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Technology Services Outlook: Near-Term Prospects Gloomy

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The technology services industry offers an array of services such as computer systems design, software support and data processing facilities management. It comprises companies with diversified end-markets and customer base.

Prospects of this industry are currently being hurt by increasing U.S. protectionism. Lack of workers with expertise in emerging technology fields in the United States has been bothering industry participants for quite some time.

Moreover, the U.S. government’s plan to reduce the issuance of H1-B visas to foreign nationals particularly from countries like India is a key concern for this industry. Further, the ongoing trade war between the United States and China has created an uncertain environment.

Industry Underperforming Sector and S&P 500

The Zacks Technology Services Industry, within the broader Zacks Business Services Sector has underperformed both the S&P 500 and its own sector in the past year.

While the stocks in this industry have collectively declined 0.6%, the Zacks S&P 500 Composite and Zacks Business Services Sector have rallied 15.8% and 20.7%, respectively (the blue line in the chart below represents the industry).

One-Year Price Performance

Stocks Appear Pretty Expensive

Since there has been an exponential surge in debt level since 2015, it makes sense to value the industry based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because this valuation metric considers the level of debt.

Owing to the overall industry outperformance in the past year, its valuation is really expensive now. The industry currently has a trailing 12-month EV/EBITDA ratio of 12.7, the highest level in the past year.

The space also looks quite pricey when compared to the market at large as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.9 and the median level is 11.5.

Enterprise Value/EBITDA Ratio (TTM)

When compared with the broader sector, the trailing 12-month EV/EBITDA ratio of the industry is below the Zacks Business Services Sector’s 13.7 but above the median level of 11.1.

Enterprise Value/EBITDA Ratio (TTM)

So, the aggregate valuation picture for the space appears rich.

Dim Earnings Outlook Keeps Us Cautious

U.S. protectionism, lack of expertise and trade war related uncertainties are expected to hurt the industry in the near term.

However, 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 shows that market participants have been willing to pay up for these stocks already, potentially limiting further upside from the 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: Business - Technology 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 71 cents EPS estimate for the industry for 2018 is not the actual bottom-up EPS estimate for every company in the Zacks Technology Services Industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the earnings of 71 cents per share of the industry for 2018 but how this number has evolved recently.

Current Fiscal Year EPS Estimate Revisions

As you can see here, the 71 cents EPS estimate for 2018 is down from $1.74 at the end of March and $3.23 at the end of September 2017. In other words, the sell-side analysts covering the companies in the Zacks Business - Services Industry have been steadily decreasing their estimates.

Zacks Industry Rank Indicates Gloomy Prospects

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 Technology Services Industry currently carries a Zacks Industry Rank #160, which places it at the bottom 38% 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 been volatile over the past five weeks and has remained among the bottom 50% all through.

EPS Trend Might Support Long-Term Prospects

While the near-term prospects do not look welcoming for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Consulting services industry appears promising. The group’s mean estimate of long-term EPS growth rate is at 12.3% compared with 9.8% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate

However, decreasing revenues remain a concern for industry participants.

Bottom Line

The near-term growth prospect for the industry is hardly encouraging. Moreover, the valuation looks pricey at the moment and the declining revenues are a concern for the long term as well.

Below are three stocks that carry a bearish Zacks Rank. We recommend investors to stay away from them for the time being.

Switch, Inc. (SWCH - Free Report) : The Zacks Rank #4 (Sell) stock has lost 15.8% over the past three months. The Zacks Consensus Estimate for current-year EPS has declined 26.7% in the past 60 days.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

iClick Interactive Asia Group Ltd. (ICLK - Free Report) : The Zacks Rank #4 stock has lost 35.1% over the past three months. The Zacks Consensus Estimate for current-year EPS has also declined significantly in the past 60 days.

Smiths Group plc (SMGZY - Free Report) : The Zacks Rank #4 stock has lost 16.1% over the past three months. The Zacks Consensus Estimate for current-year EPS has declined 8.2% in the past 60 days.

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