Our Outlook for Business and Property Services Stocks

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Our business and property services coverage includes a wide variety of industries, spanning the spectrum between business and consumer spending. Although equity indexes have almost universally moved lower over the last quarter, the impact on the firms we cover in this space was mixed. This varying performance is not surprising given that the fundamental drivers in business and property services range from demand for workers, outsourcing, discretionary income, the supply-and-demand of real estate, and many other factors.

With so many industries to consider, it can be difficult to generalize, but one theme is worth noting in our valuations: companies with positive cash flow and strong balance sheets are substantially more appealing than their money-losing, highly leveraged counterparts. This might seem like common sense today, but not long ago the investing public was not quite as sober. Current recommendations such as  Paychex (PAYX),  Automatic Data Processing (ADP),  Cintas (CTAS), and  International Speedway  all have reasonable or no debt on their balance sheets, stable demand for their services, and attractive free cash flow yields. While circumstances may deteriorate, we're not concerned about business-model-destroying outlier events at these firms. This epitomizes the type of investments we're looking for in this highly uncertain environment.

Valuations by Industry
During the quarter, several industries in the business and property services area became cheaper while others became more expensive. At the moment, gambling/hotel casinos is the cheapest industry, followed by business applications, data processing, and business support. Also, despite recent equity market declines, we still have overvalued industries, including real estate investment trusts and consultants. Meanwhile, employment, hotels, and education are about fairly valued.

Education companies were a bright spot in the generally depressing stock market over the last quarter. Fears surrounding enrollment growth because of reduced student lending eased, and most education firms reported relatively strong numbers.  Apollo , a 5-star call after missing growth expectations in March, has rebounded nicely. While lending disruptions remain a worry, we're not overly concerned about schools with limited private student loan exposure, such as Apollo,  DeVry (DV), and  Strayer (STRA). In fact, we believe that education companies could be a safe haven in the near term as the industry has been countercyclical in the past. We think these stocks are currently fairly valued for the most part.

In contrast to education, there were conflicting trends in recreation during the third quarter. Fuel prices have retreated to levels not seen since February, a significant boon to cruise line companies such as  Royal Caribbean (RCL) and  Carnival Cruises (CCL). These firms experience an immediate increase in free cash flow when energy costs retreat, contributing to our opinion that both companies are enticing opportunities at recent prices. Although cruise lines are weathering the storm well, car rental companies such as  Hertz ,  Avis Budget Group (CAR), and  Dollar Thrifty  are not. Each of these stocks fell significantly in price during the third quarter, yet continue to trade at significant premiums to our fair value estimates.

The hotel industry experienced similar head winds to recreation companies in the third quarter, as demand weakened from both business and leisure travelers. Although there were pockets of strength in urban areas such as New York City that attract international visitors lured by the cheap dollar, most markets saw occupancy decline as more people stayed close to home. In addition to weak occupancy, revenue per available room (RevPAR) has been shrinking in the midsingle digits according to Smith Travel Research. We expect further RevPAR declines throughout 2008 and 2009 due to a weak economy, which will be compounded by a flood of new hotel supply set to come online over the next year. Nevertheless, we see a few cheap names at the moment:  Wyndham Worldwide (WYN) (hotel franchiser and timeshare developer),  Interval Leisure Group  (timeshare exchange operator), and  Home Inns  (Chinese hotel operator).

Gaming-related firms, such as casinos and their suppliers, saw their stocks punished during the third quarter, causing us to re-evaluate our long-term prospects for many of these companies.  MGM Mirage (MGM),  Las Vegas Sands (LVS), and  Wynn Resorts (WYNN) have felt the sting of the weakened economy as recent data indicate a broad, unprecedented slowdown across most gaming jurisdictions. On the Las Vegas Strip, for example, gaming revenue is down 5% since the beginning of the year, a large negative outlier relative to historical data. In addition, the development pipelines of several firms are in jeopardy because of weak gambling demand and severe lending market disruption. While we still believe in the long-term economics of the casino industry, we've increased our uncertainty rating on many of these firms as we have entered uncharted territory in some respects.

Real estate investment trusts are overvalued on average, in our opinion. Although property fundamentals held up for the most part during the quarter, recent turmoil in the credit markets will make operations more challenging for REITs. High-quality REITs have been paying very large spreads on new debt issuances over the last year, and lower-quality, highly leveraged REITs are already selling assets because refinancing is not available on attractive terms. Therefore, we are actively monitoring firms with large debt maturities over the next few years and are generally limiting our recommendations to the better capitalized companies. Most of the overvaluation in REITs centers around retail and apartment property types. While these companies are still performing solidly, if consumer weakness persists as we expect, fundamentals should deteriorate over the next couple of years. One of the few 5-star REITs in our coverage universe is  Brookfield Properties , a well-capitalized New York office property REIT that has been overly punished, in our opinion, because of exposure to financial companies.

Contributing to consumer plight is severely reduced demand for workers as recent employment figures from the Bureau of Labor Statistics have painted a gloomy picture. The unemployment rate increased to 6.1% from 4.9%, and 529,000 jobs have been lost since the start of the year, with trends worsening over the last few months. Temporary employment, a leading indicator, has been accelerating to the downside, shrinking 9% so far in 2008. As a result, most employment stocks have moved lower, bringing them more in line with our fair value estimates. However, there are a few firms driven by employment that we find attractively priced, such as  Administaff  (total human resource outsourcing), Automatic Data Processing and Paychex (payroll processing), and Cintas (mostly uniform rental).

Lastly, the global economic slowdown that appears to be in full swing has adversely impacted IT services and business process outsourcing firms. Most outsourcing companies earn a significant part of their revenue from the struggling U.S. market, causing revenue growth rates to decline sharply as clients slash budgets. Europe, the second-biggest IT spender, is poised to be the next head wind as this region's economies deteriorate, which is likely to pressure demand for outsourcing even further. Still, the best managed IT companies, such as  Accenture (ACN),  Computer Sciences Corporation (CSC),  Cognizant Technology Solutions (CTSH), and  Infosys Technologies (INFY), appear cheap despite this negative outlook.

Business and Property Services Stocks for Your Radar
Below are five of the stocks already mentioned in this article along with more detail on their respective situations. Although the near term outlook is uncertain in most industries, we think some good companies have been thrown out with the bad.

Stocks to Watch--Business and Property Services
Company	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Accenture		$52	Narrow	Medium	0.73
ADP		$58	Wide	Low	0.74
Cintas		$47	Wide	Low	0.62
Int'l Speedway		$54	Wide	Medium	0.74
Paychex		$51	Wide	Low	0.63
Data as of 09-23-08.

 Accenture (ACN)
In a fragmented services industry with thousands of players, Accenture stands tall. Though the current economic crisis has affected most IT services firms due to their exposure to the U.S. financial services sector, we think the impact on Accenture will be minimal. We believe the company is well shielded because of its geographic breadth and broad service portfolio, featuring deep industry and business process expertise. Accenture is profitable with operating margins in the low teens, and the company converts an average of 12% of revenues into free cash flow. We see recent weakness in the stock as an opportunity for long-term investors.

 Automatic Data Processing (ADP) and Paychex (PAYX)
Paychex and ADP both enjoy high customer switching costs and economies of scale in good economies and bad. Combined they have approximately 40% share of the payroll outsourcing market, leaving enough untapped business to prevent intense competition. In addition, Paychex primarily concentrates on small and medium-sized clients, while ADP has concentrated on the large domestic and multinational-business client. Adding potential, Paychex and ADP have customer bases of about half a million clients each, which can be leveraged by cross-selling non-payroll human resource services. Although these firms may face mild recessionary head winds in the near term, we believe the negatives are more than priced into these stocks.

 Cintas (CTAS)
Cintas benefits from significant scale advantages and is the leading player in the uniform rental business, with about 30% market share. The firm boasts a client portfolio of approximately 800,000, over which Cintas can spread a variety of costs. No customer contributes more than 1% of total revenue, a lopsided relationship that gives Cintas the bargaining power to structure favorable long-term contracts and annual price increases with clients. In addition, because of Cintas' large volume of business, it extracts discounts from suppliers, further boosting profitability. These factors have combined to help Cintas average a 16% return on invested capital over the last 10 years. In the short term, weak employment, especially in the manufacturing sector, may pressure revenue and earnings growth, but we believe these head winds are accounted for in our valuation model.

 International Speedway 
International Speedway is the leading owner and operator of NASCAR racing venues. The company hosted 46 NASCAR events in 2007 out of a possible 96, with a significant weighting toward the most popular races. NASCAR tradition cements International Speedway's tracks as premier racing venues because fans, drivers, and sponsors all expect the same races at the same tracks each year. Further stabilizing the revenue stream, International Speedway earns 57% of its revenue from multiyear television and advertising contracts. While weak consumer spending has weighed heavily on the stock and fundamental performance recently, we think this trend will subside once economic conditions improve, allowing the company to increase attendance, and expand operating margins from recent lows in the long run.

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