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The U.S. economy may be slowing, but one sector is clearly revving up. American companies are outsourcing everything from accounting to human resources management and manufacturing -- some overseas and some to domestic companies focused on performing a task outside their customer's core competency. "The list of functions being outsourced is continuing to expand," said Robert S. Huntley, vice president and portfolio manager at North Star Asset Management in Menasha, Wis.

Outsourcing will generate about US$400 billion of revenue around the world in 2006, estimates Plunkett Research, based in Houston. The biggest chunk of that will be in the logistics, sourcing and distribution services area, followed by information technology services and business process outsourcing of things such as call centers and human resources management, according to Plunkett. The companies doing the outsourcing can avoid investing in things such as their physical plant or staff in non-core functions, and instead can put more resources into doing what they do best, Huntley said.

A Worldwide Trend
Outsourcing companies gain economies of scale from providing many customers with similar services, such as processing credit card payments, or payroll and benefits management. Globalization has added a whole new dimension to outsourcing. A host of companies are outsourcing to lower-cost countries -- from manufacturers moving production to financial companies relocating payment processing and customer service functions.

"There's no reason you can't do payment processing in India or some other lower-cost geography. The electronic connections we have now mean these things can happen all over the world," Huntley said. He and other North Star portfolio managers have bought for their clients shares in several companies they say should benefit from continued outsourcing:

First Data (NYSE: FDC) , Greenwood Village, Colo., processes electronic credit and debit payments for merchants and financial institutions. First Data has about a 50 percent share of the market, so "if you buy with your plastic, there's a one-in-two chance you'll be dealing with First Data in the background," Huntley said. First Data earlier this month completed a spinoff of its Western Union money transfer business to shareholders. That gives the company even greater concentration in payment processing, Huntley said. First Data's earnings will likely grow at rates in the low teens for the next three to five years, and the company's strong cash flow should produce a free cash flow yield after dividends of 6 percent or more, he said.

Affiliated Computer Services (NYSE: ACS), Dallas, provides business process and information technology services outsourcing. About 60 percent of the company's customer base is commercial, and 40 percent is government work, mostly from state governments, Huntley said. Affiliated has been moving out of federal government and some welfare work but continues to seek state governments who want to outsource everything from child support and employee benefits processing to management of electronic pass programs on tollways. "As state budgets become tighter and tighter, there's a big incentive to find lower-cost solutions," Huntley said. Affiliated's ability to win business has helped it increase earnings. Management is buying back stock, and its shares trade at a reasonable valuation, he said.

The company had pricing issues with several contracts that have held down profits, but will likely work through them by the end of fiscal 2007, Huntley said. Meanwhile, Affiliated is positioning itself by moving into doing more human resources functions for customers and shifting some operations to lower-cost locations, he said.

Plexus, based in Neenah, Wis., designs and makes electronic equipment such as routers and breast biopsy machines, and provides services to original equipment manufacturers in the high-end computer , medical, industrial, telecommunications , transportation electronics and defense industries. Plexus' stock soared in 2005 and early 2006 because Plexus had more revenue from defense contracts than anticipated. It fell from a high of $46.91 in May after the company warned that revenue would be lower than expected for the September quarter and into next year, and margins had likely peaked.

The company's tax rate also will rise next year. Huntley says the stock pullback got Plexus to a price that looks interesting. The company has about $3 a share of net cash on its balance sheet and is selling at 12 times 2007 earnings. Plexus has implemented some initiatives to improve manufacturing and is putting more accountability into its financial functions and operations, Huntley said. It is expanding production in Malaysia and intends to double its footprint in China. "Near-term, they'll have expenses associated with that, but longer-term, it will make them better positioned," Huntley said. Plexus has a low long-term debt to capital ratio of about 4 percent and a return on invested capital of 19 percent to 20 percent, he said.

Juniper Networks (Nasdaq: JNPR) , which represents 19 percent of Plexus' business, recently reduced earnings expectations and said it intended to consolidate its vendor list. But Plexus management is doing all the right things to retain Juniper's business, Huntley said. There's also a risk that Plexus' margins have peaked and may compress going forward if the company doesn't continue to do well at gaining defense contracts, he said. But those risks are reflected in Plexus' low price, and Huntley said he and his colleagues have been accumulating Plexus shares. These shares could go as high as $28 in the next 12 months, he said.

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Posted by hope on October 16, 2006 03:58 PM | Permalink