Three Smallcap IT Outsourcing Stocks: Zanett, Pomeroy IT Solutions, Bell Industries

At a time when technology has become an essential component to just about any kind of business, it’s easy to overlook the fact that maintaining a network of computers can be a business in itself, and a pretty complicated one at that.

For those well versed in the multi-billion-dollar IT outsourcing industry, it might also be hard to understand how some small-cap companies can compete against the global players.

There is a thriving industry that outsources IT products and services, managing other companies’ computer networks and helping them install and maintain newer technologies so that they can devote more energy to their primary operations. But as more of this work has moved overseas, it’s become increasingly difficult for the little local guys to stay in business.

But a handful of small-cap companies are, in fact, holding their own in the IT outsourcing business. What’s perhaps most interesting about these companies is that, although their total revenues are modest, large chunks of their business often come from major companies or organizations.

The North Atlantic Treaty Organization, for instance, outsources some of its IT functions to tiny Zanett Inc. (Nasdaq: ZANE), a New York City company with a market cap of about $34 million, suggesting that some of these companies really have been able to carve out valuable niches.

The recent earnings and stock price performances of Zanett and some other players reveal both the big challenges and the niche opportunities small IT businesses are finding in an industry going global.

Pomeroy IT Solutions Inc. (Nasdaq: PMRY), based in Hebron, Kent., offers a range of IT consulting services from financing to lifecycle maintenance, and is currently riding a wave of renewed optimism, following some shaky times. Its stock today sells around $10.00, up from $7.51 at the start of the year, and $7.19 a year ago. Although revenues have actually declined in recent years – totaling $631.6 million in fiscal 2007, down from $714.8 million in 2006 and $742.3 million in 2005 – its troubles were seen to be related more to poor management than soft business fundamentals.

The renewed optimism among investors follows a successful proxy battle earlier this year by a major shareholder to replace some of the company’s board members. More recently, CEO Stephen Pomeroy, who had seen the company through a series of financial restatements and missed quarters, was fired. It may take time for the company to rebuild its reputation and demonstrate that it’s capable of more than the flat growth shown in recent years, but investors seem optimistic.

PMRY 1-yr chart

Bell Industries Inc. (AMEX: BI), an Indianapolis IT services firm that helps other businesses buy and maintain technology products and services, serves as an example of how size and reliance on a limited number of customers can make the business vulnerable. Bell recently had to close its Illinois call center when it lost the sole customer that used those call center services.

After taking a hit on news of the call center closing and the abrupt resignation last month of CEO John Fellows, Bell’s stock today sells for about $2.77 per share, down from $3.73 at the start of the year and $3.08 a year ago.

The loss of the call center business has not yet shown up in financial results, which had been steady – if not stellar. Bell recorded revenues last year of $120.3 million, down from $130.9 million the year before and $144 million in 2004.

BI 1-yr chart

Then there’s Zanett Inc., the company that counts NATO among its customers. Despite that high-profile client and robust sales growth, Zanett’s stock price is suffering. Zanett’s revenues grew to $45.3 million last year from $34.9 million in 2005 and $29.9 million in 2004. Its net losses shrunk from $25.3 million two years ago to a loss of just $1.8 million in 2006. Nonetheless, the company’s stock price has been pummeled, trading at $1.14 per share recently, down from $1.36 at the start of the year, and less than half the $3 where it traded one year ago.

Zanett’s modest revenue growth clearly makes the company vulnerable to much larger rivals. On the other hand, the stock is worth watching. When it won the contract last month to provide engineering support to NATO, Zanett said that deal represented the first new client secured under a program to develop new services that would attract more business.

It’s also making changes to prepare for more new customers. After it won the NATO deal, it set up an office in Europe, which it said will position it to win more overseas business.

ZANE 1-yr chart