The Future of Outsourcing

LONDON -- The successful start to London's Olympics has distracted the public's attention away from the role played -- though perhaps not played to gold-medal standard -- by security firm G4S (LSE: GFS.L  ) . The army had to be called in after the company failed to provide enough security staff, and G4S CEO Nick Buckles was publicly 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 U.K. 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.L  ) , speaking to The Times. "G4S is a fine company which has made a slip up in one area," he told the Financial Times.

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. Labor 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 14 billion pound annual procurement program.

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

If you hold any of these, you're in good company. Invesco Perpetual's Neil Woodford has all three in his income funds. If there were an Olympics for fund managers, he would be a gold medalist. You can learn more about his holdings, and 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 U.K. 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 he 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 become the world's No. 1 security and Europe's largest employer.

But it also suggests that Mr. Woodford fears what will happen if Nick Buckles is given the push. Loss of future business may already be 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 290 million pounds in April to fund acquisitions -- its main engine of growth. Its focus on business process outsourcing makes it less vulnerable to the kind of high-profile embarrassments that G4S is prone to. But with a heavy bias toward the U.K. public sector, you can understand the CEO's fear of souring public sentiment toward outsourcing.

The shares are a good play on the current outsourcing trend. But that 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 colorful 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 has an international business, with 44% of revenue from overseas, including 17% from North America. Moves into Asia give it scope for growth.

 Company

Share Price (pence)

P/E (TTM)

Dividend Yield

G4S

247

16.9

3.4%

Capita

723

18.2

3.1%

Serco

581

16.5

1.5%

TTM = trailing 12 months.

All are expensive, trading on price-to-earnings ratios well above the FTSE 100's average of 10.1.

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

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Tony does not own any shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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