Wednesday, September 12, 2007

Opportunities in Outsourcing

As Ben Franklin famously said, "In this world nothing is certain but death and taxes." We all have to buy the farm one day, but we don't all have to do our taxes -- many of us can and do pay others, like H&R Block, to do them for us. In that regard, companies are no different from individuals.

In addition to taxes, corporations often have regulatory hurdles to clear. These seemingly mundane tasks aren't exactly what top brass at a hot, cutting-edge tech upstart wants to focus on.

Thankfully, there are companies to handle these back- and front-office functions for them. These outsourcing (not to be confused with offshoring) providers serve thousands of companies, providing added expertise, shifting burdens away from key management, and helping firms manage their cost structures. While companies might pay a premium for such services, the firms providing them free their clients to concentrate on more vital matters. And for investors, these helpful companies can yield impressive returns.

Companies helping companies

If you work in a major metropolitan area, chances are you've seen an Iron Mountain (NYSE: IRM) truck. Iron Mountain, which plies its trade in document management and data protection services, has the lion's share of U.S. document compliance contracts, and a strong presence abroad. The company owes some of its success to Enron and its mass-shredding ways. Since Sarbanes-Oxley was signed into law in 2002, Iron Mountain's stock has more than doubled.

If you aren't sold yet, know that the company passes the "Oracle" test; it's one of Warren Buffett's top 30 holdings. While Iron Mountain is pricey at more than 40 times earnings, you can't help but like its growth prospects, given its greedy domestic market share and its proven ability to gain overseas footholds.

The business-services space offers a plethora of strong outsourcing companies. Names like Automatic Data Processing (NYSE: ADP), Paychex (Nasdaq: PAYX), and First Data (NYSE: FDC) have posted solid gains over the last few years. Typically, management service companies help businesses both small and large handle such exciting tasks as payroll, benefits administration, job applicant screening, and complying with local labor regulations. While this sector is a bit overcrowded, and mostly fully valued, its occupants have been proven winners.

Think outside the cube
Don't just think cubicles and mailrooms when looking for outsourcing names. Companies that service regulatory and back- and front-office tasks also come from several other areas including the medical arena.

Parexel (Nasdaq: PRXL) performs regulatory and medical consulting, health policy and reimbursement services, and clinical trial management, helping pharmaceutical companies can focus on their drug pipelines. In a little more than 10 years, the company has gone from $10 to north of $40, rewarding those wise enough to recognize its helpful ways. At more than 30 times earnings, much of its value is baked in; however, competitor Pharmaceutical Product Development (Nasdaq: PPDI) might have a little more room to run, at a more reasonable 25 times earnings.

Yet another name that helps companies in the medical field with compliance issues is Waste Management (NYSE: WMI). Like Iron Mountain, chances are you've seen the company's trucks bustling about town. Medical waste isn't the only segment from which the company stands to profit, especially if states and municipalities enact mandatory eWaste programs. Environmentally conscious places like California and Maine have already done so, and more are likely to follow suit. Along with Allied Waste (NYSE: AW) and Republic Services (NYSE: RSG) the company controls more than half of the U.S. waste disposal market.

The advantages of being helpful
Companies that provide outsourcing services often enjoy strong, defensible moats around their businesses. Many of these companies enjoy steady work, because larger corporations are less likely to tinker with contracts that aren't part of their core business, and small businesses often have nowhere else to turn. In addition, outsourcing outfits aren't likely to attract a great deal of competition, thanks to the sheer scale required to get such operations up and running profitably.

The downsides here are obvious and few, the biggest being that regulations can change. In the event of an economic downturn, outsourcing names that handle functions like HR could face cuts, or prompt smaller business to pare back their reliance on pricey external help. Still, these same companies are often best poised to handle changes in the regulatory environment, since they typically have more resources dedicated to tracking these changes, and more experience in understanding how to roll with them.