Industry Snapshot
Monday, September 10, 2001
Outsourcing Firms:
More companies are rethinking what support functions need to be in-house
By J. Bonasia
Investor's Business Daily
They say a business is only as good as its people. In the services field, where the assets are the employees, that claim is literally true. Companies hire service firms to tackle complex tasks so they can focus on their core work.
Outsourcers take over tasks, such as payroll or tax preparation. Other firms offer consulting or data to help clients get ahead.
IBD’s Commercial Services — Miscellaneous group embraces a wide range of firms, including specialists in human resources, engineering and finance. These firms belong to a market that’s poised for long-term growth.
1. BUSINESS
The U.S. economy has shifted from manufacturing to services over the long term. More companies find they can cut costs and risks by outsourcing jobs to such firms.
Analyst Matthew Litfin of William Blair & Co. says manufacturing accounted for 24% of gross domestic product in 1970. Now it has slipped to 17%.
“There has been a phenomenal shift during that time,” Litfin said. “As the outsourcing trend grows, specializing or being very good in one area has become the rule of the day.”
Litfin says the sector has good potential because service firms can generate a lot of cash without having large capital assets.
The Internet boom spawned many new e-service firms to help clients develop online strategies. But the dot-com crash burned a lot of those start-ups, swinging the pendulum back toward big firms such as Accenture and KPMG Consulting. (KCIN)
“Clients are coming back to basics to look for large, established players with broad service offerings,” said George Price, an analyst with Legg Mason Wood Walker.
Name of the game: Mastering the details of a particular service and then executing flawlessly. Just as consumers shun shoddy products, corporate customers are demanding, too.
2. MARKET
The domestic outsourcing market topped $342 billion last year, says Frank Casale of The Outsourcing Institute in Jericho, N.Y. He says the industry averages 15% growth a year.
Casale says 29% of all firms with sales over $10 million rely on outsourcing. And more than 30% of companies that use outsourcing seek other ways to do so. He adds many users have chief resource officers to manage their providers.
Maximus Inc. (MMS) of Reston, Va., provides health and human services work to state and local governments. Projects include running welfare-to-work programs and enforcing child-support measures.
Russell Beliveau, Maximus’ head of investor relations, says the market for government health and human services administration is $23 billion a year. Yet just $1 billion is now outsourced. Beliveau attributes the low penetration to government unions.
“The issue for us isn’t the competitive landscape,” he said. “The big issue is wrestling away some of that work from the government.”
Regulatory and policy changes have a big impact on the service industry. For instance, the federal tax cut will be a bonanza for H&R Block (HRB) as people work to deal with the law.
CEO Mark Ernst says parts of the new law will take effect and expire over time, creating demand for his firm’s expertise.
“All change is good change,” Ernst said. “It’s great for business.”
Merrill Lynch analyst Fritz von Carp says a clean fuels mandate of the federal Clean Air Act will benefit engineering firms such as URS of San Francisco. URS designs plants and consults on compliance.
Von Carp says the lack of investment in heavy infrastructure for highways and bridges in recent decades has created pent-up demand for engineering services.
“We’re at the front end of an up-cycle,” he said.
3. CLIMATE
Many service firms are expanding their offerings or chasing new markets, says Gary Holdsworth of Wedbush Morgan Securities. Holdsworth says this approach boosts cross-selling of related services.
“The goal is to get a toehold with a client and then increase the portfolio of services offered to that client,” he said. “Also, you take that skill set and broaden it to other vertical industries.”
Holdsworth points to Keith Cos. (TKCI) of Costa Mesa, Calif., a civil engineering firm. Keith grew its design and engineering business by offering surveying, permitting and mapping services. The firm expanded beyond real estate into energy, telecom and public works.
Payroll giant Automatic Data Processing (ADP) has taken an acquisition approach. ADP announced a plan in June to buy Avert, which screens job applicants for criminal and credit histories. Avert should help lure customers to ADP’s payroll services.
Michael Shonstrom of Shonstrom Research Associates says such consolidation is an industry trend.
“What you get in terms of services from providers is becoming increasingly encompassing,” Shonstrom said.
Tom Golisano is the founder and CEO of Paychex Inc. (PAYX), an ADP rival that caters to companies with one to 200 employees. Golisano says Paychex buys regional payroll firms each year and looks to add more services.
“You can’t only do payroll processing today,” he said. “You need more.”
4. TECHNOLOGY
Internet and wireless technologies let service firms increase productivity and improve customer support. Companies such as Moody’s Corp. (MCO), which has 37% of the global credit rating market, have been forced to deploy electronic data delivery.
“Professionals don’t want print anymore. They want it all online,” said Joanne Park, an analyst with Merrill Lynch. “So these firms are adapting to what clients are demanding.”
Advances in computer-aided design and modeling have been a huge breakthrough for engineering services.
“In the old days, you had to make painstaking blueprint drawings by hand. It took weeks, and every change had to be redrawn,” said von Carp of Merrill Lynch.
The tech revolution also has created markets that didn’t exist before. Ernst of H&R Block says his company developed tax preparation software to compete with Intuit (INTU). Ernst says this hasn’t displaced Block’s regular business, because people who formerly did their own taxes are the ones buying the software.
“Software creates a whole new category for us,” he said.
5. OUTLOOK
The services industry has high recurring revenue and good growth potential. Analysts think demand will grow only as more companies see the benefits of outsourcing.
Upside: Granted, the services market won’t enjoy the triple-digit profits earned by the tech sector in recent years. But it won’t be hurt by the massive losses and layoffs that have plagued high-tech firms over the past year, either. In short, services offer more predictable earnings, and the market remains largely untapped.
“There are potential customers of these companies that have no idea this is available,” said Holdsworth of Wedbush Morgan.
Golisano of Paychex agrees, saying just 15% of small businesses outsource their payrolls. “We’ve got a long way to go,” he said.
Risks: An economic rebound could thwart growth for the outsourcing industry. In good times, target companies are less inclined to offload their noncore functions, like payroll.
“When things go well, the impetus to outsource is not as strong,” said Greg Gieber of A.G. Edwards. “When times get dicey, that’s when you start to get more focus on outsourcing.”
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