Profit from the fiscal crisis with outsourcing
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David Stevenson Sep 04, 2009
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Britain's finances are in a dire state. In July, just four months into the tax year, public borrowing already stood at £49.8bn, more than was borrowed in the entire 2006/2007 tax year. With borrowing for 2009/2010 on course to hit £200bn, whichever party gets into government next year faces "a once-in-a-generation challenge to bring the debt and deficit back down to manageable levels", says Richard Snook of the Centre for Economics and Business Research.
That sounds like bad news for firms that rely on government spending. But it could be very good indeed for one group: the outsourcing sector. The trend for outsourcing 'public' work once done by government departments started under Margaret Thatcher and has continued apace under Labour. These days, a whole range of jobs, including running prisons, operating railways, inspecting schools, controlling air traffic and protecting our borders is now done by private service firms rather than public sector staff.
This trend looks set to continue and perhaps even accelerate in some areas. Why? Because outsourcing is an ideal way for governments to cut costs. A report into the private sector provision of public services, published a year ago by former Bank of England Monetary Policy Committee member Dr DeAnne Julius, found that private sector firms can typically do a job formerly done by a government department for up to 30% less.
Civil servants just "don't have the access to the procedures and systems of a private company, or access to the capital that the private sector does. They can't compete, but why should they?" says Damian Reece in The Daily Telegraph. That means, as Matthew Earl of Charles Stanley puts it, that "outsourcing should be foremost among the ways to avoid the cancellation of a number of services".
Outsourcing is already big business. Major players such as Capita and Serco may not be household names, but both are part of the FTSE 100 index; Capita with a market capitalisation of £4.25bn, and Serco £2.3bn. Serco has 35,000 UK staff, 85%-90% of whom are former civil servants still doing government work, but now for a private firm.
Among other things, it controls Britain's military communications and, together with Lockheed Martin and Jacobs Engineering, manages the Atomic Weapons Establishment where the UK's nuclear warheads are stored. Last week's half-year figures show how it's happily cashing in. A record £3.5bn-worth of new contracts (including a deal to design, build and operate London mayor Boris Johnson's cycle hire scheme for the city) have just been signed, growing the order book to almost £17bn. Revenues climbed 31% to £1.95bn and pre-tax profits jumped 33% to £83.4m.
Can this growth continue? Serco's chief executive Chris Hyman reckons so: "There is more pressure on governments around the world to do more with less due to the fiscal crisis." As Mark Fleetwood of Brewin Dolphin adds, outsourcing is now such a part of the political culture that there's little chance of the process being reversed. "Consultants and outsourcers are so entrenched in the system that they're actually the ones sitting there and making the decisions for the government." We look at one of the best value plays in the sector below.
The best bet in the sector
Capita and Serco may be the market leaders in the outsourcing sector, but that's already well factored into their share prices. Both are selling on current year p/e ratios of over seventeen times, and well-below average yields of between 1% and 2%. For value seekers, Interserve (LSE: IRV) is in the same line of work, but is much more cheaply rated by investors. That's partly because of a potential pension fund deficit of £250m, which the company is busy addressing, and also due to previous one-off charges that had caused concern among investors. The share price has fallen from 530p in November 2007 to 225p today. But the company keeps on collecting contracts. Britain should account for around 38% of 2009 profits, with the largest customer being the Ministry of Defence, whose needs span from cleaning to running training services and managing rifle ranges. Meanwhile, international earnings are mainly driven by strong oil-fuelled growth in the Middle East.
Interserve has a £280m market capitalisation, and stands on a current year p/e of just over five times, according to City forecasts, and a yield of 7.7%. The dividend is covered more than 2.5 times by earnings. First-half results released this month beat estimates all round, with headline earnings per share up 20%, net debt dropping by 26% and the future workload, in effect the order book, up 5% to a healthy £6.7bn. The group will probably continue to sell on lower rating than its peers, but the shares look ripe for a re-rating. Mike Foster of Fairfax has a 268p near-term price target.
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