Our Outlook for the Business Services Sector
We think Mr. Market has unduly punished gambling, casino-related, and cruise line firms.
Quarter-End Insights
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Persistent concerns about the U.S. economy continued to weigh on the various segments that constitute the business-services sector. These segments include everything from business-spending reliant firms, such as bank technology providers and staffing firms, to consumer-driven companies, such as leisure-related and for-profit education firms.
Given fears that the financial credit environment and weak U.S. dollar are going to tip the U.S. economy into recession, it isn't surprising that Mr. Market would hesitate to invest in companies that have revenues tied to business spending. However, a lot of the expected economic slowdown appears to have already been discounted into share prices. For instance, despite the continued weak U.S. employment picture, employment-related firms--such as Paychex (PAYX), ADP (ADP), and most of the staffing companies--saw their stocks remain relatively flat during the quarter. Meanwhile, quarterly financial results from such firms didn't really surprise us, as we had long-ago factored a slowdown into our outlook. Today, several employment-related are firms trading in 5-star territory.
The consumer-driven segments of our sector presented a different story during the quarter. The weak employment numbers, higher fuel costs, and tightening credit environment took a toll on many stocks, although we believe this has presented a few choice opportunities for long-term investors. With higher travel costs--either at the airport or the gas station--dissuading some people from taking their annual family vacation or a weekend jaunt to Las Vegas, we have continued to monitor the situation and have adjusted our fair value estimates accordingly.
Valuations by Industry
| Business Services Industry Valuations | |||
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| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
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| Consultants | 0.93 | 1.06 | -12 |
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| Data Processing | 0.97 | 0.87 | 11 |
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| Education | 1.00 | 0.80 | 25 |
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| Employment | 0.97 | 0.91 | 7 |
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| Gambling/Hotel Casinos | 0.77 | 0.75 | 3 |
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| Hotels | 1.00 | 0.83 | 20 |
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| Personal Services | 0.87 | 0.82 | 6 |
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| REITs | 0.96 | 0.93 | 3 |
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| Rental & Repair Services | 0.96 | 1.16 | -17 |
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| Data as of 06-13-2008. |
The segments listed above are, officially, included in other sectors' performance categories. We re-published them here, though, as representative of the segments we focus on in the business-services equity research group.
As seen in the table above, the price/fair-value estimates of some segments moved around quite a bit during the quarter. Rental and repair services became significantly cheaper, but this group is composed mainly of car-rental firms, and as we expect air travel to continue to wane, we are not optimistic that a turnaround is in sight. The education segment, meanwhile, has returned to form after being hammered earlier in the year by consumer-slowdown concerns and the prospect of sparser student loans. Our take continues to be that disruption is likely, and we've factored this into our fair value estimates and theses.
Business-Services Stocks for Your Radar
Despite the consumer slowdown and concerns over travel-related spending, we believe that Mr. Market has unduly punished gambling, casino-related, and cruise line firms. We recently examined our assumptions for such firms. While the near-term outlook is certainly not pretty for many leisure firms, we don't believe the outlook is as dire as Mr. Market's view. The casinos, in particular, have developments coming online that we suspect are not being incorporated into the stock prices.
| Stocks to Watch--Business Services | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ |
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| Boyd Gaming |  | $31 | Narrow | High | 0.47 |
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| MGM Mirage | | $65 | Narrow | High | 0.60 |
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| Int'l Game Tech | | $47 | Wide | Medium | 0.62 |
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| Royal Caribbean | | $48 | Narrow | High | 0.52 |
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| Carnival |  | $55 | Narrow | High | 0.64 |
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| Data as of 06-20-08. |
Boyd Gaming (BYD)
Boyd is a geographically diverse casino operator. Its flagship property is the Borgata, which Boyd manages through a 50/50 joint venture with MGM Mirage. Boyd's shares have dropped almost 50% since the beginning of 2008 on recession fears. Certainly, Boyd's recent results have suffered due to weak economic conditions and competitive issues in Atlantic City. However, we believe the company's long-term potential is still intact. Specifically, we believe that the market is not currently factoring in the company's step-up in profitability once its mega-casino on the Las Vegas Strip, Echelon Place, opens for business some time in early 2010. In our opinion, patient investors with a long-term horizon can profit by taking advantage of the stock's recent weakness.
MGM Mirage (MGM)
This best-in-class casino operator earns 80% of its revenue from its Las Vegas Strip properties and controls almost 50% of the hotel rooms and almost 40% of all slots and tables on the Strip. MGM Mirage has many levers it can pull to create shareholder value. The company is investing heavily to fuel future growth. Its most ambitious project (and perhaps the most ambitious casino ever) is CityCenter, an $8.4 billion mega-casino and resort located next to the Bellagio. We have high expectations for this property. The company has also found unique ways to capitalize on otherwise dormant assets, such as its land holdings and widely recognized brands. MGM has entered into licensing and management deals with third-party developers, which should generate high-margin revenue streams that should drive future growth. In the short term, results will suffer from slower consumer spending, but we continue to believe long-term investors will be rewarded.
International Game Technology
IGT benefits from a wide economic moat, as evidenced by its 70% share of the slot machine industry. The firm designs and manufactures computerized gaming equipment (primarily slot machines), network systems, and licensing and services for the casino gaming industry. North American operations contributed 77% of consolidated revenue in fiscal 2007. IGT derives its advantages from its product-development capabilities (spending nearly twice as much as its next competitors), and significant barriers to entry in the industry, including time-consuming and costly local and federal gaming regulatory requirements, a wealth of patents, and significant economies of scale. IGT is extremely profitable with operating margins in the mid-30% range, and the firm converts an average of 18% of revenues into free cash flow.
Royal Caribbean (RCL)
The second-largest cruise operator in the world, Royal Caribbean carried 24% of worldwide cruise passengers in 2007. As opposed to Carnival, Royal Caribbean maintains a smaller fleet of larger ships. It has excellent global growth opportunities as only 17% of Americans have ever taken a cruise--the percentage is far less internationally. Cruise lines also benefit from recurring revenue because cruises have the highest customer satisfaction levels among all vacation types. Weak consumer spending and high fuel prices have weighed on the stock price, and although we have incorporated these factors into our fair value estimate, we continue to believe that, longer term, these problems will abate as general macroeconomic conditions improve.
Carnival (CCL)
Carnival carried 46% of worldwide cruise passengers in 2007, and we think the company will hold up well despite tough economic conditions. Cruise lines have historically held up well during recessionary periods as people continue to take vacations, but seek out better values. Cruises have the highest customer satisfaction levels of any type of vacation and are relatively cheap considering the amenities and activities included. Fuel prices have also weighed heavily on Carnival, but we expect these temporarily high prices to subside somewhat as general macroeconomic conditions improve. Additionally, Carnival has a myriad of international growth opportunities and is the largest operator in an industry that benefits from significant scale advantages.
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