These are very people-intensive industries, and they are particularly sensitive to rising labor expenses -- which could hurt the companies' bottom lines as average hourly earnings continue to rise. As wages climb, the Fed's concern that a recovering U.S. economy -- sparked by rate cuts -- may rekindle inflation still seems justified. Under a higher-wage scenario, employers who are scrambling to find workers will recruit them with big boosts in wages and benefits, and then pass along these increased costs to consumers in the form of higher prices.
S&P expects both rising cost pressures and slow growth in this industry to continue if wage growth doesn't decrease soon. Inflation, coupled with higher fuel costs in 2000, could hurt profits at many of these companies.
Acquisitions have allowed some service providers to fuel top-line growth and bolster margins through economies of scale. However, several companies have suffered sudden earnings shortfalls from pursuing acquisitions too aggressively, and now have high levels of debt and are unnable to integrate new acquisitions into existing operations.
On the flip side, service firms generally are not capital-intensive and so they are able to realize a higher free cash flow relative to earnings than most manufacturing firms, leading to more healthy financial positions and valuations.
S&P's outlook for this industry remains neutral. Year to date through May 11, 2001, the S&P Services (Commercial & Consumer) Index gained 8.9%, versus an 5.2% decline in the S&P 1500. Earnings for the group are expected to slow to modest single digits in 2001, a substantial reduction from the pace of recent years.
Although the sector is currently valued at a discount to the S&P 1500, S&P feels the industry is fairly valued given a cooler growth rate and difficult future comparisons to more recent results. However, due to the diverse nature of this group, each company should be evaluated on its own merits.
Best bets in the group? S&P has a 5 STARS (buy) recommendation on Cendant Corp. (CD
), a company that offers real estate, travel and direct-marketing related services.
S&P has a 4 STARS (accumulate) recommendation on Convergys Corp. (CVG
), a company that offers integrated billing and customer care services. Also, S&P has a 4 STARS ranking on document and information outsourcer F.Y.I. Inc. (FYII
). Joseph Agnese is a Commercial & Consumer Services industry analyst for Standard & Poor's