Outsourcing firms and insurers may find opportunity in the government’s fiscal crisis
It’s an ill wind that blows no good and, counterintuitively, some companies could benefit from next week’s government belt-tightening. Despite fears that spending cuts may stall fragile economic recovery, firms which provide services more cheaply than the public sector may enjoy increased turnover and profits.
Outsourcing companies ensure that light bulbs are replaced and loo rolls supplied, among a wide range of other ‘facilities management’ services, without the need to provide expensive final salary-based pensions and other benefits for staff. Whatever you think of the ethics involved, it’s no wonder a report by DeAnne Julius, a former member of the Bank of England’s Monetary Policy Committee, found that outsourcing could deliver vital services for 30 per cent less than public sector employees can.
Firms in this space such as Capita, Carillion, Interserve and Serco have long been regarded as ‘Cinderella stocks’ — a largely overlooked corner of the support services sector. Capita and Serco enjoyed a partial re-rating recently but continue to be tipped by the stockbrokers Killik & Co, while Carillion and Interserve offer greater prospects for investors willing to accept more risk.
Of the two, Carillion looks the more likely share to enjoy revaluation: nearly half of its profits came from outsourcing last year. The company provides facilities management for the whole of HM Revenue & Customs’ estate, for 43,000 Ministry of Defence military homes and more NHS hospitals than any other company. It also delivers support services for roughly 10 per cent of the motorway and trunk road network for the Highways Agency, usually under seven-year contracts. Whatever happens in the wider economy, this kind of unglamorous work will still have to be done. Carillion’s track record of cutting costs by a third will make it an attractive candidate for extra commissions from government departments keen to reduce costs further.
Carillion, which now owns Mowlam and Alfred McAlpine, has been preparing itself from the outsourcing boom since it was demerged from Tarmac ten years ago. Charles Stanley, the stockbroker, expects Carillion to make most of its profit from its support services division, where profit margins are 5 per cent. Construction, which has far thinner margins of 1.4 per cent, will account for a fifth of its profits. Carillion’s shares stand 10 per cent off their year’s high, yielding 4.5 per cent net of tax.
Capita and Serco demonstrate the scope for improvement and the gains that can be achieved. Capita has run up from a year low of 693p to around 790p on a demanding P/E of 21 times. Serco is on the same earnings multiple at a price of 610p and yields just 1.1 per cent.
By contrast, Interserve — currently yielding a tempting 8.8 per cent on a P/E of less than six times — could prove a ‘value trap’. Jackson had favoured the shares earlier this year but says hopes of a re-rating have faded. Interserve’s above-average yield, even for this unfashionable sector, could prove a warning of trouble ahead.
Elsewhere, bulls argue that fears of government cutbacks have led to an excessive marking down of some blue-chip shares which may recover sharply after spending review details are known. For example, Edmund Salvesen of Brewin Dolphin tipped the defence giant BAE Systems: ‘The sector is currently awaiting updates from the Strategic Defence and Security Review… but many of the UK programmes cannot be altered immediately. We maintain that it will take longer than expected to push significant changes through current defence infrastructure, and equipment cuts are likely to prove smaller in scale than feared. While BAE remains the largest player in the UK market, and will likely be affected by the changes, this has long since ceased to be the main driver of group earnings. The UK accounted for 17 per cent of BAE revenue in 2009, broadly the same as Saudi Arabia and Australia.’
BAE Systems yield 4.7 per cent at a current price of 352p, or less than 11 years’ earnings. At this point I had better declare an interest, with BAE comprising a quarter of the self-invested personal pension I set up last year. While that’s a substantial stake for me, your humble correspondent’s opinions are unlikely to move the price of Britain’s biggest manufacturing company.
Similarly, I must declare an interest in two insurance giants which could prosper in different ways from austerity Britain. RSA owns brands such as MoreThan and is a major international provider of general insurance. As motor cover is a legal requirement, demand is likely to remain robust whatever happens elsewhere in the economy. RSA is currently yielding 6.3 per cent on an undemanding P/E of less than 11 times.
Looking further out, Aviva — formerly Norwich Union — is Britain’s biggest insurer, spanning general and life assurance. The latter arm should benefit from an accelerating trend toward defined contribution or money-purchase pensions, which are rapidly replacing defined benefit or final salary schemes. Government plans to require employers to offer all employees pensions from April 2012 can only increase demand. Aviva is yielding about 6 per cent, priced at just over eight years’ earnings.
Dismal returns on deposits are likely to increase demand for shares that offer a decent income from businesses which can survive or even thrive in austerity Britain. While most analysis of the Spending Review to date has focused on deficit reduction, government cutbacks will produce winners as well as losers. Clouds of gloom surrounding the macro-economic outlook should not obscure the silver lining some shares offer income-seeking investors today.
Ian Cowie is head of personal finance at Telegraph Media Group.