The support services sector of the FTSE All Share comprises companies providing outsourced services to a wide range of industries and public sector entities. The fortunes of these companies inevitably vary with those of the end markets they serve as well as with the underlying profitability of their business models. As such, the share price performance of the sector’s constituents can be diverse, providing opportunities for stock pickers.
The good companies develop strong working relationships with their clients. In doing so, they benefit from high visibility of earnings from the long-term nature of many contracts and the opportunity to renew those contracts on good terms. This gives me the opportunity to benefit from dependable cash generation and sustainable growth in dividends.
I have significant positions in a range of support services companies, including Babcock, Bunzl, Capita, G4S, Homeserve and Serco. I also include here Compass Group, which is classified in the travel and leisure sector but, to my mind, shares more characteristics with the outsourcing companies within support services.
As a lead indicator of future profit growth, investors often focus on a company’s bid pipeline for new contracts and on their success rate in the award of new contracts. This focus on contract wins is logical but contains some pitfalls. For example, the new management of Serco has conceded too much emphasis was placed on contract growth at the expense of profit margins, to the extent a number of high profile contracts failed to produce any meaningful cash flow returns. We need to trust the management of a support services company to walk away even from prestige contracts if the returns are not there. This is why my major positions are Capita, Babcock and Compass, all of which have management teams focused on profitable growth.
Capita started life as a management buyout in 1987 from the Chartered Institute of Public Finance and Accountancy, working with local government to farm out contracts to the private sector. It has retained its close relationship with the public sector but now provides a much wider range of services in back office administration and front office customer services. Its revenue is broadly evenly split between local and central government and the private sector.
A decline in Capita’s bid pipeline announced last November has sparked a debate about the group’s organic revenue growth trajectory. The forthcoming UK general election has seen central government bidding activity slow considerably. However, we expect a healthy level of outsourcing activity from police, healthcare, local authorities and the private sector to replenish Capita’s bid pipeline. We expect confidence in the company’s growth outlook to be restored as new contracts are awarded.
Meanwhile, Babcock International is an engineering support services company, providing a range of services to the UK Ministry of Defence, which contributes around 45 per cent of group revenue. Much of this is provided under a 15-year terms of business agreement, which was signed in March 2010, and provides visibility over forward work.
Organic growth has been regularly augmented with acquisitions over the past five years, including most recently the purchase in March of Avincis, a large helicopter services business. It is true business is exposed to the oil and gas industry’s fortunes as it provides transport duties to offshore installations and stock market attention has focused on this rather than the longer-term growth opportunities of integrating Avincis within the group. Meanwhile, Babcock’s order book has expanded to a record £20bn following a contract signed just before Christmas. A forthcoming investor day in March should help re-focus attention on the vast majority of Babcock’s business that is performing well.
Elsewhere, Compass Group is the largest contract food service company in the world and has operations in over 50 countries. It serves around four billion meals a year in locations including offices and factories, schools, universities, hospitals, and major sports and cultural venues. Its nearest competitors are Sodexho and Aramark.
The highly regulated nature of the food services industry makes for high barriers to entry. This is also an industry where there is major scope for organic growth even in developed markets. Universities in the US are one such example. Their campuses are the size of small towns and to date only seven of the top 30 universities have outsourced their catering requirements. Only a few very large companies have the scale to tender for such contracts.
What these companies share is the ability to deliver dividend growth over the long term. The share price graphs (figures 1, 2 and 3) show how consistent growth in dividends has driven share price performance for all three companies.
Mark Barnett is head of UK equities and portfolio manager at Invesco Perpetual