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4/4/2002
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Taking Stock: Boring Isn't Bad When It Comes To The Tech Stock Market--Ask ACS

Firm's government expertise gives it a leg up in contracts

In this tech market, it helps to be really boring, and that word is usually synonymous with services. Fortunately, there's one service area, business-process outsourcing, that's growing by leaps and bounds. Accenture, Computer Sciences, and EDS are well-known entities that have seen strong demand for business-process outsourcing services and tend to get most of the attention.

A name that's less-known is Affiliated Computer Services (ACS -- NYSE). ACS focuses on business-process and technology outsourcing as well as systems integration. The company has been winning more than its fair share of business, not only from corporate clients but also, more significantly, from the government.

More than three-fourths of ACS's revenue is tied to government agencies, including state and local government (45%) and federal government (22%). The rest of its business crosses most industry groups, including health care, finance, insurance, transportation, and retail.

About 77% of ACS's current revenue stream comes from the business-process outsourcing market. This is the major reason that, despite the downturn in technology stock prices over the last couple of years, in 2001 ACS' share price was up almost 75%, and in the first quarter of 2002, it rose another 6%. Not too shabby for a service company.

Why did ACS hold up so well during the technology meltdown? First, with more than 50% of its revenue coming directly from some sort of government agency, ACS's revenue stream was less susceptible to the decline in business IT spending. Its business last year was more dependent on local and state budget spending and politics, which may or may not correlate with the national economic cycle.

ACS offers some compelling arguments for its services by offering performance-based structured engagements. As a third-party vendor, it will commit the up-front capital for building and developing the outsourced platform in exchange for a share of cost savings or additional revenue. It doesn't hurt that the company reported its 29th straight quarter of double-digit earnings growth without an earnings-per-share miss or downward guidance revision.

One major operational difference in ACS's business-process outsourcing program is its use of offshore talent in Latin America and Africa instead of Asia and India. Expertise in government processes also gives ACS a leg up when dealing with government agencies.

What's not to like? At some point, national economics will play a role and affect local and state spending. ACS already is seeing a slowdown this year due to lower tax revenue collections at the state and local levels. It's also seeing significant slowdowns in electronic benefit transfer and child welfare support services, and is suffering the same drought in corporate IT spending as everyone else. Projects are slipping or being deferred due to tight budgets. This has resulted in top-line growth slipping from about 15% into the low teens.

ACS's fiscal year ends in June, and the consensus estimate among Wall Street analysts for earnings per share in 2002 is $1.75, rising to $2.10 in 2003. Its stock traded recently at $55.84.

In the most recent quarter, ACS generated revenue of $750.4 million and a cash earnings per share, adjusted for a recent 2-for-1 split, of 42 cents (reported at 84 cents), up 42% year over year. Gross margin was at 43.6%, up from 42.4% last year. Operating margins came in at 13%, up from 11.3% last year. Debt-to-total-capital ratio was down to a very reasonable 25%.

I wish I were writing this early enough for my readers to make some money but, alas, it's a little too late. The stock is trading at a very reasonable 26 times fiscal 2003 earnings estimates. However, buyers should be aware that the day the company either misses an earnings-per-share consensus number or guides those numbers down, even a bit, the stock is likely to get overly punished. Most times, it pays to be patient.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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