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Our Picks Among U.S. IT Service Providers

The good, the bad, and the hairy among U.S. IT services firms.

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Over the past several months, we have revisited our outlooks for all of the U.S.-based information technology services firms in our coverage universe. Investors wading into this group must sort through a bevy of issues, so we thought we would lend a hand to those so interested. We will survey the competitive landscape and then sort the list into the good, the bad, and the hairy. Next month, we will devote a column to the non-U.S. IT services firms that we cover.

The problems confronting the U.S. firms are wide-ranging. First, Indian firms have been disruptive to the entire industry, exerting pricing pressure through lower-priced contracts (leveraging their lower labor costs) and more-transparent contract language. Second, whereas commercial clients used to contract a single vendor for long-term projects, they are starting to use multiple vendors for shorter-term projects; by slicing up the contracts, they can send appropriate work to Indian firms. Both of these phenomena have likely lowered the overall profitability of commercial contracts for IT firms. Third, to deal with these problems, most U.S. firms have set about restructuring their commercial operations, which primarily involves developing offshore operations to create a global delivery network. Lastly, the companies are not immune to more typical problems such as management turnover and regulatory filing delays.

The process of analyzing and valuing the entire group of U.S. IT services firms led to some broad characterizations. 

  • On the IT services pyramid (a tool we use to differentiate the value of services offered), firms that provide high-value-added knowledge (such as consulting, transformative IT projects, and application management) can avoid direct competition with Indian firms, which typically compete for business process outsourcing, software application maintenance, and software application enhancement projects.
  • Firms that can lean on a large government business while riding out commercial challenges, are more stable. For reasons of national security, government contracts are typically not awarded to non-U.S. firms.
  • A history of overseas operations makes a build-out in low-cost countries more likely to succeed, in our opinion.
  • If a company is undergoing a massive restructuring and concurrently has a newfound love for India, that should lead one to ask if management actually has a strategy or if they are grasping at straws.

The Good
We would willingly invest in these companies' shares if they traded at the proper discount to our fair value estimate. (Star ratings as of Nov. 17, 2006.)

 Accenture (ACN)
Rating: 4 Stars
Moat: Narrow
At Morningstar, we have long-considered Accenture to be the crown jewel of the IT services industry. Although technically not a U.S.-based firm, we'll claim it as our own. With a truly global delivery network, arising from its days as a partnership, Accenture was far ahead of the competition in opening facilities in India and Eastern Europe. Accenture's offerings span the value pyramid in scale and scope.  The firm has not had to undergo a disruptive restructuring, management is steady, and the board is buying back shares.   

 Computer Sciences  (CSC)
Rating: 5 Stars
Moat: Narrow
Computer Sciences has been operating overseas since the 1970s, so like Accenture it already had global operations before the lower-cost competitors emerged. Its current restructuring plan is, in our opinion, rather limited and has not led to the internal disruption we see in lesser firms. Although CSC's commercial business has been under pressure recently, the firm derives about one third of revenues and operating income from U.S. federal government business. The board has also authorized a massive share buyback program.

 Electronic Data Systems (EDS)
Rating: 5 Stars
Moat: Narrow
Problems in 2002 and subsequent changes in management spurred Electronic Data Systems to restructure earlier than most of its rivals. We recently changed EDS' risk rating to average from above average, as we believe that management has fully recovered from past problems. Cost-cutting plans are still in effect, which we believe position the firm to deliver continued improved results. With a long-term global presence, EDS recently increased its Indian-based operations through the purchase of a majority stake in Indian firm Mphasis. With more than two thirds of reported operating income coming from government work and the winning of major commercial contracts in 2006, EDS remains a predominant IT player. A share buyback plan is also in place.

The Bad
We would avoid these companies, as they face the brunt of competitive threats.

 Keane  (KEA)
Rating: 3 Stars
Moat: None
Turmoil and turnover in the executive suite, coupled with a challenging restructuring, make us less than keen on Keane's long-term prospects. To better compete with low-cost rivals, Keane is building a global delivery network from scratch, which entails reorganizing its internal operations and building a presence in India. We are skeptical that the restructuring will materially change results, despite the firm's continued ability to win deals. Recently, we lowered Keane's moat rating from narrow to none, as we believe results have confirmed that Keane's competitive advantages have eroded.

 Sapient  (SAPE)
Rating: 1 Star
Moat: None
Sapient, too, has experienced large-scale turnover among its senior management, and the firm is--in our opinion--a serial restructurer. Moving most operations to India in 2002 and 2003 saved the firm once already, but we believe the firm is too reliant on this strategy. Sapient is also restructuring its European sales teams. Another worry is that the board found evidence of stock option backdating and is now in the process of restating its financials back to 1997.

 Unisys  (UIS)
Rating: 1 Star
Moat: None
Although Unisys' restructuring seems to be in the early stages of bearing fruit, the firm has had problems increasing its revenue, and we believe it is in poor financial shape compared to its peers. Other turn-offs include continuing struggles in its mainframe hardware business and a severely underfunded pension fund.

The Hairy
This group includes firms we like, but for various reasons we cannot wholeheartedly recommend their shares.

 Affiliated Computer Services  ACS
Rating: 4 Stars
Moat: Narrow
Affiliated is a strong firm, with compelling offerings for state and local governments in particular. Delivering services throughout the IT services value pyramid, ACS is significantly insulated from low-cost competitors, in our opinion, and we recently significantly raised our fair value estimate to $75 per share. However, we are deeply concerned about shareholder governance issues at ACS. We have raised our risk rating from average to above average, as the company is reeling from stock option backdating allegations and delayed regulatory filings.

 BearingPoint  (BE)
Rating: 3 Stars
Moat: Narrow
BearingPoint ranks right behind Accenture in terms of quality and scope of offerings, in our opinion. Normally, we would urge investors to load up on its shares if they reached our "consider buying" price. Unfortunately, the firm is in the process of becoming current with its regulatory filings. Since we do not yet have financials after fiscal 2004, we recently raised our risk rating to speculative and are hesitant to give the firm our endorsement. That said, the delay in filing has had little apparent effect on BearingPoint's ability to retain and attract clients. CEO Harry You has done a great job in guiding the firm through this difficult process and keeping employees focused on the projects at hand. 

 Perot Systems  (PER)
Rating: 4 Stars
Moat: Narrow
Core competencies in delivering health-care IT services and deep relationships with the U.S. government protect Perot Systems from some overseas competitive threats. Perot has also been successful in moving some business processes offshore. But it seems that every year a contract crops up that is either being renegotiated or being under-managed that spooks investors. The firm seemingly cannot hit on all cylinders at once.

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