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G4S's Olympics Punishment Could Be a Buying Opportunity

LONDON -- We might not know whether the Olympics legacy has been economically beneficial for the country, but there is one company that is definitely suffering from its disastrous Olympics performance. That, of course, is outsourcer G4S (LSE: GFS.L  ) , which infamously failed to provide enough security guards, forcing the government to call in the troops to cover the shortfall.

What many feared would be a persistent legacy for the company has come to pass. Last week the Ministry of Justice stripped G4S of its contract to run Wolds Prison, the first prison to be privatized in the U.K. And it has been excluded from a short list of contractors to run four more prisons that includes rival Serco (LSE: SRP.L  ) .

But that's scant consolation for Serco, as the government canceled the privatization of three prisons and announced a scaling-back of the program. As predicted, G4S's Olympics debacle has tainted the U.K. public-sector outsourcing industry and got government ministers running scared.

How bad is this for G4S investors?

It has some impact on future earnings. The Wolds Prison contract was only worth about 9 million pounds a year, but the company's exclusion from government short lists is a wider concern, and G4S will, of course, suffer along with the rest of the sector from a rowing-back of public-sector outsourcing. That's on top of the 50 million pounds the company provided for the Olympics contract.

And the reputational damage is significant. Somewhat unfortunately, G4S's CEO Nick Buckles had said only earlier in the week that the prison-outsourcing announcements would be the real test of the post-Olympics climate for the company. Though the director in charge of the Olympics business has just resigned, Buckles himself has held on to his job in the face of high-profile criticism.

One reason for that is support from investors. Under his direction, the company has grown to be the world's largest security firm. One of his most vocal supporters is Neil Woodford, who, as manager of Invesco Perpetual's high-income fund, is G4S's second-largest shareholder.

The upside
It's not all bad news. The prison announcement overshadowed a positive third-quarter trading statement. Organic revenue growth -- excluding the Olympics -- grew 5.5%, combining a 9% growth in developing markets and 4% in developed markets.

That developing-markets figure is important. Not only is it growing faster, but margins are much higher. At the half-year, developing markets contributed 30% of turnover but 40% of cash profits. The diversity of G4S's business, by market and by geography, gives it resilience and growth potential.

Bargain territory
After falling back on the latest news, the shares are cheap. A 3% fall has taken them not far above the bottom they hit after the Olympic story broke. In fact, you can now pick up G4S's shares at the same price they were trading at in October 2009, while markets were still shell-shocked by the financial crisis. The FTSE 100 has risen nearly 10% in that time.

G4S's shares are on a prospective P/E, based on analysts' estimates of 2013 earnings, of just more than 11. That's well below its historic trading range and much cheaper than sector peers Serco, at 13.5, and Capita, at 14. That might be justified if G4S's recent contract loss is the start of a trend, but shareholders will be hoping that after some visible bloodletting, ministers will now judge G4S on its merits.

G4S can ill afford to lose one of the few bidders capable of taking on major public-sector contracts. Despite the recent tilt away from outsourcing, it's still a massive business.

A secure sector
That's one reason why G4S's No. 2 shareholder, Neil Woodford, is so positive on the sector that he holds all three companies, G4S, Serco and Capita, in his index-beating portfolio. He avoided techs in the dot-com bubble and banks in the credit boom, so he knows something about sectors to steer clear of, as well as those to invest in. You can find out more about where the U.K.'s leading stock-picker is investing in this Motley Fool report: "8 Shares Held by Britain's Super Investor." It's free, and you can download it here without any obligation.

Ironically, Capita could be the biggest loser if U.K. ministers lose their nerve over outsourcing. It has just issued a confident trading statement but is relatively more dependent on U.K. public-sector contracts. Serco, which is relatively skewed to U.K. and Europe but has a broader business mix, might be the beneficiary if G4S continues to be treated as the black sheep of the sector.

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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