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Industry Outlook

Business services stocks have lately given strong performances, with players among the S&P 500 up more than the index both in the year-to-date and trailing 12-month periods. In this writeup, we highlight the sector’s positives in order to appreciate its recent outperformance and give an outlook for the near future.

Labor Intensive: The sector, which offers intangible products, has immense employment opportunities as it requires both skilled and unskilled labor for its smooth functioning.

As per the Bureau of Labor Statistics, the unemployment rate over the last few months has remained almost stagnant. Nonetheless, the rate compared favorably with year-ago period. Sep 2016 saw 5% unemployment (versus 5.1% in Sep 2015) while the same in August was 4.9% (versus 5.1% in May 2015). Total nonfarm payroll employment increased by 156,000 in September. Notably, jobs were added in professional and business services. Healthcare also witnessed job addition.

Sep 2016 witnessed professional and business services employment increase by 67,000, taking the year-to-date tally to about an increase of 582,000.

Business reports indicate that the two most populated countries, China and India, are together expected to create 300 million placements in the global job market by 2030.

Free of Inventory: By virtue of the nature of its operations, these companies provide services instead of products to others. This in turn frees them from producing goods which would otherwise need manufacturing facilities. As a result, business services do not have inventory or stock, which would again involve costs, for later use. Moreover, services can be tailor-made for any situation.

Global Reach: Companies can reach their consumers or prospective buyers across the globe when Advertising & Market Services and Direct Marketers act on behalf of these in informing consumers about new products or added features in existing products. Thus, these service providers help in widening a company’s customer base and maintaining a better retention ratio, apart from opening the door to international trade.

A key development in this regard has been noticed in the banking space. Online banking for transfer and collection of money from anywhere in the world, mobile money transfer and ATMs are fast gaining traction. The Western Union Company (WU - Free Report) and MoneyGram International Inc. (MGI - Free Report) are among the stalwarts that are continuously offering cutting-edge services via electronic channels to ensure smooth fund transfers. Fund transferors are forming alliances with banks and mobile operators to launch their services.

Mobile payment is gaining popularity owing to its convenience and round-the-clock accessibility. This channel will see a faster adoption rate than any other electronic channel. Western Union with its Vigo and OrlandiValuta branded services were available through a network of more than 500,000 agent locations in 200 countries and territories and over 100,000 ATMs. Importantly, 90% of those locations are outside the United States. The company plans to add retail locations and more account-based options in 2016. MoneyGram has 350,000 agent locations spread over 200 countries and territories.

A large portion of the world market remains underpenetrated. With the strategic introduction of money-transfer in these markets, service providers should enjoy ample business opportunities.

In addition, a continued shift toward electronic forms of payment from paper-based forms has created a dependence on plastic money or debit and credit cards. This has encouraged card processors to ramp up their growth profile. Visa Inc. (V - Free Report) and MasterCard Inc. (MA - Free Report) are among the primes that are well placed to benefit from the tailwinds riding on their respective fundamental strengths.

Cost Effective: All business operators prefer to minimize cost of operation and maximize margins. This sector offers cost effectiveness to the companies that opt for services that would otherwise be far more expensive.

With specialized services, these providers reduce operational cost and in turn lower the overall cost of companies. Notably, a higher number of companies opting for such specialized services would increase volumes for the service providers. This would eventually lead to services at lower costs and a further reduction in costs for companies, thereby fueling margin expansion.

Our data shows that BS margins have consistently grown in the trailing four quarters, and will retain the momentum in the next three quarters too. Importantly, BS margin expansion is faring better than that of the S&P’s.

Gaining from Stronger Currencies: Companies in a country with a stronger currency can gain from the same if it gets its jobs or services done by companies from another country that have comparatively weaker currencies. This is because the country will have to spend less and thus gain from currency translation. In turn, this will lower the cost of its goods or services and favor margin expansion.

Specialized Service: The industry offers specialized services based on the latest technologies. This is crucial for security and consulting services. To safeguard data, companies are compelled to engage security service providers, which need the latest and most efficient technologies to persuade their clients and win business contracts.

Also, with increasing mergers and acquisitions across the globe, the prospects of legal service providers look good. Consulting service is another wing of this industry that is fast gaining traction.

Business complexities are on the rise and companies are opting for expert advice before entering into any new venture rather than risking losses by trial and error. Hence, this service sector looks promising owing to its indispensability to companies that are battling to survive in a competitive market.

Consolidations: Mergers and acquisitions play a vital role in not only strengthening a company’s foothold with more market share but also in edging out competition. Also, the inorganic route helps to insulate the industry from macro headwinds to a great extent. Since the sector is highly fragmented, a wave of mergers and consolidations is quite llikely.

Earlier this month, Cardtronics Inc. (CATM - Free Report) agreed to buy DirectCash Payments Inc. for C$19.00 per share to leverage the acquirer’s capabilities in Australia, Canada and the United Kingdom besides generating operating synergies. PRGX Global (PRGX - Free Report) will acquire Cost & Compliance Associates to enhance commercial recovery audit and contract compliance businesses.

In August, Viad Corp (VVI - Free Report) acquired the business of ON Event Services, LLC, a leading provider of audio-visual production services for live events in the United States to leverage its event production capabilities. In July, an affiliate of Leonard Green & Partners, L.P. acquired ExamWorks Group, Inc.

Bottom Line

The economy is now improving and population increase is never a problem in the U.S. This sector, being labor intensive, involves lower capital investments and confidently addresses this problem. While emerging nations are becoming important destinations for business services, these economies pose challenges to employment growth in developed economies.

Given the inherent strengths, the business service sector has enough steam left to drive the engine toward growth.

Investors can look for InnerWorkings Inc. (INWK - Free Report) sporting Zacks Rank #1 (Strong Buy) and Performant Financial Corporation (PFMT - Free Report) carrying Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

While both these stocks delivered positive surprise in each of the last reported quarter, they are also witnessing upward estimate revisions.

Check out our latest Business Services Outlook here for more details from an earnings perspective, and how the trend is looking for this sector from now onward.

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