Business services sector can be defined as ancillary services provided by companies to other players in the market. Hence, the core business of one company can be a business service for another.
Operating efficiencies demand companies to focus on functions and activities that are close to their core competence. This not only helps them to reap the benefits of economies of scale in those core functions, but also improves their competitive positioning. Importantly, this dynamic opens the door to business services companies to provide those non-core services.
The business service sector is highly fragmented, with no single service provider enjoying market dominance. As per business reports, the top 50 companies of the sector contribute less than 25% to the overall revenue of this sector. However, given its unique nature, Zacks has classified the group as one of 16 sectors (the S&P’s official GIC classification has only 10 sectors where business services are grouped within the ‘Industrials’ sector).
Stand-Alone Zacks Sector – Zacks Industry Rank
This industry covers 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 revenue of about $620 billion, though many companies mentioned below 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 or M-level) and 259+ industries at the expanded or X-level. We rank all 259+ X-level industries in the 16 sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.
The way to align the ranking and outlook from the complete list of Zacks Industry Rank for the 259+ industries is that the outlook for the top one-third of the list (Rank of #85 and lower) is positive, while the outlook for the bottom one-third (Rank #170 and higher) is negative. The outlook of the middle one-third of the list (Rank of #86 to #169) is therefore neutral.
Please note that the Zacks Rank for stocks, which is at 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 (1 to 3 months). We have 7 X-level industries within the Business Services sector: Auction/Valuation Services, Business Information Services, Business Services, Consulting, Financial Transaction Services, Outsourcing, Staffing, and Waste Removal Services.
Outsourcing as well as Staffing at Zacks Industry Rank #101 and Business Services at #154 and Waste Removal at #168 are the industries falling in the mid 1/3 of all Zacks industries and have a neutral outlook. The rest Business Information Services at #183, Consulting industry at #179, Auction/Valuation at #204 and Financial Transaction Services industry at #183 -- fall into the bottom 1/3 with a clear negative outlook. This distribution of industry ranks within the sector shows that the overall bias is neutral to negative.
Earnings Review
With 100% of the companies under the Business Service sector having reported their fourth quarter results, let’s take a look at how things shaped up for the sector.
Earnings for the sector grew 10.6% in the fourth quarter faring better than the overall 9.4% growth for the S&P 500. The Q4 earnings growth was an improvement over 8.6% growth in the third quarter. Revenues showed an improvement of 5.6% faring much better than the S&P 500’s year-over-year average of 0.8%. Revenue growth also improved sequentially.
In terms of surprises, the sector’s performance was weaker than the broader market, with 42.9% of Business Services companies beating earnings expectations compared with the ‘beat ratio’ of 64.3% for the S&P 500 as a whole.
Looking ahead, 2014 and 2015 earnings are expected to improve 12.3% and 13.7% respectively. This compares favorably to the +8.1% and 11.6% growth for the S&P 500 in 2014 and 2015.. Revenue growth is expected at 4.9% for 2014 and 6.1% for 2015 for the sector compared with a minimal improvement of 1.1% and 2.2% for the respective years for the S&P 500. The Zacks Business Services sector as a whole accounts for 3.2% of the S&P 500 index’s total market capitalization and is expected to bring in roughly 2.3% of the index’s total earnings in 2014.
For a detailed look at the earnings outlook for the Business Services and other sectors, please check our weekly Earnings Trends report.
Top Picks
Considering Zacks Rank, share prices, earnings surprise history and future growth prospects we think the following two stocks can enrich ones portfolio.
Exlservice Holdings, Inc. (EXLS): This provider of business process solutions, utilizing operations management, analytics and technology primarily in the United States and the United Kingdom delivered positive earnings in the last four quarters in with an average beat of almost 8.3%. Share prices also gained about 11% year to date. Given the prospect of the company we find more room for upside. Our model projects earnings growth of about 16% over the long term.
The growth drivers include new relations signed with initial scope of several million dollars in annual contract value once implemented. The company also continues to benefit from strong secular demand. U.S.-based health insurance will continue to experience rising volumes, pressure to improve patient outcomes and a need to comply with regulatory change.
The company also engages in share buyback that down the line would enhance shareholder value.
ExamWorks Group, Inc. (EXAM): This provider of independent medical examinations (IMEs), peer and bill reviews, Medicare compliance and other related services delivered positive earnings in three of the last four quarters in with an average beat of almost 29.3%. Share prices also gained about 17% year to date. Given the prospect of the company, we find more potential left. Our model projects earnings to grow about 20% over the long term.
The company continues to benefit from market share gains that lead to superior organic revenue growth, technology solutions that drive operating leverage and expanding margins, and considerable cash flow. Its compelling inorganic growth story is also expected to boost its performance level.
Both these stocks carry a Zacks Rank #2 (Buy).
Stocks to Avoid
Benchmarking the above attributes we also have two stocks that you may like to avoid.
CoreLogic, Inc. (CLGX): This provider of property, financial and consumer information, analytics, and services in the United States, Australia and New Zealand continues to suffer from the impact of lower mortgage volumes, integration costs related to the BoA integration cost as well as severance and facilities charges.
The company posted negative surprise with an average of 1.1% over the last four quarters. The underperformance was reflected in share price, which declined 10.6% year to date.
Clean Harbors Inc. (CLH): This provider of environmental, energy, and industrial services primarily in the United States, Puerto Rico and Canada delivered negative surprise of 7.05% in the last four quarters. Share prices also showed downward movement by 10.2% year to date.
In mid-January, the refining majors led by Motiva, lowered their group two lubricant pricing by 25–30 cents. This pricing affected the company’s contracted base oil volumes.
Both these stocks carry a Zacks Rank #5 (Strong Sell).
OPPORTUNITIES
The most important feature of this industry is that it is labor intensive, given the nature of intangible products offered by the service sector. Business reports indicate that the two most populated countries, China and India, are together expected to create 300 million employment opportunities in the global job market by 2030.
The industry offers specialized services based on the latest technologies. With specialized services, these providers reduce the operational cost and in turn the overall costs of companies, thereby benefiting margins. Notably, an increased number of companies opting for such specialized services would expand volumes for the service providers. This would eventually lead to services at lower costs and a further reduction in costs for companies.
The industry offers global reach, helping the company widen its customer base and maintaining a better retention ratio. It also opens the door to international trade.
CHALLENGES
A major challenge faced by this industry is spending by companies to avail of services from business service providers. This, in turn, is directly tied to the health of the economy.
As this industry provides specialized services, it involves continuous spending on research and development as well as training, maintaining skilled workforce. While continuous research and development help it acclimatize or adapt to new services to account for the ongoing development, training and maintaining skilled workforce limit high turnover rate.
Increasing competition also threatens this industry. As the main business of one company can be a business service for another, maintaining or increasing market share can pose risks to business service providers.
To Conclude
The dearth of skilled labor in the business services sector can impact future growth possibilities. Non-availability of quality workforce at a reasonable rate might increase overall operational costs.
Mergers and acquisitions play a key role in not only strengthening a company’s foothold by grabbing more market share but also in edging out competition.
However, due to the highly fragmented nature of the industry, it is difficult to set a distinct trend or predict a concrete future for it. The expected annual compounded growth rate for this sector is 4% from 2010 to 2015.
The sector might also attract new investors as nearly one-third of the companies under our coverage in the business service industry shares profits with their shareholders via dividend payments. Dividend payments help in retaining stockholders confidence in the company. Also companies undertake share repurchases to enhance shareholders value.
With an ever-increasing population and economic turmoil being a constant drag, generating employment is a burning issue. This sector, being labor intensive, involves lower capital investments and confidently addresses this problem. The emerging economies such as India and China are also becoming important destinations for the business service sectors. On the flip side, the same poses challenges to employment growth in developed economies.
Nevertheless, we can safely say that despite all the hurdles, this industry is crucial for business operations.