How to analyze the market? Business Services

While the companies in our business services sector operate in relative obscurity, the sector deserves more attention. Here, we can find a large number of firms running wonderful, wide-moat businesses - just the kind we like to buy at the right price and hold as long-term investors.

Companies in the business services sector are as varied as the businesses they serve. After all, the group include firms such as Fiserv (financial institution data processing), Waste Management (waste hauling), Omnicom (advertising), and even United Airlines (air transportation). Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at:

1. technology-based
2. people-based, and
3. hard-asset-based subsectors.

Although not all companies within the industry fit perfectly into just one of these categries, it's a useful distinction to make when you're analyzing a potential investment in business services. Despite being such diverse group of businesses, a few major themes impact the majority of business services companies.

Outsourcing Trend

Business-to-business services have grown significantly, increasing as a percentage of GDP from 3.5 percent in 1990 to 5.4 percent in 2001. Fueling the growth has been the popularity of outsourcing - the practice of offloading noncore tasks to third parties.

Many business services providers have essentially created markets for themselves based on this trend. Cintas, for example, has successfully convinced companies tha it's better to pay Cintas to service employees' uniforms than to leave the responsibility to each individual employee or to handle it themselves. Other industries developed to fill needs that would be difficult or impossible for companies to handle internally. It is impractical, for example, for every mom-and-pop retailer to develop its own infrastructur to facilitate its acceptance of credit and debit card payments. Instead, companies such as First Data and National Processing allow retailers to tap into larger systems, the fixed costs of which can be leveraged across many clients.

Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the sucess of their company.

Economic Moats in Business Services.

In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume - especially over fixed-cost networks - companies can lower unit costs and achieve greater profitability.

To capitalize on this, many business services firms have attempted to acquire their way to critical mass and achieve scale economies by consolidating the operations of multiple businesses. For example, data processing firms such as Fiserv, First Data, and ADP have all made acquisitions an important part of their overall strategies.

Size impacts the industry through branding as well. Often,brands play a major role in a business outsourcing purchase decision. Companies amy be hesitant to utsource payroll processing (and the related handling of employee pay and tax funds) to Fly-By-Night Upstart, Inc., but are comfortable entrusting the responsibility to ADP, founded in 1949 and currently the biggest payroll processor. Even in business services, brands count, and it's usually the biggest companies that have the most recognizable brands.

Many industries in business services have significant barriers to entry, making it tough for new players to enter the field. For example, a company that wanted to process credit card transactions for banks and retailers would have to build a processing infrastructure to support its business, including hardware, the software development to manage the data, and a sales network to sign customers. Such a company would have to go through considerable trouble and expense just to try to compete against a company such as First Data, which already handles billions of transactions each year.

Despite the relatively high barriers to entry in th electonic transaction processing industry, their's little protection against competition from other industry participants. For example, in 2001, Concord EFS lost Bank of America's electronic funds transfer switching business to a very aggressive bid from competitor Visa. Thus, although most business services industries have wide moats, companies still need to differentiate themselves further to fend off potentially intense competition from established industry players.