The Future Of Outsourcing

Published in Investing on 1 August 2012

Will Capita and Serco suffer from G4S's travails?

The successful start to London's Olympics has distracted the public's attention away from the role played -- but perhaps not played to gold medal standard -- by security firm G4S (LSE: GFS). The army had to be called in after the company failed to provide enough security staff, and G4S's CEO Nick Buckles was publically roasted by a committee of MPs.

The shares lost 15% and have yet to recover. The company dropped plans to bid for the 2014 football World Cup in Brazil and the next Olympics, and the chairman has expressed fears it could lose out on more UK public sector contracts.

Unusual support

But here's some support from an unusual quarter. "I can understand why G4S is newsworthy, but frankly the amount of high-quality projects that have delivered what was promised outnumbers the instances where something hasn't gone as well as it should." That was Paul Pindar, CEO of rival outsourcer Capita (LSE: CPI), speaking to The Times. "G4S is a fine company which has made a slip up in one area." he told the FT.

You might expect a competitor to revel in G4S's difficulties. Something strange is going on. What it reveals, I think, is the fear that the scandal will reduce the public sector's appetite for outsourcing, and so damage all participants.

Those fears could be well founded. Within days, Surrey Police had pulled out of an outsourcing contract, while Bedfordshire, Cambridgeshire and Hertfordshire police were reconsidering a planned IT and HR outsourcing project. Labour leader Ed Miliband called for tougher procurement rules. Now the Royal United Services Institute has cited the Olympics debacle in arguing that the Ministry of Defence should scrap plans to outsource its £14bn annual procurement programme.

Prospects

So what are the prospects for the sector, and especially its three FTSE 100 (UKX) players G4S, Capita and Serco (LSE: SRP)?

If you hold any of these, you're in good company. Invesco Perpetual's Neil Woodford has all three in his income funds. Now if there was an Olympics for fund managers, he would be a gold medallist. There's more about his holdings, and things you can learn from his investment style, in this free report from the Motley Fool: "8 Shares Held By Britain's Super Investor". It's free and you can get it downloaded to your inbox immediately by clicking here.

One thing boosting the sector -- at least before the Olympics debacle -- is that the UK is going through the biggest boom in outsourcing since Margaret Thatcher's day, driven by austerity spending cuts.

G4S

Mr Woodford is the second largest shareholder in G4S, and has come out strongly in support of Nick Buckles. That no doubt owes much to the fact that the share price has doubled during his tenure, with the company growing to be number one globally in security and Europe's largest employer.

But it also suggests that Mr Woodford fears what will happen if Nick Buckles is given the push. Losing future business may be already priced into G4S's shares, but the cost of being leaderless until a new CEO is found may not be. With a new chairman and no obvious internal candidate, it could be a lengthy interregnum.

Capita

Meanwhile, Capita has enjoyed a string of contract wins since raising £290m in April to fund acquisitions -- its main engine of growth. Its business process outsourcing focus makes it less vulnerable to the kind of high-profile embarrassments that G4S is prone to. But with a heavy bias towards the UK public sector, you can understand the CEO's fear of public sentiment souring towards outsourcing.

The shares are a good play on the current outsourcing trend. But it can't last forever, so the company faces a challenge to increase its private sector business. The shares aren't ones to tuck away and forget.

Serco

Serco has a more colourful spectrum of contracts, including a new joint venture with the Ministry of Defence to maintain nuclear warheads: let's hope that doesn't suffer an Olympics-style meltdown! It's has an international business, with 44% of revenues from overseas including 17% in North America. Moves into Asia give it scope for growth.

 Share pricePE (ttm)Dividend yield
G4S247p16.93.4%
Capita723p18.23.1%
Serco581p16.51.5%

All are expensive, trading on price-to-earnings (P/E) ratios well above the FTSE 100's (UKX) average of 10.1.

Investing is by no means easy in today's uncertain economy. That's why we've published "Top Sectors Of 2012" -- our guide to three favourable industries. This free report will be dispatched immediately to your inbox.

More investment opportunities:

> Tony does not own any shares mentioned in this article.

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