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FTSE 350: Outsourcers still rebuilding trust

The shadow of previous scandals and weakness in certain end markets means that doubts over the sector will persist in 2017
January 26, 2017

This year is likely to be dominated by the continued rehabilitation of G4S (GFS) and Serco (SRP), but also continued soul-searching over whether the outsourcing sector is fundamentally flawed. Such a view would have been bolstered by the recent deterioration in Capita's (CPI) prospects.

Twelve months ago Capita was the darling of the sector, untainted by the scandals that had rocked peers. But back-to-back profit warnings last year sent its shares crashing down. The group blamed referendum-related contract delays and a slowdown in its IT services division. It now plans to sell off its asset services division to reduce what has become an uncomfortable debt level. But the asset services business is high-margin, enjoys strong organic growth and represents a large chunk of profit. Anxiety over the disposal, together with uncertainty over future earnings (the City expects earnings to continue to fall in 2017), are likely to weigh on the group this year.

G4S and Serco, meanwhile, are now well into their turnaround plans. Buy tip Serco slashed costs and raised profit guidance twice in 2016. However there is still uncertainty over this year’s numbers, due to the sensitivity of profit to small movements in revenue or costs. With the shares up by over 70 per cent in the past 12 months, Serco’s ability to deliver current-year guidance will be closely watched. G4S has seen a revival in its shares, too, up almost a fifth on first-half results that flagged up strong cash flow. This year, look for the company to make progress towards its 2.5 times target ratio for net debt to cash profit. Disposals will continue to feature, with around £200m of proceeds possible over the next year.

WS Atkins (ATK), meanwhile, is a beneficiary of rising infrastructure spending in the UK, Europe and to some extent North America. There are other factors in the company’s favour at the moment – the UK and Europe operating margin ticked up impressively in the first half on improved efficiencies and the rating of 12 times forecast 2017 earnings looks undemanding versus historic norms.

Price (p) Market value (£m)PE (x)Yield (%)1-year change (%)Last IC view
Atkins (WS)1,4531,45513.22.8-1.4Buy, 1,647p, 21 Nov 2016
Babcock9504,80312.42.81.9Buy, 975p, 22 Nov 2016
Capita5043,36276.4-55.6Hold, 665p, 6 Oct 2016
G4S2453,801128.93.814.8Hold, 232p, 10 Aug, 2016
Mitie Group19670411.95.5-29.0Hold, 206p, 1 Dec 2016
Serco Group1501,64826.90.082.6Buy, 135p, 8 Aug 2016

Favourites: The high terror threat level continues to support demand for Babcock's (BAB) defence and cyber security offerings and its nuclear division has plenty of opportunities. But its forward price/earnings ratio fails to do justice to its strong fundamentals and high barriers to entry.

Outsiders: Economic uncertainty and increasing labour costs have hit demand for Mitie's (MTO) facilities management services, cuts to social housing rents have hit the property management division and the healthcare division has slid further into the red. City consensus is for a 30 per cent drop in earnings when Mitie reports full-year results in May and that was before another profit warning issued as we went to press. Steer clear until greater signs of stabilisation are evident.