Should We Expect Another Rally in This Space?

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Given the sharp upward move by the market in 2013, it would be a good time to provide an updated assessment of where the analysts see the most value within the business and professional services coverage.

Overall, every company in the business services sector has grown in terms of market cap for the year. However, does that mean that there is no more room for capital appreciation? Which is the best investment in this space? Let’s see find out. 

The largest rally in the group for the year

Corporate Executive Board (NYSE: CEB) is up by more than 30% for the year, which is easily the largest gain in this industry in 2013. Corporate Executive is a good small-cap idea, and there is a lot of room for strong appreciation over the next few years. It has a premium business model featuring attractive margins, low capital intensity, above-average revenue visibility and very strong free cash flow (~150% of net income). These positives result from the company’s subscription business model, where customers typically prepay annual fees and renewal rates are high.

The key to this company’s performance over the next few years will be its ability to achieve its high single- to low double-digit revenue growth target, which would allow for low teens or better EPS and cash flow growth over time. The recent trend is encouraging, as Corporate Executive has grown its core business at double-digit rates since 2011, which has been boosted by the August 2012 acquisition of SHL. For those who don’t know, SHL, based in the UK, is the largest global provider of cloud-based solutions for talent assessment and decision support.

The end markets for this company are improving. The U.S. large company best- practices business is growing at a mid-teens rate, as are the mid-market offerings. This is dampened somewhat by weaker European activity, though Corporate Executive has generated slight growth in this region through good sales execution. Total customers and revenue per average customer are both growing at mid single-digit rates, and operating metrics including contract value and deferred revenue growth both point to continued healthy expansion in the quarters ahead.

SHL remains a work in progress as its heavy European exposure is depressing growth rates and weighing on margins. However, acceleration in 2H 2013 and 2014 is expected as comps ease and U.S. investments begin to pay off. And, the business remains solidly profitable with especially strong free cash flows (12% to 15% accretion is expected to 2013 free cash flow from SHL). As the growth accelerates and investments slow, margins are expected to trend toward the level of core Corporate Executive, which seems likely to boost profits in 2014 and beyond.

A glimpse of valuations

Corporate Executive is attractively priced at 13.9x 2014 free cash flow, which is a modest discount versus the market’s 2014 price-to-earnings multiple (P/E). In addition, Corporate Executive trades at an 18% discount vs. its peers despite the expectations for similar growth.

Similarly, one of the large-cap players in the industry, Ecolab (NYSE: ECL), the provider of cleaning and sanitization services, also trades at attractive valuations. Ecolab currently trades at a forward price-to-earnings multiple of 21.2x, which is below its historical average of 22.5x.

On a P/E-to-growth basis, Ecolab trades at ~1.0x expected 2014 growth, below the 1.7x five- and 10-year averages. While far from cheap, the stock should hold a premium valuation based on its consistent historical performance and the expectations for high-teens EPS growth over the next three years.

Ecolab remains a very high quality large-cap company that should be a core holding for growth investors. Ecolab, well-managed and diversified across several stable end-markets and geographies, has endured competitive advantages through its R&D focus and unique selling model and an enviable long-term track record of successful growth.

Another player in this space

Robert Half International (NYSE: RHI) remains the one of the slowest “runners” in this space with a 6% rise in market value in 2013. The company provides temporary and permanent staffing services. The stock is attractively priced at 2014 expected P/E and P/FCF multiples of 17.6x/15.3x, versus a historical average P/E of 23.5x during mid-cycle periods. The earnings are likely to compound at a low-to-mid teen or higher rate in the next two-to-three years, which should drive good share-price appreciation.

Robert Half is in the middle of a multi-year profit expansion that should drive healthy share-price appreciation over the next few years. The stock has under-performed the market year-to-date due to somewhat weaker 1Q13 results and sluggish 2Q13 guidance. However, re-acceleration is expected in 2H 2013 and 2014, and the company is expected to generate solid growth in the current economic environment, with improvement likely if U.S. economic activity improves.

Final word

Business and professional services as an industry has been growing in terms of both revenue and margins in 2013. Despite double-digit increases in the stock price, there are still some investing gems hidden in the industry. Corporate Executive is one of them, given its strong margins and cash flows. Ecolab and Robert Half are also recommended as buys on the basis of diversified product offerings and bottom-line expansion, respectively. 

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Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Robert Half International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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