TCS Daily


Think Tech Services

By James K. Glassman - June 12, 2003 12:00 AM

Our story thus far. . . .

After rising from 777 in the summer of 1982 to more than 11,000 in the spring of 2000, the Dow Jones industrial average declined for three years in a row, descending to 7524 on March 11, just before the start of the Iraq war. Then stocks rallied powerfully. Through last Thursday, the Dow was up 20 percent from its low, the Nasdaq composite index up 28 percent. Last Wednesday, 915 companies on the New York and American exchanges and the Nasdaq hit 52-week highs; just nine hit lows.

If you bailed out of stocks earlier, you missed the rally. But that's spilled milk. Instead of crying over it, consider what you should do next. What's the next twist in the plot?

No one knows for sure, of course. But much of the market appears exceptionally attractive, especially when you compare the likelihood of higher stock prices (not to mention those dividends, now taxed federally at just 15 percent) with the puny yields (taxed up to 35 percent) on bonds; the two-year Treasury is paying 2.2 percent.

Let's assume (and hope) you have a balanced stock portfolio. Which stocks should you add? I have been enthusiastic about solid technology companies this year - mainly because the entire sector was indiscriminately clobbered in the three years before.

Unfortunately for prospective buyers, many tech stocks have already risen powerfully. So far this year, iShares Dow Jones U.S. Technology (IYW), an exchange-traded fund that tracks a popular tech index, has risen 20 percent. More aggressive funds have done far better. Amerindo Technology fund (ATCHX) is up 64 percent; Jacob Internet (JAMFX), 49 percent. Since they reached their lows in mid-March, Amazon (AMZN), Yahoo (YHOO) and Sun Microsystems (SUNW), for example, are each up by more than half.

There is, however, a high-growth sub-sector of technology where stock prices, having fallen sharply since 2000, remain mired near their lows. It's composed of companies that provide technology services for other companies.

A good example is Paychex (PAYX), which provides computerized payroll-accounting services to 400,000 smaller companies (typically with 10 to 200 employees). From 1992 to 2000, the stock split eight times! An investment of $10,000 rose to $400,000. But Paychex peaked in November 2000 at about $61 a share, then collapsed. It's recovered only mildly. So far in 2003, shares have risen from $27.90 to $29.57.

No doubt Paychex is coping with what a Value Line analyst calls "a difficult environment." Overall U.S. employment is falling - not a happy circumstance for a company that makes its money processing payrolls. But, despite what's happening all around, Paychex continues to grow. Its earnings continue to rise in the Beautiful Line that began in 1991, increasing every year - though now at a slower pace. Revenue went from $728 million in 2000 to $870 million in 2001 to $955 million last year. Value Line expects $1.1 billion for fiscal 2003, which ended on May 31. Earnings per share for 2003 should be around 78 cents (up from 73 cents in 2002), and are estimated to reach 90 cents in a year. That's hardly torrid growth but, compared with the growth of most companies, it's admirable.

Paychex isn't cheap, but it trades at a valuation far below its average of the past five years. In 2001, for instance, Paychex had a price-to-earnings (P/E) ratio of 70. Today, the P/E is 39 and, based on expected 2004 earnings, it's 32.

Earnings aren't everything, either. This is a company with a spectacular cash flow and little need to burn up that money in capital expenditures. So, unlike most tech companies, it pays a nice dividend, which has risen from 6 cents a share to 80 cents in 10 years. The stock last week was yielding 1.5 percent.

At a time when companies are out-sourcing - that is, saving money by hiring other firms to perform services that used to be done in-house - Paychex appears to be a great business, with plenty of room to grow. And it has gone beyond payrolls, to tax-filing, payment services and human-resource products. Also, as Value Line's Adam Rosner writes, "There are barriers to entry that should stop new businesses from competing with Paychex, such as . . . the extensive software necessary for electronic bill management."

No, Paychex won't keep increasing its cash flow by 29 percent annually, the astounding rate of the past 10 years. But even at 15 percent, it doesn't deserve the shunning it's received this year from investors.

Automatic Data Processing (ADP), which is in the same business, targets larger companies and is more broadly diversified, with about 40 percent of its revenue coming from specialized services for brokerage firms, auto dealerships and auto insurers. ADP, which has a pristine balance sheet and tons of cash, has also tumbled by half, despite profits that continue to impress. But it is a more mature company than Paychex, growing at a slower rate. ADP trades at a P/E of 20 and yields 1.3 percent. It's hard to see why the company doesn't boost its dividend payout, especially with the recent tax cut. It certainly has the money, and its capital requirements are minuscule.

Paychex and ADP aren't alone. Look at SunGard Data Systems (SDS), another technology-services firm whose earnings have risen in a Beautiful Line, increasing each year, from 10 cents a share in 1987 to $1.15 in 2002.

SunGard has two lines of business. It provides trading, processing and record-keeping support systems for companies in the financial industry, and it helps companies stay up and running in times of disaster ("continuity services," as they're called). The declining stock market and the soft economy have hurt business, but SunGard's competitors have suffered even more, and the company has used the recession and its aftermath to grab market share through acquisitions - a strategy that should pay off.

While SunGard's operations haven't missed a beat, its stock has been curiously miserable, falling from $35 in March 2002 to $25.10 on Thursday. If you don't own SunGard, this is very good news. It's one of those stocks I have long lusted after but have found unapproachable - too beautiful (and expensive) for me. Now it's not. In 2001, shares traded at a P/E of 36. Today's P/E is 21, which is considerably below the average of 28 for the Dow and 35 for the benchmark Standard & Poor's 500-stock index. Using next year's estimated earnings ($1.45, up about 12 percent), I calculate a forward P/E of 17.

This is a company that is well managed, flush with cash and only lately starting to increase its foreign operations. Its valuation is lower than in any year since 1994, and the dispassionate analysts at Value Line estimate that cash flow will rise at an annual pace of 16.5 percent over the next five years, actually a bit faster than over the past decade.

Also strangely suffering is Fiserv (FISV), which specializes in services for banks and other financial institutions. If you own a bank, you can farm out practically all the operations to Fiserv, from processing checks to administering trusts. Fiserv has increased earnings from 8 cents a share in 1987 to $1.36 in 2002, without a single annual decline. Cash flow rose 13 percent in 2002 and is expected to increase 15 percent this year. But Fiserv's stock dropped by more than half between the spring and fall of 2002. So far this year, it's up less than one buck, or about 3 percent, trading at a P/E of 24 - which seems low for a company whose revenue and cash flow should easily grow at double-digit rates for the next five years.

A smaller company in the same business, Jack Henry & Associates (JKHY), offers a more speculative play. The stock is down from $33 in 2002 to slightly more than $15 Thursday. But the company's revenue has been hurt by slowing hardware sales, and it's expected to endure its first drop in earnings since 1989.

One of the largest of the tech-services firms, First Data (FDC), processes credit- and debit-card transactions and, through its Western Union division, performs highly lucrative money transfers. First Data announced plans last month to acquire Concord EFS (CE), which provides automated-teller-machine and debit-card processing. Between the two of them, First Data and Concord process about three-quarters of all transactions that involve customers using debit cards and punching in an identification number, an increasingly popular way to buy things.

Unlike Jack Henry and Fiserv, First Data is no laggard. Its stock has more than doubled in the past five years, and it's up by about 20 percent in 2003, but it still trails the recent growth of pure tech plays. Keep an eye on the company -- especially if the Concord deal gets past regulatory scrutiny.

Is there a way to buy tech-services stocks through a mutual fund? Not as a pure play. Fidelity Select Technology (FSPTX), a good general sector fund, owns only two tech-services stocks - First Data and Paychex - among its top 25 holdings.

The flashy Amerindo fund, the one that's up by nearly two-thirds this year, owns no tech-services stocks at all. Its last report showed that 48 percent of assets were in just three stocks - eBay (EBAY), Expedia (EXPE) and Yahoo, each with a P/E or more than 100.

As much as I like each of those three companies (and, hey, at least they're profitable!), it's important to remember that fairly recently millions of investors got into deep trouble buying companies with triple-digit (or infinite) price-to-earnings ratios. It's fine to own highflying technology, but keep some perspective - and some balance to your portfolio. One way to do that is to own shares in businesses that use technology to make other businesses more efficient. Now there's a growth industry.
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