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Our Outlook for the Business-Services Sector

This sector is home to several undervalued gems.

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Morningstar's coverage of business-services firms runs the gamut of industries from waste collection to transportation, but a few key themes are important for investors to keep their eye on. As the sector name implies, these companies provide services to other businesses and are therefore tied to the economic cycle, though the exposure differs significantly across the business-services universe. We think the cash-rich and steady-eddy business models of many waste haulers are relatively recession-resistant, while engineering and construction (E&C) firms and airlines rank at the top of our list of companies levered to changes in the global economy.

Recent reports suggest that the domestic economy has continued its expansion through May, though most indicators point to slower growth compared with previous years. Nonresidential construction and energy infrastructure spending remain strong, as construction contractors such as  Emcor (EME),  Fluor (FLR),  Chicago Bridge & Iron (CBI), and  Jacobs Engineering (JEC) continue to rack up solid gains in backlog. The American Institute of Architects' Architectural Billings Index (ABI), a leading indicator for nonresidential construction spending, as well as global orders for refinery work and liquefied natural-gas terminals suggest that infrastructure construction demand should remain healthy through 2007.

That said, we note that recent ABI readings--though still indicating an increase in billings--have fallen from the higher measures posted in January and late last year. Inquiries for new nonresidential construction projects have improved recently, but given the prospects of slower economic growth, we remain cautious in extrapolating the current strength beyond next year, which some stock prices for construction contractors seemingly imply. And while the energy construction cycle may have comparatively longer legs, we think some of the names tied to that trend are also reaching rather rich price levels (see the table below).

Residential construction spending and the housing market in general continue to languish, which could be contributing to the weakness we're seeing in the domestic airline market, as consumers are becoming increasingly resistant to fare increases (perhaps most have already tapped their housing ATM). Pricing conditions in the domestic market could even deteriorate further, as upstarts such as Skybus and Virgin America add seats to the system and as carriers such as  Continental (CAL) and  Alaska (ALK) engage in aggressive pricing to defend their turf. Ultimately, we think these capacity additions will pressure domestic yields and load factors, thereby damping the industry's fledgling recovery.

Pricing in the waste industry, however, continues to strengthen, providing support for future profit-margin and return-on-invested-capital gains for haulers such as  Waste Management (WMI),  Allied Waste (AW),  Republic Services (RSG), and  Waste Connections (WCN). Public trash collectors continue to achieve real pricing growth, while independent collection firms follow suit, as they strive to counter increased operating and capital costs. Though there is a limit as to how much prices can increase, we think the waste industry is still in the early innings, since garbage collection remains a small and nondiscretionary portion of corporate budgets.

Valuations by Industry
The median price/fair-value ratio equals about 1.04 across the business-services sector, suggesting the sector as a whole is modestly overvalued, in Morningstar's opinion. Based on the ideas discussed above and other trends, however, we have identified pockets of undervalued stocks, as the table below reveals.

 Business Services Industry Valuations
Segment

Average
Star Rating

Average
Price/Fair Value
Stocks Covered
Security Services 4.00 0.75 1
Transportation--Misc.  3.50 0.98 13
Waste Management  3.00 1.00 12
Environmental Control  3.00 1.01 5
Distributors 2.88 1.03 8
Data Processing 2.80 1.02 21
Business Support 2.75 1.11 17
Business/Online Services 2.60 1.09 20
Employment 2.56 1.12 16
Advertising  2.50 1.10 10
Land Transport  2.42 1.09 12
Water Transport  2.36 1.18 11
Air Transport 2.36 1.26 25
Printing 2.25 1.22 4
Consultants 2.14 1.19 7
Engineering & Construction  1.77 1.22 13
Data as of 06-15-07.

Several of our highest-rated business-services industries are benefiting tremendously from globalization, outsourcing, and global economic expansion. Transportation and logistics companies such as  United Parcel Service (UPS),  UTi Worldwide (UTIW), and  Expeditors (EXPD) continue to meet the growing demand for the shipment of goods to and from every corner of the globe.

Industry consolidation and natural selection are behind several of the opportunities we see in MRO (maintenance, repair, and operation) distribution. Small independent players have been almost helplessly watching their larger competitors gain insurmountable cost advantages through unmatched distribution networks. We also continue to find investment opportunities in the waste business as investors remain concerned over the sustainability of the industry's newfound pricing strength.

Business-Services Stocks for Your Radar
We've picked five stocks from our 5-star list that we recommend keeping on your radar. Four of the names are new, with cash-cow Republic Services the only repeat from our previous business-sector outlook. One of the new names is a records-management company, which employs a solid recurring revenue model, while another is a well-run MRO distributor, which we continue to think is attractive. Uniform-maker  Cintas (CTAS) and human-resource outsourcer  Administaff (ASF) round out our remaining picks.

 Stocks to Watch--Business Services
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Fastenal $63 Wide Below Avg 0.66
Administaff $46 Narrow Average 0.75
Republic Services $36 Narrow Below Avg 0.84
Cintas $47 Wide Below Avg 0.84
Iron Mountain $31 Wide Below Avg 0.83
Data as of 06-22-07.

 Fastenal (FAST)
Fastenal has leveraged its vast product selection and efficient distribution network into decades of profitable growth. The firm continues to dominate the fastener niche and take market share in a highly fragmented market, and we think a recent strategy tweak bodes well for shareholders. As the name suggests, this company focuses on fasteners--everything from nuts and bolts to screws and anchors. By offering more than a quarter million types of fasteners (and a similar variety of maintenance, repair, and operations--or MRO--products) through its 2,000-plus stores, Fastenal provides far more selection and convenience than broad-line or regional distributors.

 Administaff (ASF)
Administaff is the dominant player among professional employer organizations (PEOs) that focus on human resource outsourcing for small businesses. By aggregating workforces of multiple clients into a single bargaining entity, Administaff keeps benefit and insurance costs below what individual clients could obtain on their own. And by billing clients as a percentage of employee wages instead of a fixed fee, Administaff is rewarded as payrolls increase (which they tend to do annually). Such a combination has led to high switching costs and solid operating performance.

 Republic Services (RSG)
Republic boasts an attractive business model that throws off strong and predictable cash flow, even during tough economic times. The waste hauler's landfill network and exclusive, long-term monopolistic contracts (about 40% of revenue) offer key competitive advantages. Further separating the trash taker from the pack is its geographic exposure to the faster-growing Sunbelt states (67% of revenue), which, due to their higher-than-average population growth, help Republic outpace competitors in terms of waste volume expansion. The hauler should also be a key beneficiary of the industry's fresh focus on return on invested capital, which is driving real pricing growth.

 Cintas (CTAS)
Cintas generates about two thirds of revenue from designing, manufacturing, and laundering employee uniforms, a largely recurring rental business where it visits clients on a weekly basis to pick up dirty uniforms and drop off clean ones. Cintas is twice as large as its closest competitor, and with no customer contributing more than 1% of sales, Cintas is generally the most powerful player in the value chain. The result is an operating margin nearly double that of the closest competitor. We think it would take enormous missteps by management, exceptional performance by competitors, and probably a decade to unseat Cintas as the dominant force in the industry.  

 Iron Mountain (IRM)
Iron Mountain has the largest global reach of any records-management company and serves big, stable customers including more than 90% of the Fortune 1000 and more than 75% of the FTSE 100. The company's recurring revenue stream, which makes up over half of total revenue, derives from the fees it charges customers to store records. Since customers are "sticky," Iron Mountain doesn't have to compete for incremental business, leading to high-single-digit internal revenue growth. The firm has also expanded to digital record management and is building infrastructure to handle digital e-mail archiving, a business that provides a wellspring of recurring revenue and one in which the firm has started to gain traction. Whether through acquisitions or internal expansion, Iron Mountain is well-positioned to continue gaining scale while expanding across the globe.

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Brian Nelson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.