Business Services Industry Outlook - May 2018

The business services industry's outlook is a function of the health of the broader economy, which is currently quite favorable.

A rise in GDP, an improving employment scenario, inflation approaching 2%, easing of the U.S. dollar and momentum in oil prices are all signs of improvement in the U.S. economy, which in turn is positive for the business services industry. The Trump administration's business-friendly policies, including tax cuts and the repeal of regulations, are additional tailwinds.

The Zacks Business Services Industry has performed well in the past three months compared with the benchmark. It has gained 3.9%, significantly outperforming the S&P 500's rally of 0.6% in that time frame. The stand-alone Zacks sector that covers this space - the Zacks Business Services sector - has gained +7.9% in the year-to-date period, outperforming the S&P's +2.6% gain.

What's in Favor for Business Services?

Stronger GDP a Key Catalyst

Gross Domestic Product (GDP) grew at a seasonally adjusted annual rate of 2.3% in the first quarter of 2018, following 2.6% gain in the fourth quarter of 2018, per the "advance" estimate released by the Bureau of Economic Analysis.

The slowdown in growth was mainly due to seasonal quirk and economists expect growth to accelerate in the second quarter. Lower corporate and individual tax rates along with increased government spending are expected to push annual economic growth to the 3% target.

Tax Cuts, Trump's Business Friendly Moves

The Trump administration remains focused on improving the ease of doing business as evident from the recent tax cuts. The historic overhaul of the tax structure to reduce tax liabilities from 35% to 21% has given a boost to corporate earnings, investments and in some instances reflected in employee rewards. In addition, Trump's pledge to spend $1 trillion on infrastructure projects over a period of 10 years and regulatory rollbacks remain tailwinds.

Employment and Manufacturing and Non-Manufacturing Activity

The employment index registered growth of 54.2% in April, which indicates employment growth in April for the 19th consecutive month. Of the 18 manufacturing industries, 12 reported employment growth. The increase came as companies are hiringmore skilled workers and indirect personnel.

Economic activity in the manufacturing sector expanded in April and the overall economy grew for the 108th consecutive month. U.S. manufacturing activity continued its robust performance in April as the PMI measured by ISM touched 57.3%. This shows strong growth in manufacturing for the 20th consecutive month, driven by continued increase in new orders, production activity and employment and inventories. Of the 18 manufacturing industries, 17 reported growth in April.

As far as the non-manufacturing sector is concerned, NMI stood at 56.8% in April, recording the 99th consecutive month of expansion. While the Prices Index gained 0.3% to 61.8%, the Employment Index declined 3% to 53.6%. As many as 18 non-manufacturing industries reported growth.

Continuous upsurge in the PMI, NMI as well as greater number of jobs offered by manufacturing giants buoys further optimism.

What are the Headwinds?

Expenses on a High

Business service providers need to stay abreast of the latest technologies, which involves continued spending on research and development. Moreover, training of unskilled workers or taking in new skilled workers increases operational costs, in turn affecting margins. Since skilled workers are always in demand, there is the possibility of a high turnover rate, which further adds to cost.

Higher labor costs due to a competitive labor market are expected to continue keeping profits under pressure. For example, Avis Budget (CAR) or Budget continues to face hurdles like high fleet costs and unfavorable currency headwinds. Though the company is progressing well with its disciplined pricing initiatives and expects these to offset the rising fleet costs, we would wait to see more pronounced results on this front before turning optimistic.

Competition Intense

Maintaining or increasing market share remains challenging for business service providers. As discussed earlier, the main business of one company can be a business service for another. So, target customers for both may at times be the same. Strategic mergers and consolidations also pose competition for players.

Therefore, business service providers need to be adequately equipped to win over customers. While larger providers bank on the broad variety of service offerings and can effectively take up difficult ventures, relatively smaller players compete in an industry backed by specialized services.

Zacks Industry Rank

Within the Zacks Industry classification, hotel companies are broadly grouped under the Consumer Discretionary sector (one of the 16 Zacks sectors).

We rank 265 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our X 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).

In fact, ourback-testing shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1. Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by more than twice as much. The Zacks Industry Rank for Business - Services industryis currently #201 (bottom 21%).

The ranking is available on the Zacks Industry Rank page .

Earnings Trends

So far, the first-quarter 2018 financial performance for business services companies has been encouraging. While First Data Corp. (FDC) surpassed the Zacks Consensus Estimate for earnings and revenues, Xerox (XRX) beat the consensus mark for revenues but missed on earnings.

Earnings prospects for Q1 are encouraging with the sector expected to be up 22.6% from the year-earlier level on 6.8% higher revenues.

You can see the complete list of today's Zacks #1 Rank stocks here.

Valuation Picture

Looking at the industry's trailing 12-month price-to-earnings (P/E) ratio, the space's valuation picture remains rich. The sector is currently trading at 25.3X trailing 12-month earnings. Over the last 5 years, the sector has traded as high as 25.8X and as low as 19.8X, with a median of 23.1X. The S&P 500 index is currently at 20X trailing 12-month earnings, with the broader index's 5-year high, low and median at 21.9X, 15.3X, and 18.1X, respectively.

Looking at forward estimates, the sector is currently trading at 21.5X forward 12-month earnings estimates. Over the last 5 years, the sector has traded as high as 22X and as low as 17.2X and 5-year median of 19.4X. The S&P 500 is currently trading at 17X, with the index's high, low and median of 19.1X, 14X, and 17.1, respectively.

In other words, the sector's valuation picture is far from attractive.

Bottom Line

The U.S. economy is now improving and population continues to increase in a nation. The business services industry, being labor intensive, involves lower capital investments and confidently addresses the issue.

While emerging nations are becoming important destinations for business services, these economies pose challenges to employment growth in developed economies. However, given the inherent strengths, the business services space has enough steam left to drive the engine toward growth.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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