Outsourcers have endured a chequered history. Since the Ministry of Justice first announced evidence of fraudulent behaviour by Serco (SRP) and G4S (GFS) relating to prisoner escorting contracts, the outsourcers have suffered their largest annual fall in their relative share prices on record. The public relations disasters and plethora of contract provisions that ensued have been well documented. In September, it was the turn of Mitie (MTO) and Capita (CPI) to suffer huge sell-offs after both released profit warnings in quick succession. Some blame has been attributed to a delay in public spending following the EU referendum. The question is whether recent profit warnings reflect longer-term structural problems within these companies.
With Serco and G4S still at an early stage of their mission to clear up their balance sheets and streamline their businesses, and Capita and Mitie warning of a bleak outlook this year, investors could be forgiven for thinking investment opportunities are in short supply within the sector. The fact that in such a diverse sector it's very difficult to draw exact comparisons can make it even more difficult to spot future upside potential.
The recurring 'exceptional cost'
A high level of so-called 'exceptional costs' is a health warning for companies. Most companies incur some one-off expenses each year. The real problem comes when these costs recur each year and start to ratchet up against the bottom line. These 'exceptional costs' often relate to restructurings, the write-down of acquired goodwill and/or provisions for contracts due to earn the company less money than originally anticipated. This has been the case for Mitie.
Management's recent profit warning blamed uncertainty around the recent referendum for clients delaying investment decisions, as well as public sector budget constraints and the introduction of the National Living Wage. Revenue for the first half of the year is expected to be modestly lower than the previous year, while operating profit is expected to contract significantly. For the 12 months to March 2017, only modest sales growth is expected. Mitie chief executive Ruby McGregor-Smith - due to step down from the board in December - says the group's increased scale makes it harder to absorb economic weakness than during the financial crisis. "We had the advantage that we were small so we could take more market share," she says.
However, sizeable costs have blighted the group's accounts during the past six years. By 2011 and 2015, other items relating to acquisitions and restructuring grew to £73m, or 64 per cent of the group's headline pre-tax profits. However, in 2016, this fell to £16m or 17 per cent of pre-tax profits. "These business pressures have existed anyway. What has really happened is the accumulation of delayed contracts, which has accelerated the process of strategic decline in these business units," says Shore Capital support services analyst Robin Speakman.
Ms McGregor-Smith says one-off items are an inevitable by-product of the group's decision to exit mechanical and electrical engineering construction services following the financial crisis, as well as acquisitions. That same year the decision to exit its asset management business resulted in a £46m charge. Cuts will be made this year to address slower economic growth and higher staff costs. Organisational changes are expected to cost £10m, including the combination of the hard and soft facilities management businesses. However, management also expects to save £15m during the second half of the year as a result of its plans.
Growing pains
Capita may carry out different work to Mitie - more white-collar, administration - however, it is suffering some of the same growing pains. Delays to client decision-making, as well as idiosyncratic problems implementing contracts, has meant pre-tax profits for the year are expected to be below expectations. However, longer-term problems may have existed before management first flagged profit downturn during the summer. Capita has a recurring and steadily rising amount of charges and exceptional items on its books. These included a £110m impairment on goodwill and other assets last year after exiting non-core and low-growth businesses.
Organic growth has been patchy during the past decade and management expects it to shrink to just 1 per cent this year. However, as Numis analyst Julian Cater points out, "there have been years when they have had negative organic growth". He upgraded Capita from a hold to a buy rating, arguing that the outsourcer's troubles are now priced in following a 30 per cent fall in the share price. The group's heavily acquisitive strategy has typically saved overall sales when organic growth has slumped. As a result, the group has built up a relatively large amount of goodwill on its balance sheet. Panmure Gordon analyst Michael Donnelly believes goodwill relating to the troubled IT services business could be at risk of being written down. There is also the risk supplementing organic with bought-in growth will dampen returns on equity over time. While Capita is highly cash-generative, it has built up a large amount of debt as a result of its acquisition spending spree. Leverage is expected to reach 2.7 times cash profits by the end of the year.
Unknown cost of growth
Analysts at Shore Capital estimate Capita will incur restructuring and other exceptional costs of around £200m for FY2017, as management redirects the group's strategy. This is in addition to the £25m guided by management for delayed implementation of its Transport for London congestion charge contract. Poor visibility on costs is a recurring theme among large outsourcers.
Serco and G4S are still suffering from past mistakes. The former, in particular, has a long way to go, with sales still declining as it exits legacy contracts and pursues a more streamlined business structure. Yet shares in Serco are up a fifth during the past 12 months. Shares in G4S also started to rally after management revealed growing sales and a stronger bid pipeline during the first half of the year. While the problems at G4S and Serco were more dramatic, they're making progress as recovery stocks. Serco has lowered its net debt and impairments dramatically and is reducing costs ahead of plan.
IC VIEW:
Investment opportunities are few and far between among the large outsourcers at present. While slower economic growth, referendum-induced uncertainty and higher staff costs undoubtedly do not help matters, we believe recent profit warnings are symptomatic of longer-term structural difficulties within the affected companies.
Favourites
Babcock (BAB) stands out as the primary investment opportunity among its peers. The group is the largest provider of support services to the Ministry of Defence and carries out nuclear decommissioning work. It recently gained contracts for new-build nuclear, too. In other words, Babcock carries out high-barrier-to-entry work and faces less competitive pressure than other outsourcers. As a result, it has a strong pipeline of work worth £20bn and has a track record for generating strong organic sales and profit growth - 8 per cent and 6 per cent, respectively, last year. It is also without the high proportion of exceptional costs like some of its peers. Babcock's shares are trading on 12 times forecast earnings for 2017, a slight discount to their historical average.
Outsiders
Capita has frequently changed its divisional structure during the past two years as it integrates its many acquisitions. This makes it hard to compare like-for-like performances on a divisional basis. As organic growth is expected to fall to just 1 per cent this year, with another 3 per cent sales growth from acquisitions, we are also concerned about the flattening of returns on capital invested in the group. Cash generation remains very high and the shares are now trading on just nine times forward earnings for 2016 and 2017. However, we believe the group needs to re-think its strategy and with future costs possible, too, we wouldn't recommend buying in at the moment.
