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Industrial Services Stock Outlook: Few Bumps on Growth Path

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The Industrial Services industry primarily includes providers of industrial equipment products and MRO (maintenance, repair and operations) services. These items (repair components, cutting fluids, lubricants, safety supplies and other consumables) are utilized in production and plant maintenance but are not directly related to customer’s core products or services.
 
The industry’s customers are a varied lot comprising commercial, government, healthcare and manufacturing. Recently improved outlook and increased spending for these customers bodes well for the industrial services industry given that MRO inventory accounts for as much as 40% of their annual budget. Further, the evolution of e-commerce has significantly impacted MRO demand with every passing year.
 
In the United States, business investment and exports are two major indicators of MRO spending. Business investment is likely to grow supported by favorable financial conditions, expanding global markets, lower capital costs and an improving regulatory climate.
 
The recent tax reform is likely to lead to higher capital spending and attract incremental foreign capital to the United States, consequently bolstering exports. However, the recent heightened trade tariffs have left the industry dealing with higher costs of raw material as well as the threat of undercutting business spending.
 
Outstanding Industry Returns
 
The Zacks Industrial Services Industry, which is a 17-stock group within the broader Zacks Industrial Products Sector, has outperformed the S&P 500 group as well as its sector over the past year.
 
The stocks in this industry have collectively gained 53.6%, much higher than the Zacks S&P 500 Composite’s 14.0% climb. Meanwhile, the Zacks Industrial Products Sector dipped 0.3% over the past year (the blue line in the chart below represents the industry).
 
Steady growth in the country’s industrial production (from 2.8% in January to 3.8% in June), rise in new orders for the U.S.-manufactured machinery, improving ISM Purchasing Managers’ Index — suggest expanding economic activities in the manufacturing sector. Moreover, an improving construction sector and increased government spending have reinstated investors’ confidence on the Industrial services industry’s growth prospects.
 
One-Year Price Performance
 
 
Group Trading Cheaper Than Sector
 
One is likely to get a good sense of the industry’s relative valuation by looking at its enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) ratio.This metric is the most appropriate multiple for valuing this industry as the enterprise value not only accounts for equity and preference shares, but also takes into account the debts. Also, EBITDA excludes the impact of non-cash expenses.
 
The industry currently has a trailing 12-month EV/EBITDA ratio of 11.9, which is close to the highest level over the past year.
 
The space looks a bit stretched when compared with the market at large, as the trailing 12-month EV/EBITDA for the S&P 500 is 11.7 and the median level is 11.4.
 
EV/EBITDA Ratio (TTM)
 
 
However, as industrial services stocks have unique characteristics, a comparison of the group’s EV/EBITDA ratio with that of its broader sector is probably the best approach. Such a comparison ensures that the group is trading at a decent discount. The Zacks Industrial Products Sector’s trailing 12-month EV/EBITDA ratio of 13.9 and the median level of 15.4 for the same period are way above the Zacks Industrial Services Industry’s respective ratios.
 
EV/EBITDA Ratio (TTM)
 
 
Outperformance May Continue on Solid Earnings Outlook
 
Improvement in its end markets like recovery in manufacturing activity, residential and non-residential construction; ongoing recovery in the oil and gas industry along with economic growth will continue to drive the industry.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion displays that market participants have been willing to pay up for these stocks already, potentially limiting further upside from current levels.
 
One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.
 
The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018. 
 
                       Price and Consensus: Zacks Industrial Services Industry
 
 
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
 
Please note that the $3.39 'EPS' estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks Industrial Services industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the dollar earnings of $3.39 'per share' of the industry for 2018, but how this dollar number has evolved recently.
                         
Current Fiscal Year EPS Estimate Revisions
 
 
As you can see here, the $3.39 'EPS' estimate for 2018 is up from $3.25 at the end of March and $2.76 this time last year. In other words, the sell-side analysts covering the companies in the Zacks Industrial Services industry have been steadily raising their estimates.
 
Zacks Industry Rank Indicates Recent Bumps
 
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
 
The Zacks Industrial Services industry currently carries a Zacks Industry Rank #171, which places it at the bottom 33% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
 
Our proprietary Heat Map shows that the industry’s rank has slipped to the bottom half over the past two weeks, after remaining in the top half for six consecutive weeks.
 
 
Industrial Services Industry Promise Long-Term Growth
 
The long-term prospects for the industry are alluring. When compared with the broader Zacks S&P 500 composite, the long-term (3-5 years) EPS growth estimate for the Zacks Industrial Services Industry appears promising. The group’s mean estimate of long-term EPS growth rate is now at 15.9%, which compares favorably with 9.8% for the Zacks S&P 500 composite.
 
Mean Estimate of Long-Term EPS Growth Rate
 
 
In fact, the basis of this long-terms EPS growth could be the recovery in the top line that industrial services stocks have been exhibiting since the beginning of 2016.
 
 
Bottom Line
 
Inflation has hit the industry hard, particularly for metal-based products. Distributors will continue to pass along higher prices to customers. However, in the competitive environment, it may not always be possible and may not be adequate to cover rising product inflation, consequently crippling margins. 
 
Nevertheless, the overall economy and leading economic indicators provide general insight into projecting the industry’s growth. Further, increased investments in its e-commerce and digital capabilities and executing continuous improvement initiatives within supply chain will drive the industry’s growth. Efforts to reduce cost base will also deliver returns.
 
We have only one stock from the Industrial Services industry sporting a Zacks Rank #1 (Strong Buy), while there is another that has been witnessing positive earnings estimate revisions and carries a Zacks Rank #2 (Buy).
 
 
DMC Global Inc. (BOOM - Free Report) : The consensus EPS estimate for this Boulder, CO-based company has moved 6% higher for the current year over the last 60 days. The Zacks Rank #1 stock has soared 281% over the past year.
 
Price and Consensus: BOOM
 
 
HD Supply Holdings, Inc. (HDS - Free Report) : This Atlanta, GA-based company has witnessed a rise of 3% in its Zacks Consensus Estimate for the current fiscal over the past 60 days. The Zacks Rank #2 stock has gained 4% in the past year.
 
Price and Consensus: HDS
 
 
Stocks to Stay Away From
 
Due to the short-term concerns related to Industrial Services stocks, we suggest that you avoid stocks which have a Zacks Rank #5 (Strong Sell) and have undergone negative earnings estimate revisions.
 
Hudson Technologies, Inc. (HDSN - Free Report) : The consensus EPS estimate for this Pearl River, NY-based company slumped 33% for the current fiscal in the last 60 days. The stock has plunged 77% in the past year.
 
Price and Consensus: HDSN
 
 
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