Analysis - UK outsourcers target slice of shrinking govt pie

LONDON (Reuters) - British outsourcers are fighting for a slice of a deficit-ravaged government spending pie, and investors will need to be stock- rather than sector-specific to bag a winner.

Smaller government has typically meant bumper payouts for outsourcers, but the expected scale of the cuts could see some services, and the outsourcing contracts that back them, done away with in Whitehall's planned Spending Review, details of which are due to be released on October 20.

While the outlook for the sector long term is bright, analysts said, short-term stock picks will need to be focussed on specifics -- exposure to UK Plc, the services they offer and how that compares to peers on a relative value basis.

Operational support services firms Capita (CPI.L) and Serco (SRP.L) and defence services firm Babcock (BAB.L) have all said they expect to benefit, while social housing maintenance firm Connaught CNT.L and IT firm Logica (LOG.L) expect to be hit.

Whoever wins, the sector is facing a period of constraint.

"In the short-term I think outsourcers are going to come under huge amounts of pressure, off less activity within the public sector market but also their margins are going to come under pressure," said James Thorne, fund manager of the Threadneedle UK Smaller Companies Fund.

"However, certainly there's going to be an issue where some of these (outsourcing) companies will benefit in the long term from increased outsourcing."

While details are scarce ahead of the review, the government has kickstarted immediate spending cuts to rein in a deficit running at 11 percent of GDP, trimming 6.2 billion pounds ($9.86 billion) from this year's expenditure.

Cuts of at least 25 percent will hit most government departments over the next five years with the Office for Budget Responsibility estimating that up to 600,000 public sector employees could lose their jobs.

MUDDY WATERS

The scale of the cuts mean short-term value is likely to be stock-specific, with a focus on the firm's reliance on UK GDP growth, exposure to government spend, revenue visibility, financial structure and valuation, said analysts.

Also key is a firm's exposure to specific local government authorities. While Whitehall controls central government spend, the decision on which road-sweeping contract to renegotiate or which social housing deal to extend is a local decision.

Britain's biggest back-office outsourcer, Capita (CPI.L), said it was optimistic it would win new contracts from any squeeze in state spending, and added its bid pipeline had grown to 4.4 billion pounds.

Likewise, support services peer Serco cited its strong order book and possibility of winning orders for frontline services when reporting results in June, although valuation could well play a key part in the short term.

Serco trades at a price-to-earnings ratio of 20.6 times 2010/2011 earnings, according to Thomson Reuters data, compared with a sector average of five FTSE 100 firms of 22.1 and Capita's 23.09.

"Both (Serco and Capita) remain well placed for growth ... in the mid term, (they) have the scale and expertise to significantly assist the UK government in achieving its budget cuts," said David Rigby analyst at Credit Suisse.

Defence services company Babcock International (BAB.L) is another firm that could benefit if the Ministry of Defence's planned Strategic Defence Review results in more outsourcing, even if it loses some contracts, thanks to its size.

While near-term margin pressure remains, said Investec analyst John Lawson, Babcock's size and "ability to save money for the MOD (in return for some of the benefit) helps its business proposition."

The stock also currently trades at a significant discount to its major support services peers on a P/E of 11.94, as does highway maintenance firm Mouchel Plc (MCHL.L) on 5.1 times, which could insulate both stocks from too much downside.

PICK 'N' MIX

Not everyone will gain, however.

IT firm Logica has already faced headwinds ahead of the review when it was downgraded by JP Morgan, citing its reliance on government contracts for up to 32 percent of group revenues and 62 percent of UK revenues.

Another potential loser is Connaught, whose shares have slumped to 34 pence from 320 pence after the social housing provider detailed its exposure to government cuts and issued a profit warning on June 25.

That theme is not constant, however, as rival Mears (MERG.L), said it had yet to feel any margin hit in social housing and had a strong order book of 2.5 billion pounds as well as a 3 billion pound bid pipeline.

An intra-sector disparity that highlights the need to stock-pick carefully.

"The problem for a lot of these firms is the uncertainty over precisely where these cuts will hit and that will likely hang over the shares until the government clarifies its position," said Jimmy Yates, head of equities at CMC Markets.

($1=.6288 Pound)

(Additional reporting by Tricia Wright; editing by Simon Jessop)