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Carve Up

The UK government is outsourcing more public sector services as it tries to cut spending. We look at which companies stand to benefit most from this trend.
November 20, 2015

In July, chancellor George Osborne announced £20bn in budget cuts over the next four years. Government departments have spent the last few months drawing up plans to cut spending by around 40 per cent. The winners and losers will not be known until 25 November, when Mr Osborne will unveil his strategic spending review. However, recent history has taught us that when government money is tight, the level of services outsourced to private providers often rises. According to research from the Information Services Group, consultancy spending on outsourcing almost doubled from £62bn to £120bn in the five years of coalition rule until 2015. What’s more, data from OC&C Strategy Consultants suggests outsourcing could rise by a third under the current regime, driven by the growing population and the need for cost savings. It forecasts that £1 in every £3 spent by government and local authorities on delivering public services will go to outsourcing companies.

Of course, being on the government’s payroll carries an implied level of political risk, as outsourcers’ revenue streams are reliant on favourable policy. Naturally, the degree of public scrutiny is also heightened and the largest providers G4S (GFS), Serco (SRP) and Capita (CPI) have often featured in the national press over the past five years – not usually for the best reasons. The prisoner-tagging scandals and other operational blunders involving Serco and G4S have been well documented, as have the series of charges and management changes that have followed. It will be some time before Serco, in particular, is back to full health. Part of the problem for these outsourcers, and one outsourcers generally can fall prey to, is an overly aggressive attitude towards bidding for government work. Taking a ‘win-at-all-costs’ approach to tenders meant some contracts won by Serco and G4S were built on wafer-thin margins, which cost the groups later on in impairment charges. Now outsourcers’ margins may come under pressure from the introduction of the national living wage. Research by broker Liberum revealed support service groups would be most impacted by the increase of the minimum wage to £9 an hour by 2020. In particular, groups including Interserve (IRV), Mitie (MTO) and Mears (MEAR) are expected to be the most exposed due to factors such as the extent wages account for total costs. For Mitie, it is just over half of their total costs.

The outsourcing giants provide services ranging from security services to blue-collar work such as cleaning services for a variety of government departments. These groups have the benefits of huge scale and bargaining power, and critics say, an oligopoly on the outsourcing market. In 2013 the government set an objective for smaller companies – defined as having fewer than 250 employees and with a turnover of less than £35m a year – to handle 25 per cent of government contracts by the end of 2015. Often having an established track record can be a difficulty for smaller companies. Yet, there are some smaller companies getting a piece of the government outsourcing market and others, which are already established outsourcers, entering new specialisms or beefing-up their expertise in certain areas.

We examine some of the key service areas of government outsourcing, where the money is going and where smaller UK-listed companies are trying to muscle in. Apart from the traditional ‘big three’ listed companies, what options are open to investors in the growing UK outsourcing market?

 

Reducing reoffending

The part outsourcers have played in prisoner-tagging to attempt to reduce reoffending has been well reported. However, equally as important in reducing reoffending is the education of ex-offenders and trying to get them back into work once they leave prison. As part of the MoJ’s transforming rehabilitation programme, responsibility for offender interventions and the management of medium and low risk offenders has been transferred to new providers. These ‘community rehabilitation companies (CRCs)’ include charities as well as private companies.

When the MoJ signed contracts with the eight new probation services providers last December, Interserve was one of the biggest winners. The group secured seven-year contracts providing probation and rehabilitation services in five areas, including Greater Manchester and Cheshire. These contracts, which Interserve delivers with partners including charity Shelter, are worth around £622m in aggregate. While this is clearly good news for the group, it is important to note that these contracts are structured on a ‘payment-by-results’ basis so the amount Interserve will receive is not known.

 

Welfare-to-work

The Work Programme, introduced by the coalition in 2011, is the cornerstone of government policy aimed at getting the long-term unemployed back into work. Welfare-to-work is just part of this. Under the scheme, private companies, including outsourcing stalwarts G4S and Serco, were awarded seven-year contracts to try to find work for welfare claimants. The programme itself has not been without its criticism, particularly from the Public Accounts Committee, which has questioned the effectiveness of the programme. Nevertheless, between June 2011 and March 2020, the DWP expects to refer 2.1 million people to the work programme and forecasts total payments to prime contractors of £2.8bn. While the government will stop referring people to the programme after March 2016, payments to providers will continue until 2020.

This might be why investors in welfare-to-work provider Staffline (STAF) were some of the most well rewarded following the election of a Tory majority in May. Shares in the recruiter skyrocketed more than a fifth the morning after the election and have risen another quarter since then to 1,560p. The recruiter has beefed up its welfare-to-work provisions substantially over the past two years, acquiring Avanta in 2014 and A4e in April this year. We think the company has the edge on its competitors. It works in partnership with companies, training jobseekers using equipment loaned by these companies, to give them real-life skills. The work programme accounts for around two-thirds of Staffline’s recently rebranded PeoplePlus business. Through A4e and Avanta, Staffline handles nine welfare-to-work contracts - more than any other provider. This puts the group in a prime position to benefit from DWP work programme contracts, set to be retendered once the current round of contracts expires in 2017. However, the group’s recent good fortune means its shares now trade on a full-looking 16 times forward earnings, which is why we recently downgraded our advice from buy to hold.

In a bid to share in the spoils available from providing welfare-to-work, Interserve also made its first foray into the market via its December 2014 acquisition of the Employment and Skills Group. The acquisition was quite a departure from the majority of the blue-collar services Interserve offers. We think the jury's still out as to whether the acquisition was a wise move. Nevertheless, Interserve’s UK support services division is putting in a sturdy enough performance, bolstered by long-term contract wins in the travel sector. In the first half of the year this part of the business increased sales by 15 per cent to £933m.

 

Social housing opportunities for support services

A shortage of social housing and growing financial and operational pressure on local authority landlords means the outsourcing of social housing maintenance and management is well-established. Mears Group and Mitie are the key plays in the market, providing repair and maintenance services, as well as care at home. However there is a much smaller outsourcer carving its way in the social housing market, which we are more favourable on. Lakehouse (LAKE) was founded in Essex as a construction business in 1988. Around 95 per cent of the group’s revenue comes via the public sector, with social housing accounting for around 60 per cent of the total. Lakehouse provides a range of services via its four divisions including repair, maintenance and compliance services to social housing landlords as well as energy services, such as domestic insulation. The group is also commissioned by local authorities to build additional school spaces, catering to a shortage of classroom places.

The outsourcer listed in March this year and has a market cap of £161m. It is much more immature than its counterparts Mears and Mitie, but has posted rapid earnings growth. Its maiden first-half results revealed pre-tax profit growth of more than 200 per cent. Lakehouse’s strategy is built around cross-selling its services to its client base. To do this the company is focused on making acquisitions in order to broaden out its service offering and expand its footprint across the country. Most recently Lakehouse bought social housing gas-servicing business Sure Maintenance. The company is based in the North West and fits with Lakehouse’s strategy of expanding its presence beyond the South of England, where it is most prevalent. Via its acquisition of smart-metering installer Providior, Lakehouse is also able tap into the high-growth smart-metering market, which should benefit from government plans for a national upgrade of UK energy meters by 2020. Chief executive Stuart Black – formerly of Mears – says next on the shopping list will be some type of building management controls business, catering to demand to centrally control the energy usage of multiple sites.

Funding measures introduced under the Localisation Act in 2012 have also made life easier for Lakehouse. Previously rents collected by local authorities were centrally pooled. Now local authorities are able to retain all rental income collected from social housing tenants and decide where it is reinvested. Mr Black says self-financing has not only meant fewer delays in the awarding of contracts, but because local authorities must devise a 30-year plan to ensure they can fund the delivery and maintenance of housing stock over this period, the company is more easily able to plan ahead its bidding activity. House broker Peel Hunt expects Lakehouse to commence paying a 2 per cent dividend at the end of the current financial year, which it predicts will rise to 4.3 per cent in FY16. With the shares trading on just 8 times forward earnings and a healthy £21.1m in net cash on the balance sheet, we rate Lakehouse a speculative buy.

Admittedly, this new legislation has created a lag effect, as some local authorities have delayed tendering for new contracts. Mears blamed this for its slower-than-usual start to the year’s trading and a £500m fall in its order book to £3.2bn. However, this hiatus is expected to end during the second-half. The outsourcer has also benefited from moving more towards higher-margin housing management work, generating average margins of 10 per cent and boosting its overall margin by 80 basis points during the first-half. With the majority of management work taken care of in-house at present, this market has considerable growth potential. Mears' bosses think this business could double over the next three years.

 

Care providers squeezed at the margins

Social care providers are coming under increased pressure as a result of government spending cuts, while the arrival of the national living wage also looms large over the sector. A recent survey by the National Care Association revealed 82 per cent of social care providers were concerned about their viability once the living wage is introduced, under the current legislative framework.

It is no surprise then that Mears’ care at home division is facing tough trading conditions. A lack of government funding for social care as well as a difficult recruitment environment has held the business back. Operating margins slumped to 4.6 per cent during the first-half, compared to 7.8 per cent a year earlier. What’s more, the division pulled in contract wins amounting to just £35m during the period, nearly half what it did in 2014. However, some of this reduction was due to the decision to increase care worker wages from April, to cut down churn. In June Mears beefed up its care operations, buying rival Care UK Homecare (CAH) for £11.3m. However, CAH anticipates a £0.5m operating loss this year. Along with £5m in integration costs, this means Peel Hunt expects adjusted EPS to fall 10 per cent to 28.9p this year. With a forward earnings rating of 14, we’re keeping the shares on hold for now.

Property management and care in the home are only a small part of the services heavyweight outsourcer Mitie offers. Its property management business, which provides repair maintenance and investment advice to a largely public sector client base, has experienced slower growth than its counterparts recently. However, operating margins for its homecare businesses, MiHomecare and nurse-led complex care provider Complete Group, more than halved to 5.4 per cent last year. Although what concerns us most about Mitie is the rapid level it has ratcheted up exceptional costs over the past five years, as it has attempted to sort out struggling parts of the business and its contracts. A case in point, the outsourcer incurred a £45.7m hit last year at its now-defunct energy solutions business after the forecast performance of three of its contracts deteriorated. Net debt represented twice last year’s statutory cash profits. These are just some of reasons behind our recent sell tip.