The outsourcing of essential public services to publicly listed companies run for shareholders’ profit was once again thrown into the spotlight on Wednesday after Capita’s (CPI) profits warning and rights issue.
Capita’s problems come just two weeks after the collapse of fellow outsourcer Carillion, which counted the UK Government as one of its clients.
Fears over other companies in the wide-ranging support services sector have been voiced. Serco (SRP) and Babcock (BAB) were worst hit, falling almost 5% initially. Mitie (MTO) also got stung and was off nearly 3%.
Investors are becoming increasingly nervous on the outlook for these stocks, perhaps correctly in the case of some.
Ben Peters, co-manager of the Evenlode Income Fund, is a former investor in Mitie, which he admits “wasn’t one of our greatest hits”. However, he still thinks there’s “a lot to like about those businesses in terms of long-term contracts that they have”.
On Babcock specifically, Laura Foll, co-manager of the Morningstar Silver Rated Lowland Investment Company (LWI), says fears are overdone. It’s a company her and co-manager James Henderson have been buying, despite being stung by Carillion.
“I think Babcock is somewhat unfairly lumped in with the likes of Capita, Mitie and Interserve (IRV),” Foll says. She points out that Babcock tends to only bid for contracts where it is the sole bidder, like the decommissioning of nuclear submarines.
“They are the only company in the UK capable of doing that,” she explains. “Therefore the margins they’re making are more like 10%, whereas the general contractors tend to be aiming for between 1% and 3%.
“So they’re in a very different position. And around half of their work is with the Ministry of Defence and is that type of work.”
Babcock’s share price has almost halved since a peak of £13 in February 2014 and Foll says shares have continued to de-rate as a result of a swathe of profit warnings from the more general contractors. “I think that’s quite unfair,” she continues.
One of the criticisms new Capita chief executive Jonathan Lewis levelled at previous management was that they had under-invested in the business for years. He will now set out to remedy this.
But Foll says Babcock has been punished for the opposite reason. Babcock has been investing heavily ahead of contracts it eventually won. As a result, she continues, there have been question marks around the firm’s cash generation.
“But you want these businesses to be growing and therefore they need to invest behind the contracts they’ve won. We will have to see – there are a lot of sceptics.”
Don't Buy Damaged Companies
Lowland was one of the last standing investors in Carillion, as revealed by Morningstar a fortnight ago. Henderson says the holding was never more than 1% of the portfolio. He added that contrarian investors will occasionally “get it wrong” and these are risks you have to take.
“I thought people were over-exaggerating the difficulties – things are usually not as bad as you’re told,” Henderson says. “But sometimes they are. They were with the banks in 2008, they were with Carillion this year. As an investor, these things will happen if you are buying damaged companies.”
While you’ve got to learn from your mistakes, he continues, if you don’t take risk you won’t make the return.
“I don’t want to sound flippant – it should hurt, Laura should be cross with me. At the same time, you must always put it behind you and look for the next opportunity.
“Usually in investment you make your next mistake trying to avoid your last one. What you could do is say this whole area isn’t investable and not invest in it. Well you’re going to miss out on some amazing opportunities.
“People are very wary about bidding for contracts – that is the period when actually you often get contracts on the best sort of margins.”
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