The recent history of trading for some of the UK's largest outsourcers has been littered with reputational disasters. The mistakes made by Serco (SRP) and G4S (GFS) in 2013 have been well-documented and in some ways the companies are still dealing with the fallout. Yet even as we write, the latter is undergoing fresh investigation for alleged mistreatment of inmates at its Medway Secure Training Centre in Kent. And last year Serco launched an internal inquiry into its Yarl's Wood immigration detention centre after a Channel 4 documentary alleged employees had verbally abused detainees. Serco has pledged improvements at the start of 2016, including hiring more staff and the inclusion of body cameras for front-line employees. However, what is important for these outsourcing giants in the year ahead is whether they can keep their recovery plans on track.
But the road to recovery in 2016 for Serco and G4S will continue to be an arduous one. A plethora of contract provisions and impairment charges pushed Serco into a pre-tax loss last year and during the first-half of the current financial year. There was more bad news late last year, when management announced revenue attrition would likely be £150m more than the £350m forecast in August. However, analysts are forecasting that the decline in earnings per share and pre-tax profits will bottom out during the current financial year.
As government spending on outsourcing public services to the private sector has increased, so too has the reliance of private companies on favourable government policy. Mitie's (MTO) social care business has suffered as a result of restrictions to local authority funding for care in the home. The business has also struggled to recruit high-quality care workers as wages are depressed by tight public sector budgets.
The policy backdrop looks rosier for Babcock (BAB). Defence spending has become a ringfenced priority, given the fear of Islamic State-inspired terror threats and more companies falling victim to cyber attacks. In November the government increased defence spending to 2 per cent of GDP in its strategic spending review. Management confirmed at the time of the group's first-half results in November that its security and defence division was already working with the armed forces on some of the initiatives announced. Yet Babcock's support services division is set to drive real growth this year. Management's strategy of shifting the business mix more in favour of support services is already working - the division grew revenue by almost a third during its first half. Its nuclear decommissioning work via its Cavendish Nuclear joint ventures should also continue to generate long-dated returns for the business.
| NAME | Price (p) | Market cap (£m) | PE (x) | DY (%) | 1-year change (%) | Last IC View |
| ATKINS (WS) | 1,491 | 1,493 | 14.2 | 2.5 | 16.0 | Buy, 1,455p, 17 Nov 2015 |
| BABCOCK INTERNATIONAL | 950 | 4,787 | 17.6 | 2.5 | -8.1 | Buy, 1,049p, 25 Nov 2015 |
| CAPITA | 1,159 | 7,702 | 17.0 | 2.6 | 6.1 | Buy, 1,257p, 29 Jul 2015 |
| G4S | 217 | 3,369 | 17.4 | 4.3 | -23.4 | Sell, 219p, 14 Jan 2016 |
| MITIE GROUP | 283 | 1,023 | 12.0 | 4.2 | 2.6 | Sell, 314p, 23 Nov 2015 |
| SERCO GROUP | 83 | 912 | NA | 3.7 | -36.7 | Buy, 103p, 9 Dec 2015 |
Favourites
Buy tip Capita (CPI) has avoided the reputational damage incurred by rivals Serco and G4S and has maintained solid order book growth, securing £1.6bn in new work during its first half. The group's bid pipeline also stood at a healthy £5.4bn at the end of this period. The outsourcer has also reorganised its European businesses under one umbrella to drive cross-selling among its clients. The shares are trading on 16 times forward earnings, which is not cheap, but it is towards the bottom end of the group's five-year range of forward ratings.
Outsiders
We tipped Mitie as a sell in August last year as we grew wary of the high amount of 'other items' listed on the group's balance sheet. In 2015 'other items' grew to 64 per cent of headline pre-tax profits. These 'other items' relate to acquisition and restructuring-related costs. What's more the group's healthcare and property management businesses are also facing government budgetary pressures. Shares in the group are 2 per cent down on our tip, but we think they will fall further.
