyouts by private equity firms or other potential acquirers. While acquisitions could be catalysts for stock price growth, Standard & Poor's favors the subindustry for fundamental reasons.
The speculation about "significant interest" from investment firms in companies in S&P's data-processing & outsourced-services subindustry "reflects, we believe, their significant recurring revenues and cash flows," says Scott Kessler, group head for technology sector equity analysis at S&P.
MORE UPSIDE, LESS RISK. In early January The Wall Street Journal reported that private equity firm Blackstone Group and Hewlett-Packard (HPQ ) could be exploring a buyout of Computer Sciences (CSC ). None of the parties have confirmed the report. According to another recent Journal report, three investment firms -- Texas Pacific Group, Bain Capital, and Blackstone -- are reportedly discussing an acquisition of Affiliated Computer Systems (ACS ) in a deal worth nearly $8 billion. None of the parties has confirmed the report.
The current interest in outsourcing outfits may have its roots in the March, 2005, acquisition of SunGard Data Systems, a provider of software and technology processing services, primarily for clients in financial services and higher education. A consortium of private equity investors acquired SunGard for $36 a share. Before the announcement, SunGard had traded for about $25 a share. The SunGard deal, which was valued at $11.4 billion, was the third-largest U.S. leveraged buyout ever, after Kohlberg Kravis Roberts' $31 billion RJR Nabisco deal and a $15 billion deal to buy Hertz by three private equity firms.
Computer outsourcers are appealing to investors because, according to Standard & Poor's data-processing & outsourced-services industry analyst Zaineb Bokhari, "We think these stocks provide an opportunity to participate in the potential upside of technology stocks without the higher levels of risk normally associated with unproven business models and...premium valuations."
GROWTH, VALUE, & QUALITY. Private equity investors have traditionally looked to invest in businesses that generate a lot of cash. Recently, S&P believes, private equity investors have been drawn to certain technology companies due to their recurring revenues; large, steady cash flows; and relatively low debt levels.
Private equity investors can acquire a company in the sector and then leverage it up with debt that can be paid off with the company's future earnings. Debt can also be appealing because it's tax-efficient.
S&P's fundamental outlook on the data-processing & outsourced-services subindustry is positive. S&P believes that many data processors garner notable recurring revenues, generate ample free cash flow, and have healthy balance sheets. S&P sees a number of data processors as offering an attractive combination of growth, value, and quality that comport with S&P's growth-at-a-reasonable-price investing discipline.
ADP'S BIG MO. S&P equity analyst Dylan Cathers has a 5 STARS (strong buy) recommendation on Automatic Data Processing (ADP ), based on valuation and improvement in the job market, which has aided payroll providers such as ADP. The company is the largest global provider of services extending from human-resources outsourcing, payroll, tax filing, and benefits administration, with a broad range of data-processing services in four business segments: employer, brokerage, dealer, and claims.
Cathers expects ADP's solid momentum to continue in 2006. Cathers also believes ADP's balance sheet is strong, with $1.5 billion in cash and securities and little debt. The company's free cash flow was $1.24 billion in fiscal 2005 (ended June), and S&P expects free cash flow growth over the coming five years will average 30% per year.
Because of ADP's strong balance sheet, recurring revenue stream, and strong cash flows, Cathers strongly recommends the stock.
FISERV GROWING. Meanwhile, S&P's Kessler has a 5 STARS recommendation on Fiserv (FISV ), which provides integrated data-processing and information-management systems to global financial services companies. S&P expects significant growth in coming years, driven by expansion of products and services and strategic acquisitions.
"The shares look attractive to us based on our discounted cash-flow analysis, relative p-e and p-e-to-growth parameters," says Kessler. "We estimate that more than three-quarters of the company's revenues are recurring. We project free cash flow to increase 13% annually from 2005 to 2009. Moreover, we expect that more than 75% of the company's net income is captured in free cash flow, meaning free cash flow divided by net income equals or will equal 75%."
Fiserv is a component of S&P's 2006 PowerPicks and 2006 Global Picks portfolios.
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Source: Business Week and Standard & Poors
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