Service providers get squeezed by the cuts
THE words austerity and budget are now commonplace in our national lexicon. For those with a glass-half-full mentality the shrinking of the state offers an opportunity for private outsourcing firms. However, some analysts have now thrown that into doubt.
Execution Noble, the investment banking group, has produced research suggesting that service providers in the private sector will no longer be able to see government contracts as a free lunch. Instead it argues that the government will demand a tougher bargain, which could squash profit margins for maintenance companies, IT firms, administration firms and management consultants.
As details of the extent of the UK’s budget cuts have been revealed – in some cases budgets will be cut by up to 40 per cent – outsourcing companies came into focus: “Outsourcing remains one of the most practical ways to reduce the UK’s indebtedness given the scope for savings, approaching 30 per cent, which can be achieved without adversely impacting service levels,” Execution Noble’s analysts wrote.
This is an appealing prospect. But although demand from the state for these services is rising, the outcome might not be so favourable as the government pushes for a better deal fuelling higher competition. Due to this, contracts for difference (CFD) traders who want to ride a wave of greater outsourcing by the government need to pick companies that have scale or an advantage, such as high barriers to entry.
Babcock International, the engineering company that provides marine maintenance to the government, is one of Execution Noble’s top stock picks because there is a high barrier of entry – defence maintenance is highly specialised and requires a deep level of knowledge and skill. Babcock also has a strong global presence.
Execution Noble also likes the prospects for WSP Group, the consulting firm, due to its global business and public/private sector balance. Added to this, WSP Group has an attractive dividend yield of 4.3 per cent. In contrast, it has a sell recommendation for Mouchel Group, the consulting and highways business. Execution Noble argues that the company will be hit by tighter-than-forecast transport budgets, which should hurt revenue growth in the medium-term.
Traders should think about copying the investment bank’s method for stock selection. Firstly, try to choose companies that have specific areas of expertise, or are in sectors where there isn’t tough competition. Secondly, look for attractive features that might make stock prices rise in volatile financial markets – for example, stocks that are cheap or have strong dividend yields.
In the past government contracts were considered a safe revenue flow. This is no longer the case. Although the government will still spend a huge amount of money this year, it will be less than in past years and companies will have to try harder to get a slice of the government spending pie. For traders this leaves the task of sifting the wheat from the chaff.