The argument over the past few years that the UK outsourcing industry was entering a bonanza period is losing its strength. The sector has been tarnished by contract scandals, a profit warning from a major outsourcing provider and high-level criticism from independent thinktank the Institute for Government that the UK government 'lacks the skills to design and manage complex contracts'.


This is the view of Westhouse Securities analyst Michael Donnelly who has published an interesting research note into the outsourcing industry entitled 'Reputation. Investigation. Valuation.' He argues that Babcock International (BAB) is the only 'long-term winner', upgrading his rating from 'neutral' to 'add'.

BAB - Comparison Line Chart (Rebased to first)

Donnelly took a negative view on the sector last October when he said the outsourcing industry could be experiencing another 'false start' such as the 2010 election and subsequent white paper. Neither really created value for outsourcers and there remained a big risk that UK government contracts could be easily deferred or cancelled.


We've now seen G4S (GFS) go from the Olympics contract scandal to issuing a profit warning over lower margins and then the departure of its chief executive officer. The security expert then appeared unwilling to co-operate with a government investigation into its contracts, the opposite of Serco (SRP) which is also involved and said it would help with the probe.


Other negatives hanging over the sector include the effective end of prison outsourcing and the government spending review (26 June) finding £5 billion savings from renegotiating contracts.


Donnelly reckons 'UK government contracting is no longer what it once was'. He adds: 'Increased risk, falling margins, timetable slippage and selective, if temporary, blacklisting appear to be the new norm.'


Babcock is singled out as the only positive stock in the sector because of its 'international angle, asset ownership model and excellent management team.'


Shares last wrote in detail on Babcock in June 2012, saying to buy at 865p. The stock has subsequently rise by 38.7% in value to £12.

GFS - Comparison Line Chart (Rebased to first)

We said to sell G4S at 226.8p earlier this month, identifying further risks to the share price beyond May's profit warning. The outsourcing group has since fallen by 4.1% to 217.4p. The big test for the share price will be half-year results on 28 August which could see the much-rumoured rights issue and new restructuring efforts which will initially incur costs despite any longer-term benefits.


To read the Institute for Government's 'Making public service markets work' report, click here (warning, opens as a pdf document.)

Issue Date: 22 Jul 2013