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Sector looking to put profit warnings and accounting issues behind it
Thursday 07 Sep 2017 Author: Tom Sieber

Among the worst performing group of stocks in the last five years are the outsourcers. According to number crunching by UBS these companies, which do a variety of jobs in the public and private sectors such as running prisons or air traffic control, have underperformed the wider market by 50%.

But now analysts at the investment bank think the names in its outsourcing universe – G4S (GFS), Serco (SRCO), Mitie (MTO), Capita (CPI) and Carillion (CLLN) – are poised to make a comeback in 2018.

They argue: ‘Our core thesis is that the varied problems hampering performance for the past five years have been a result of overexpansion in the period before this. However, 2018 will see these problems come to an end, in our view: companies are generally finishing restructuring, have significantly transformed internal cultures, and are starting to rebuild sales pipelines.’

In the last 12 months, there have been multiple profit warnings from the space. The latest and probably most serious of which came from Carillion which suspended its dividend and was forced to set aside £845m to cover problem contracts. The share price subsequently slumped more than 70% in a matter of days.

Many of the problems facing these companies have been of their own making but last September Capita and Mitie also blamed the uncertainty created by Brexit for their respective warnings that month. And as we discussed in this column back in June the inconclusive result of the UK General Election is not helpful in terms of agreeing new contracts.

EDITORS VIEW1

Accounting issues

Arguably outsourcers are also more prone to issues over the way they prepare their accounts. Unlike a manufacturer, for example, which would typically produce a good which would then be sold in short order for an agreed price, an outsourcer is selling a contract to provide a service over several years. The way revenue and profit from this contract is reported to the market can be open to interpretation.

UBS notes managers of outsourcers were ‘until very recently’ encouraged to put near-term revenue growth above everything else. This distorted the running of these businesses so they were focused on securing very large contracts with little thought to their ability to deliver the work profitably down the line.

It adds: ‘This increasingly became an issue in the sector as contracts grew in complexity from 2008 onwards as clients looked for continued incremental savings. Whereas the client saw a ‘one line’ price, behind it were increasing layers of assumption on volumes, wage growth, procurement savings, etc.’

Having interviewed customers and former employees and reviewed long-term performance UBS now reckons the culture is changing with a greater emphasis on sustainable returns. It notes the sector is pricing in lower margins and growth but believes both are poised to recover, with new technology helping to boost demand for outsourcing.

Even so, it does not think all of the outsourcers can recover – remaining firmly negative on Carillion. Its favoured stock is Serco, which is also one of top ten selections for 2017.

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