books about online stock trading, forex, futures, stock investing, market, trading systems
Research Stock Technology-Based Businesses
Back to contents page

Technology-based companies include data processors (ADP, First Data), database providers (IMS Health, Equifax, Getty Images), and other companies that leverage technology to deliver their services. When technology- based companies get cheap, they can be a great opportunity for investors. Due to the sizable and defensible competitive advantages most companies in this subsector enjoy, they've often generated better-than-average long-term returns. For example, the 10-year average total return for a group of data processors "was 14.2 percent through May 2003, which was above the 9.7 percent average total return for the S&P JOO.

Industry Structure

Technology-based businesses often offer the strongest cases for outsourcing. For example, a bank looking to implement electronic check imaging could spend the money to develop and maintain its own proprietary system, or it could contract with Fiserv. Because Fiserv spreads its system's development and maintenance costs across many banks, the cost of Flserv's system to any one bank is relatively low. And with input from all its clients feeding feature development, it's likely that Fiserv's product would be superior to something just one bank could develop on its own.

In general, technology-based businesses like Fiserv and its check imaging system require huge initial investments to set up an infrastructure that can be leveraged across many customers. These huge investments are a barrier to entry for new competitors.

Although the current participants in the various technology-based industries compete vigorously against one another, their markets generally have so much potential that price competition tends to be less intense than you might otherwise expect. For example, in 2OO2, Paychex and ADP—by far the two largest companies in payroll processing—had fewer than 900,000 U.S. clients between them, which represented only about 12 percent of the 7.2 million employers believed to be operating in the United States. Similarly, the use of card payments (such as credit and debit transactions) is expected to grow from about 28 percent of all consumer expenditures in 1999 to almost 50 percent by 2OIO (based on dollar volume of transactions in the United States), 1 which should benefit firms such as First Data and National Process­ing. Faced with markets like these, companies are less inclined to compete vigorously on price, instead counting on enough growth to go around for all companies to benefit.

Another desirable characteristic of technology-based businesses is the low ongoing capital investment required to maintain their systems. For firms al­ready in the industry, the huge upfront technology investments have already taken place. And the cost of technology tends to drop over time, so upkeep expenditures are minimal. First Data's Western Union franchise, for example, spends only about 5 percent of revenue each year to maintain and build its fixed assets in the business.

Companies in this subsector often benefit from both economies of scale and operating leverage. Economies of scale refers to a company's ability to leverage its fixed cost infrastructure across more and more clients, as demonstrated by Cintas washing loads upon loads of uniforms in a single plant and First Data processing billions of transactions via one network. The result of scale economies should be operating leverage, whereby profits are able to grow faster than sales.

The combination of operating leverage and low ongoing capital requirements suggests that technology-based firms should have plenty of free cash to throw around. Telltale signs of good cash generation are dividends, share buybacks, and an accumulation of cash on the balance sheet.

Another characteristic to look for when evaluating investments in this subsector is predictable sales and profits. Because 5- to 10-year customer contracts can be the norm for technology-based businesses, 80 percent to 90 per­cent of a company's revenue may be booked before the year even begins. That makes financial results more stable and predictable.

As a result of the high barriers to entry into technology-based businesses and long-term customer contracts, firms in this subsector tend to have wide, defensible moats. For this reason, when a technology-based business services stock is cheap, it's usually worth a good look.

Hallmarks of Success for Technology-Based Businesses

Investors interested in technology-based companies should look for businesses that:

Throw off cash: With big market opportunities, operating leverage, and
minimal ongoing investment requirements, technology-based businesses
have no excuse for not generating loads of cash. Technology-based busi
nesses often have free cash flow margins in the mid-teens or higher.

Enjoy economies of scale: Because bigger is better in this industry, the market leaders benefit from cost advantages relative to small competitors. This usually translates into better financial performance, either by retaining cost advantages or sharing them with clients and gaining even more market share.

Report stable financial performance: Because customers usually sign con­
tracts that last 5 to 10 years, the majority of technology-based companies'
revenue should be recurring and predictable year in and year out.

•  Are exposed to fast-growing or underpenetrated markets: Given the operating
leverage of most technology-based firms, exposure to markets with lots of
growth potential should translate into impressive profit expansion.

•  Offer a complete range of services: Many outsourcing buyers look to consoli­
date their purchases, so they have fewer relationships to manage. Com­
panies with a one-stop collection of services should benefit from this trend.
Furthermore, getting existing clients to sign up for more services is gener­
ally easier than signing up a new client, and cross sales can also increase
customer switching costs, binding customers ever tighter to the firm.

•  Have strong sales capabilities and access to distribution channels: Business
services don't sell by themselves, so it's no surprise that the most success­
ful companies have strong salesforces.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading