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Quarter-End Insights

Our Outlook for Business and Property Services Stocks

The stock market downturn has created potential buying opportunities.

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Our business and property services sector includes various industries that are affected by many different factors. Over the last quarter as the equity markets have taken a beating, most of the segments in the business and property services sector have had similar results.

Although no segment was completely safe from the market sell-off, potential buying opportunities have been created. On aggregate, all of the segments within the business and property services sector are trading below their fair value. That doesn't mean that every stock is cheap, but it does mean that as a whole we think the sector is on sale, although not necessarily a fire sale. Some segments are cheap because shares have been taken too far down with the rest of the market, while others have stayed stagnant while growth remains healthy.

Valuations by Industry

 Business and Property Services Valuations
Segment

 Price/Fair Value*

Three Months
Prior
Change
(%)
Business Applications 0.63 0.79 -20%
Business Support 0.61 0.76 -20%
Business/Online Services 0.58 0.72 -19%
Consultants 0.76 1.04 -27%
Education 0.81 0.93 -13%
Employment 0.70 0.97 -28%
Gambling/Hotel Casinos 0.86 0.72 19%
Hotels 0.73 0.97 -25%
Personal Services 0.75 0.88 -15%
Real Estate 0.56 0.70 -20%
Recreation 0.75 0.90 -17%
REITs 0.78 0.96 -19%
Waste Management 0.76 0.81 -6%
Data as of 12-15-08. *Market-Weighted Harmonic Mean

The education industry should benefit from the economic slowdown. As the economy slows and the job market deteriorates, out of work individuals turn toward education to better their employment marketability. While there currently aren't any 5-star stocks, this segment is still trading below its aggregate fair value with a price to fair value of 0.81. We think the market has yet to capture the upside potential of these firms during a downturn.

While REITs became cheaper on average over the last quarter, our coverage universe displays a wide range of valuations. Certain property types such as hotels appear substantially undervalued, in aggregate, while retail and apartment REITs are fairly or even slightly overvalued. Overall, we still have plenty of concerns about commercial real estate values and the cash flow declines REITs will experience over the next few years. In addition, persistent credit market turmoil is compounding the situation. However, after sorting through how the head winds will affect each of these firms, we've been able to find a select few REITs that are cheap, such as  Sunstone (SHO) discussed below.

Hotels are getting hit hard by the economic slowdown. Fewer people are traveling in the face of economic uncertainty and rising unemployment. This is sending occupancy rates downward and putting pressure on nightly rates. Timeshare sales, which have been a key earnings driver for hotel managers, fell sharply in the quarter as consumer financing for purchases disappeared. We believe that the next few years will be extremely challenging for the industry, but that much of this pain is already priced into the stocks. Our industry price/fair value ratio is 0.73.

Watching the employment market over the last few months has been like watching a Detroit Lions football game; ugly and cringe-worthy. Unemployment is at a 15-year high and the U.S. has lost 1.8 million jobs since the start of the year. The temporary employment market, a leading indicator of the overall employment market, has seen job losses accelerate. Thus, the stocks of employment-related firms have also experienced large moves downward, bringing some more in line and others slightly below our fair value estimates. Not all employment-related firms are as sensitive to the overall employment market, and we believe some, such as  Paychex (PAYX),  Automatic Data Processing (ADP), and  Cintas (CTAS), are attractively priced. These firms have a few things in common: high customer switching costs and the ability to leverage scale through superior infrastructures.

We expect the recreation industry to continue to suffer in the ongoing economic slowdown. Declining discretionary consumer spending and rising unemployment have weighed heavily on demand for recreation activities. However, not all recreation companies are alike and we believe  Ticketmaster (TKTM),  Regal Entertainment (RGC),  International Speedway (ISCA), and  Expedia (EXPE) are significantly undervalued given their potential to succeed once consumers again open their wallets, although that may still be more than just a couple of quarters from now.

Business and Property Services Stocks for Your Radar
Below are five stocks that are worth considering in today's market. Some of these stocks have been unjustly beaten down with the rest of the market, others will be positioned well once the economy starts to pick up, and others may see limited impact from a slowing economy or actually benefit from today's economic conditions.

 Stocks to Watch--Business and Property Services
Company Star Rating Fair Value Estimate Economic
Moat
Fair Value Uncertainty

Price/FV

Jackson Hewitt $30 Narrow Medium 0.53
Sunstone Hotel Inv $17 None Very High 0.37
Convergys $18 Narrow Medium 0.35
Expedia $26 Narrow High 0.33
Paychex $51 Wide Medium 0.53

Data as of 12-17-2008

 Jackson Hewitt (JTX)
Even in weak economic times, individuals must still pay taxes, making tax preparation firms a defensive investment. Jackson Hewitt is a tax return preparer that focuses on lower-income individuals. These customers typically make use of refund anticipation loans (RALs) in order to receive a faster tax refund. With a weakening economy, we expect the demand for RALs to increase as cash-strapped consumers look for ways to gain access to capital as soon as possible. Jackson Hewitt was hurt last year by a lack of a pre-season product. With a new pre-season product this year and increased demand for RALs, Jackson Hewitt should do well when the tax season kicks off in January.

 Sunstone Hotel Investors (SHO)
Sunstone Hotel Investors' upscale, West Coast-focused hotel portfolio is feeling the strain of the faltering economy, but the firm's financial strength should carry it through the downturn. Demand for hotel rooms is falling as both business and leisure travelers cut back in the face of lower corporate profits and an uncertain economy. At the same time new hotel supply is increasing at the fastest rate in years, putting further pressure on nightly rates and occupancy. In the short term, these trends will put tremendous pressure on the firm, but Sunstone has a strong enough balance sheet to ride out the storm and emerge on the other side ready to take advantage of the recovery.

 Convergys (CVG)
Convergys is one of the leading providers of third-party billing and customer care solutions to clients in the communications industry. The company benefits from economies of scale and high switching costs. Its business model is based on a fairly stable and recurring revenue base and most of its contracts are long-term in nature (three to seven years). These long-term contracts, combined with expensive service implementations, tend to keep Convergys' client turnover low. Though an unexpected non-cash write down in the third quarter has weighed heavily on the stock, we believe that Convergys' fundamentals remain intact, and we expect revenue growth and profitability to improve over time.

 Expedia (EXPE)
Expedia is the largest online travel agency. Of the approximately $250 billion of gross online worldwide travel bookings in 2007, Expedia booked the most, with $20 billion. The company's size fuels its competitive advantage via a network effect. Potential travelers visit Expedia's Web sites because they know they can find good, cheap travel options, including hotels, cruises, car rentals, and flights. In turn, travel suppliers continue to use Expedia as an outlet for their inventory because Expedia attracts the greatest number of visitors to its Web sites. While weak consumer spending and slowing travel volumes have weighed heavily on the stock and fundamental performance recently, we think the company will excel once economic conditions improve. In addition we believe Expedia will continue to capitalize on the significant growth opportunities in more profitable international markets.

 Paychex (PAYX)
High customer switching costs, inherent scalability, and a respected brand image are the main drivers for Paychex's wide economic moat. However, the firm has felt and will continue to feel some mild near-term pressure as the economy slows and small business closures pick up. Lower average employee headcount for its clients also adds to current near-term head winds as this translates into lower per-check processing fees. We strongly believe, however, that the extreme difficulty customers face with switching payroll processing servicers, the scale Paychex is able to leverage from its servicing infrastructure, and its strong cash position will continue to provide the firm with long-term profits that few companies can match.

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