The economic backdrop exhibits signs of improvement with the rise in GDP, a better employment scenario, inflation approaching 2%, easing of the U.S. dollar and momentum gained by oil prices.
The outlook for business services sector moves in line with the broader economy. Significantly, the business-friendly orientation of the current administration is widely expected to give the U.S. economy a nudge of growth.
The business services sector includes companies that provide ancillary services to other industries in the market. Companies from this sector help other firms focus on their core competencies, helping them benefit from operating efficiencies. Many of these functions fall within otherwise ancillary areas for most companies -- for example, payroll processing, staffing, marketing/advertising and information technology, to name some of the major areas.
Gradual improvement in interest rate environment points toward improving economic conditions. The Fed has kept its promise of three rate hikes in 2017 and the interest rate now stands at 1.25-1.50%. Retaining this optimism, outgoing Fed Chair Janet Yellen reiterated expectations for three rate increases in 2018.
The Fed also provided an optimistic employment outlook. Fed officials expect the unemployment rate to be 3.9% for both 2018 and 2019 and 4% in 2020.
President Trump has signed the Tax Cuts and Jobs Act into law on Dec 22, 2017. The tax reform policy, an overhaul of the tax code after 31 years, lowers the corporate tax burden to 21% from 35%. This move is likely to act as an impetus.
Per the U.S. Energy Information Administration (EIA), gross domestic product is estimated to increase in the upcoming quarters. GDP growth is now expected to accelerate 2.4% in 2018 and 2019, better than 2.3% in 2017. This favorable outlook for the U.S. economy is a net positive for the business service sector as well. No doubt the Zacks Business Services sector has been a strong performer, gaining 20.9% in a year, outperforming the S&P 500 index’s 18.2% gain.
The intensely competitive business services sector must diligently work toward controlling costs and generating higher revenues in order to maintain profitability. Focus on functions and activities in line with core competence is a prerequisite in reaping the benefits of economies of scale, as well as improving competitive positioning.
Economic sensitivity aside, business service companies are quite conservatively managed, with a large number of players sharing excess cash with investors through dividends and share buybacks. Another attribute of the sector is its highly fragmented nature, with no single service provider enjoying market dominance. Per business reports, the top 50 companies of the sector contribute less than 25% to the sector’s total revenue.
Stand-Alone Zacks Sector: Favorable
Given the group’s unique nature, Zacks has classified it as one of the 16 sectors (the S&P’s official GIC classification has only 11 sectors where business services are grouped within the ‘Industrials’ sector). Notably, with about 3.8% of total market capitalization, the sector generated 3.1% of the total S&P 500 income in 2017.
This industry offers an array of services that include marketing, consulting, staffing, security, telecommunications, Internet services, logistics and waste handling. In its expanded sense, the U.S. business services sector generates consolidated yearly revenues of about $620 billion, though many of these companies do not strictly fall within the generally accepted definition of the industry.
Within the Zacks Industry classification, we have divided the business world into 16 sectors comprising 60 industries at the medium (M-level) and 265 industries at the expanded (X-level). We rank all 265 X-level industries in the 16 sectors based on the earnings outlook of the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.
We rank the 265 sub-industries in the 16 Zacks sectors based on earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries into two groups — the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than two to one. To learn more visit: About Zacks Industry Rank.)
Please note that the Zacks Rank for stocks – the core of our Industry Rank – has an impressive track record, verified by outside auditors, to foretell stock prices, in particular over the short term (one to three months). We have eight X-level industries within the Business Services sector, namely Auction/Valuation Services, Business Information Services, Business Services, Consulting, Financial Transaction Services, Outsourcing, Staffing and Waste Removal Services.
Staffing at #59, Business Information Services at #65, Auction/Valuation Services at #68, Waste Removal at #88 and Outsourcing at #108 all fall in the top half.
Financial Transaction Services at #148, Business Services at #171 and Consulting at #234 are the industries that fall in the bottom half.
Our top picks from the Outsourcing industries are ExlService Holdings, Inc. (EXLS - Free Report) and The Brink's Co. (BCO - Free Report) , both carrying a Zacks Rank #2 (Buy).
Heidrick & Struggles International, Inc. (HSII - Free Report) , On Assignment, Inc. (ASGN - Free Report) and Robert Half International Inc. (RHI - Free Report) , carrying a Zacks Rank #1 (Strong Buy), are our top picks from the Staffing industry. You can see the complete list of today’s Zacks #1 Rank stocks here.
Black Knight, Inc. (BKI - Free Report) , IHS Markit Ltd. (INFO - Free Report) and S&P Global Inc. (SPGI - Free Report) , carrying a Zacks Rank of 2, are our favorites from the Business Information Services.
A Zacks #1 Ranked player, Copart, Inc. (CPRT - Free Report) is our top pick from Auction/Valuation Services. US Ecology, Inc. (ECOL - Free Report) and Waste Management, Inc. (WM - Free Report) are #2 Ranked player and our favorite from the Waste Removal industry.
Valuation of the Sector
The valuation of the business service sector seems attractive relative to its own history as well as the broader S&P 500 index.
The Zacks Business Service sector is currently trading at a trailing 12-month EV/EBITDA multiple of 11.2X. Over the last five years, the sector has traded as low as 9.2X and as high as 11.2X with a median of 10X. In other words, the sector is currently trading at the high end of its five-year range and higher than median on a trailing 12-month EV/EBITDA basis.
On a forward 12-month EPS basis, the sector trades at 21.8X, comparing with the five-year range of 19.1X and 21.8X and a median of 20.3X. In other words, the sector is trading toward the high end of its five-year forward 12-month P/E range as well as its median.
The sector is trading at a discount to the S&P 500 index on the trailing 12-month EV/EBITDA basis.
The sector modestly underperformed the S&P 500 index in a year’s time. While the sector has gained 21.3%, the index has rallied 23.2%.
Companies have already started reporting fourth-quarter earnings. While earnings are expected to be improving 5.4%, revenues will grow 4.8%. Both compare unfavorably with the S&P 500 index.
For 2017, earnings for the business service sector are estimated to increase 9.4% on 3.7% revenue growth compared with the S&P 500 index’s earnings growth of 7.5% on back of 5.2% top-line growth.
For 2018, earnings for the business service sector are estimated to increase 12% on 6.4% revenue growth. This compares unfavorably with the S&P 500 index’s expected earnings increase of 13.7% but favorably with 5.1% higher revenues from 2017.
The graph below shows year-over-year bottom-line growth of the Business Services sector in comparison to the S&P 500.
The graph below shows year-over-year top-line growth of the Business Services sector in comparison to the S&P 500 index.
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