Data Processors: It All Computes


By Sam Stovall July's employment report, released Aug. 5, surprised many investors with stronger-than-expected growth in nonfarm payrolls, particularly since the prior month's total was revised upward (see BW Online, 8/5/05, "The Jobs Explosion"). Now investors are wondering if too many new jobs are being created, which may pressure the Federal Reserve to continue raising short-term interest rates throughout the year.

Indeed, S&P Economics forecasts a Fed funds rate of 4.25% by year end, indicating that the central bank will tighten at each of its remaining policy meetings this year.

Instead of worrying about which industries will suffer in a strengthening job market, maybe investors should think about a segment that likely would be buoyed by increasing payrolls: Data/payroll processors.

ATTRACTIVE COMBO. With that idea in mind, I set out to check the fundamental outlook for the S&P Data Processing & Outsourced Services subindustry.

Zaineb Bokhari, S&P's application software and data processing analyst, has a positive fundamental outlook on the group. S&P believes many data processors garner notable recurring revenues, generate ample free cash flow, and have healthy balance sheets.

These stocks also often have price/earnings-to-growth-rate ratios below that of the S&P 1500. Several of them pay dividends and have favorable

S&P earnings/dividend rankings. Bokhari sees a number of data processors offering an attractive combination of growth, value, and quality consistent with S&P's growth-at-a-reasonable-price investing discipline.

EXPLOITING TRENDS. In Bokhari's view, these stocks also provide an opportunity to participate in the potential upside of the technology revolution without the higher levels of risk normally associated with unproven business models or premium valuations.

This view is supported, in her opinion, by the modest but positive 1.6% five-year compounded annual growth rate (CAGR) for the S&P Data Processing and Outsourced Services index, compared to a negative 15.4% five-year CAGR for the S&P Information Technology index.

Bokhari believes data processors will post revenue and earnings growth above that of the S&P 1500 over the next three to five years, largely due to two significant trends S&P sees: The growth of outsourcing and the continuing prevalence of electronic (nonpaper) transactions. Shares of data processors should continue to attract attention, as they position themselves to exploit these trends, in her view.

GLOBAL TREND. In Bokhari's opinion, companies are increasingly outsourcing technology-oriented tasks to third parties in an effort to achieve greater efficiencies and profitability and focus on core competencies.

Globally, companies spent some $77 billion on technology outsourcing in 2003. Industry-research outfit IDC forecasts this amount will rise to $112.5 billion by 2009.

Moreover, the number of U.S.-based electronic transactions is expected to grow to 47% of all payments in 2010, from 33% in 2002 and 23% in 1997, according to the Nilson Report a newsletter on consumer payment systems. Bokhari believes growth in technology outsourcing and electronic transactions bodes well for data processors.

So there you have it. This jobs-driven subindustry has a positive fundamental outlook and improving momentum, which we think may translate into future advances in share prices. S&P's top stock selections in the group are Automatic Data Processing (ADP) and Fiserv (FISV), each of which is ranked 5 STARS (strong buy).

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with relative strength rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Aug. 5, 2005.

Industry

Computer & Electronics Retail

Construction Materials

Diversified Metals & Mining

Fertilizers & Agricultural Chemicals

Homebuilding

Managed Health Care

Marine

Oil & Gas Drilling

Oil & Gas Equipment & Services

Oil & Gas Exploration & Production

Oil & Gas Refining & Marketing

Water Utilities

Glossary

S&P STARS: Since Jan. 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.

S&P Earnings and Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:

A+

Highest

B

Lower

A

High

C

Lowest

A-

Above Average

D

In Reorganization

B+

Average

NR

Not Ranked

B-

Below Average

S&P Issuer Credit Rating: A Standard & Poor's Issuer Credit Rating is a current opinion of an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor. Issuer Credit Ratings are based on current information furnished by obligors or obtained by Standard & Poor's from other sources it considers reliable. Standard & Poor's does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances.

S&P Core Earnings: Standard & Poor's Core Earnings is a uniform methodology for calculating operating earnings, and focuses on a company's after-tax earnings generated from its principal businesses. Included in the Standard & Poor's definition are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities. Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.

S&P 12 Month Target Price: The S&P equity analyst's projection of the market price a given security will command 12 months hence, based on a combination of intrinsic, relative, and private market valuation metrics.

Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, NY, NY.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB").

The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute Standard & Poor's judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fall against the interests of the investor and the investor may get back less than the amount invested. Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate. Where an investment or security is denominated in a different currency to the investor's currency of reference, changes in rates of exchange may have an adverse effect on the value, price or income of or from that investment to the investor. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

For residents of the U.K.: This report is only directed at and should only be relied on by persons outside of the United Kingdom or persons who are inside the United Kingdom and who have professional experience in matters relating to investments or who are high net worth persons, as defined in Article 19(5) or Article 49(2) (a) to (d) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001, respectively.

Readers should note that opinions derived from technical analysis might differ from those of Standard & Poor's fundamental recommendations. Stovall is chief investment strategist for Standard & Poor's


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