This troubled sector could be star of 2018

It's been a basket case for years, but some now claim the previously accident-prone UK outsourcing sector is set to be the star of 2018.

Some high-profile cock-ups from industry leaders like G4S and Serco, and a string of profit warnings from Carillion, had stuffed the Footsie's quintet of listed outsourcers. It's why the sector has underperformed by 50% since 2013.

These five companies are all listed under the umbrella of support services, a disparate bunch, ranging from tool and equipment hire group HSS Hire to credit ratings agency Experian.

The sector is a serial profits warner, too, having topped consultancy EY's list of most warnings between Q3 2015 and Q1 2017.

Performance-wise, both G4S and Serco had an abysmal period between 2013 and 2016 as a serious fraud office (SFO) investigation into alleged overcharging for electronic tagging of offenders wiped out 45% and 89% off their value respectively.

Both had recovered since, although G4S more than Serco, but have weakened recently - Serco by over a quarter since full-year results in February and G4S more modestly since a half-year update three weeks ago.

And the duo top and tailed the FTSE 350 Thursday after UBS reassessed prospects for the sector. Serco tops the table after the broker upgraded to 'buy' from 'neutral' and upped its price target by 16%. Serco shares rose almost 9% to a nine-week high and broke above the downtrend in place since late 2014.

It was the opposite for G4S - downgraded from 'buy' to 'neutral' with a price target slashed by 16% to 300p. Its shares are currently down 5% at 278p, a six-month low.

But analyst Rory McKenzie is largely positive on the sector, believing 2018 will be "a major inflection point" as growing earnings momentum drives a sustainable recovery. "After companies spent five years on cultural transformation, 2018 could see the start of a multi-year structural but disciplined expansion in outsourcing," he explains.

He's selective, though, with his company-specific views coming down to valuation. The recovery story he predicts is priced in to differing degrees.

Serco's share price doubling between February 2016 and February 2017 was "a false dawn", he argues. Now the market has returned to near-max pessimism over the firm's long-term prospects and recovery prospects are "undervalued" as it enters the final chapter in its five-year turnaround story.

G4S's five-year turnaround story, meanwhile, is pretty much complete and the lower target price suggests it now looks "fairly priced". "We see little upside in the near term… as we see most catalysts as having played out for now."

It's an in-depth analysis of the sector, and the broker says it's "reviewed incentives, accounting, contracts and performance spanning 12 years, and interviews customers and ex-employees".

Its conclusion that 3-6% organic growth per annum from full-year 2018 is possible, alongside sector margin recovery towards 6.5%, cash conversion to improve by more than three-quarters and leverage to stabilise or reduce amount to "a structural growth opportunity in outsourcing that companies are only now able to exploit".

Elsewhere, he thinks Carillion is a 'sell' and struggles to see it executing a turnaround. Both Mitie and Capita, meanwhile, fail to capture the imagination.

Mitie has some scope for earnings upgrades as management executes on cost savings and "still offers a positive risk/reward skew". However, there remains some balance sheet uncertainty and much depends on the ability of management to execute its new strategy through to 2020.

Capita, currently without a CEO, has a wide range of potential outcomes weighted to the downside.

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