Investors looking for a safe place to invest over a turbulent summer may want to consider shares with valuations near historic lows, strong earnings visibility and a solid track record of earnings and dividend growth through the credit crunch. Outsourcing giants Serco, Babcock, G4S and Mears are just such shares. Earnings multiples are - historically speaking - on the floor (see graph) while order books for the year ahead look strong. And with an ongoing crisis in the eurozone, comfort can be taken from these companies' proven ability to weather the credit storm in 2008 and more recently survive harsh government cutbacks. But perhaps most tantalisingly for investors is that these companies are now well placed to benefit as the public sector is opened up to private competition. So, as contract momentum picks up, it looks as though investors' patience could finally be rewarded.
Few outsourcers could describe their businesses as glamorous. The type of activities they are involved with include locking up the UK's prisoners, refitting our nuclear subs and fixing boilers in council houses. But what they lack in glamour they make up for in reliability. And arguably the sector is even more defensive now due to the relentless drift downwards in valuations since 2007 as the scope for losses has been drastically reduced while the potential for reratings has been increased.
What's the problem?
The key reason for the recent torrid years endured by investors in the sector is the order hiatus that preceded and followed the 2010 general election. A once widely anticipated upturn in outsourcing has been a long time coming and the market has started to question whether the early promise of a raft of contracts from a cost-conscious new government will ever become reality. Not long after coming to office, Prime Minister David Cameron said in an interview with the Daily Telegraph: "We will create a new presumption - backed up by new rights for public service users and a new system of independent adjudication - that public services should be open to a range of providers to offer a better service." This sounded confident and sure footed, and was interpreted by many that it was only a matter of time before billions in government contracts would switch to the private sector.
The benefits of outsourcing are clear. The 2008 Julius report showed that competitive tendering and outsourcing could provide between 10 and 30 per cent in cost savings. The problem is that these savings usually mean job losses, and that can be politically damaging, which is a problem for a government seen as out of touch and plunging in the mid-term ratings.
The White Paper entitled 'Open Public Services' was expected in February 2011 but, following Union uproar, it was delayed for a further five months. When it was released, the language had clearly been softened. As far as outsourcers were concerned, the heirs apparent, Cameron and Clegg, seemed to be fluffing their lines and the sector was suffering. Social housing specialists Rok and Connought went to the wall, local government contractors such as Mouchel edged towards the abyss under tightening margins and shares in the rest drifted sideways.
However, in 2012, many of the key players in the sectors have begun to announce encouraging levels of contract wins and bid pipelines look healthier than they have for a long time. The worm may have finally turned.
IC VIEWs
We believe investors should be looking for outsourcers with scale and a track record of contract wins in a tough environment like this. Contracts are now coming through at a faster pace, with Babcock, Serco, Mears and Mitie all reporting growing order books. Neil Woodford, manager of Invesco Perpetual High Income, also added to his holdings in Capita and Serco in the first quarter. Momentum is picking up and low valuations provide a margin of safety so we've run the rule over the outsourcing sector and believe there are a number of enticing opportunities on offer (see below).
Favourites
Serco
| TIDM | Price | Market Cap | Forecast PE* | DY |
|---|---|---|---|---|
| LSE: SRP | 540p | £2.6bn | 13.2 | 1.6% |
| Net debt/cash profit | Forecast EPS growth* | 5-yr average annual underlying -EPS growth | 5-yr average annual dividend growth |
|---|---|---|---|
| 1.8 | 6.9% | 16% | 19% |
* Forecasts for the next 12 months
Source: S&P CapitalIQ
Serco has an excellent five-year record of growing both earnings per share and dividends. More recently it seems to have edged its nose in front of rivals in the contract race, with big wins including the six-year contract to operate ferries to the Orkney and Shetland islands, which is worth £350m a year. It has also just announced an extension of a contract to manage the UK's nuclear bomb facilities, worth £1.5bn or £300m a year. Serco is a trusted outsourcer with close ties to government and international exposure, as such it warrants a slight premium to peers, trading on a PE of 13 times forecast 2012 earnings. The shares remain a buy.
G4S
| TIDM | Price | Market Cap | Forecast PE* | DY |
|---|---|---|---|---|
| LSE: GFS | 267p | £3.7bn | 10.8 | 3.2% |
| Net debt/cash profit | Forecast EPS growth* | 5-yr average annual underlying -EPS growth | 5-yr average annual dividend growth |
|---|---|---|---|
| 2.7 | 41% | 7.6% | 15% |
G4S is another group with scale on its side, and the dividend growth record is impressive. It offers something different, having only a 10 per cent exposure to the UK public sector as it has been seeking growth in overseas markets. Chief executive Nick Buckles says he wants over half of revenues to come from the developing world by 2019, from 30 per cent currently. Nevertheless, according to Mr Buckles the most active part of the group is currently the UK as it benefits from increasing Ministry of Justice outsourcing. The start of prison contracts in Birmingham and Oakwood kick off an exciting period of Police and Probation Service outsourcing. Buy.
Babcock International
| TIDM | Price | Market Cap | Forecast PE* | DY |
|---|---|---|---|---|
| LSE: BAB | 799p | £2.9bn | 12.2 | 2.4% |
| Net debt/cash profit | Forecast EPS growth* | 5-yr average annual underlying -EPS growth | 5-yr average annual dividend growth |
|---|---|---|---|
| 2.3 | 13% | 17% | 25% |
At the moment, investing in Babcock is all about the momentum of contract wins. The BBC World Service, London Fire Brigade and Sellafield all recently joined the order book and a strong set of full-year results saw the order book grow from £12bn to £13bn. The bid pipeline was also up from £7bn to £9.5bn, despite the move of £800m of work over to the order book. Management flagged that the pipeline could soon rise by £2bn if progress is made on the Super Magnox Nuclear contract. Babcock has also just announced the sale of struggling American business VT Inc. for £61m, which analysts estimate reduces the net debt to 1.3 times cash profits. Buy.
Mears
| TIDM | Price | Market Cap | Forecast PE* | DY |
|---|---|---|---|---|
| LSE: MER | 271p | £238m | 9.9 | 2.8% |
| Net debt/cash profit | Forecast EPS growth* | 5-yr average annual underlying -EPS growth | 5-yr average annual dividend growth |
|---|---|---|---|
| 0.4 | 5.0% | 3.5% | 18% |
Mitie
| TIDM | Price | Market Cap | Forecast PE* | DY |
|---|---|---|---|---|
| LSE: MTO | 286p | £1.0bn | 12.3 | 3.3% |
| Net debt/cash profit | Forecast EPS growth* | 5-yr average annual underlying -EPS growth | 5-yr average annual dividend growth |
|---|---|---|---|
| 0.9 | 11% | 13% | 14% |
Building maintenance outsourcers Mears and Mitie both have excellent records of growing earnings and dividends in all economic conditions. Social housing specialist Mears has managed double-digit dividend increases every year since 1996, and in March reported that 94 per cent of forecast revenue for 2012 was already booked, along with 80 per cent of what is expected for 2013. They remain a buy. Mitie shares were hit earlier in the year by the volte face of Edinburgh council after selecting them as a preferred bidder. This politically motivated move has not damaged the long-term prospects for the company or the sector. Mitie recently announced a £155m-a-year five-year facilities management contract with Lloyds Banking Group. These shares are also a buy ahead of full-year results on 21 May.
Outsiders
It looks as though some management teams may have misjudged the timing of new contracts coming through. Capita recently announced it was turning to shareholders to fund further growth as it announced a £274m fundraising, which caused the shares to drop by more than 10 per cent. Andy Brown, support services analyst with Panmure Gordon, pointed out that big businesses like this should really generate enough cash to fund growth.
Smaller players have been suffering as well. May Gurney, the road-repair and local government maintenance firm, has seen shares slip 14 per cent this year after it announced it was considering the closure of its facilities management business because the schools budget has been slashed under Michael Gove. The downturn in construction is also hurting those companies with greater exposure to building schools and hospitals. Interserve may have a strong balance sheet and is well placed to benefit from growth in the Middle East, but chief executive Adrian Ringrose recently told Investors Chronicle that he doesn't expect a significant improvement in construction for another two years. Interserve shares have drifted down 12 per cent since the start of the year.
