Utilities and Support Services

Friday, 18th May 2012 15:36 - by David Harbage

That was the week that was... There are two prime ways of making an assessment about markets: a top downmacro-economic and global perspective or a bottom up investigation of micro data and local news. There has been plenty of the former - by reference to political activity in Europe, in particular - dominating the media headlines. Suffice it to say, the slow progress of any resolution of Greece's political and financial problems is likely to cast a pall over markets and constrain short term enthusiasm. However, this week's commentary is going to take a bottom-up perspective on five big UK listed businesses, from two leading sectors, mindful that often positive news on the health of companies is buried beneath the big macro (of anticipated or actual) negatives. In a future article we will take a look at some interesting smaller companies, and how their size can be an advantage over big business, but today we will be looking at firms worth at least 3bn in equity market capitalisation terms. Certainly there would appear to be some truth in the suggestion that the biggest and strongest businesses survive, and ultimately thrive, unfortunately often at the expense of the smaller 'Momma & Papa' concerns. Trading results or management statements from a number of leading businesses caught the writer's eye this week. Utility giants National Grid and Scottish & Southern Energy delivered reassuring updates, in particular by reference to dividend pay-outs which met expectations. These firms are particularly favoured by private individuals, and other investors, seeking inflation-beating income from relatively reliable (by reference to economically sensitive) sources. Prima facie, 2011/12 attractive dividend payouts - equating to a 5.5% yield on NG and 6.0% on SSE - appear comfortably covered by current year profits but, looking forward, the industry regulator could impose greater capital expenditure requirements and alter the rate of returns these companies are allowed to earn, which in turn could jeopardise their ability to return cash to shareholders. Populist, if not political (to boost public revenue), pressure to claw back some of the profits made by the utilities - who are often perceived as benefitting from high electricity & gas prices - via an exceptional windfall tax, can also not be ruled out. Having flagged those risks, these impressive cash generators probably merit a place in cautious investors' portfolios based on their defensive merits and potential to add shareholder value via corporate action. Against the backdrop of very low short & longer term interest rates, both NG and SSE have performed well over the past two years. When interest rates rise, as they inevitably must over the longer term, the relative attraction of the current dividend may abate. Investors, as will the industry regulator, should also be mindful of future trends in inflation in terms of assessing the extent to which these businesses are allowed to earn a real return - and with it the magnitude of dividends, going forward. Another segment of the market to announce pleasing trading this week - albeit from a variety of very different firms - was a sector perhaps best described as 'Support Services'. Babcock International, which proclaims itself to be the UK's leading engineering support service group, reported full year results for the year to end March 2012 which comfortably exceeded the consensus of City analysts' earnings forecasts, driven by organic profit growth of 15%. A 35% increase in the bid pipeline to 9.5bn (order book 13bn), evidences the board's belief that there is real opportunity in outsourcing. The UK government - like many others is seeking to reduce immediate costs, by using the private sector to carry out functions previously carried out by its public bodies. For example, Babcock have benefitted by picking up defence work at Devonport dockyards, and another company announcing an encouraging update this week G4S - best known for Securicor and its London Olympic Games contract - has opened another prison in Wolverhampton. Austerity-driven measures to privatise guarding and security offers lucrative long term contracts for G4S, which is one of the world's biggest employers (via some 657,000 staff). G4S' management statement highlighted strong organic growth in the first quarter of this year and, following its ill-advised plans to buy the Danish group ISS for 5.2bn last year, investors warmed to the prospect of a return to its policy of procuring small, but frequent, typically in emerging economies, bolt-on or in-fill acquisitions to boost growth. Crime is, unfortunately, a growth industry around the world; G4S is likely to continue to be a beneficiary of demand for safeguarding services. In the current economic downturn which is impacting the developed world, it is not just governments that are seeking to cut expenditure. As seen previously at this point in the cycle, many big companies are endeavouring to take cost off their balance sheet by outsourcing services to external providers. Another support service company to advise its investors on recent trading, this week, was the global catering business Compass. Trading in the half year to 31 March matched best forecasts, and featured 10% profit progression and an 11% hike in the interim dividend. A breakdown of revenue growth, by geography, delivers to intuitive expectation: emerging economies +17.4%, North America +10.1% offsetting relatively pedestrian +3.3% in Europe & Japan. As Compass has grown its customer base, the group has shared some of its economies of scale (think bulk-buy of food stuffs) with its customers - in turn promoting a virtuous circle of winning more contracts, as companies or public institutions are forced by budgetary requirements to disband high overhead catering establishments. Investors have to be mindful of the price which they pay for these businesses: after performing well over the past three years, each appears fairly if not fully valued - with Babcock International set to join the FTSE100 index, if its stock's relative progress is maintained. While outsourcing appears set to continue apace for the next three years, no trend continues indefinitely and corporate cycles could yet see firms bring services - such as canteen catering - back in-house, perhaps prompted by a pick-up in confidence, prosperity or driven by contractors' overpricing of the service. While we are now moving into the quiet season until results for the quarter or half year to 30 June 2012 are announced, listed companies are becoming increasingly cute at managing expectations, by providing updates to the Stock Exchange towards the end of the trading period and guidance to leading institutional share holders via face to face meetings (typically facilitated by their own broker). However there are always exceptions, such as the oil services group Lamprell, whose shares fell 56% on Wednesday on advising that profits would be significantly lower in the current year. Best known for building oil rigs, this FTSE250 mid cap firm provided a positive outlook statement, when announcing full year trading results, seven weeks ago. A loss in the first half of 2012, and probable profits for the full year of just one third of that previously anticipated, is likely to result from underutilised resources and contract slippages following supply line difficulties. That two directors sold 1.7m worth of stock two weeks previously will annoy investors, as would the missed opportunity to provide an update when Lamprell reported a US$227m contract win on the 1 May. Such poor communication is not easily forgiven by fund managers; a recovery in investor sentiment and support for the share price is likely to be slow. In the absence of any major company-specific trading news or other developments, next week this blog intends to take a look at another natural resource industry - having looked at the oil & gas sectors in our previous commentary. The mining sector began the year brightly, rising almost 20% in January 2012 (by reference to the UK listed stocks), but has fallen away sharply since on fears of a slowdown in the global economy and China in particular. Perhaps the area of the market that courts most controversy, speculation and polarised views  not just over the past couple of years, but for as long as the write can remember  investors cannot afford to overlook the mining sector, either as a focus for global cyclical momentum, new entrants to the London stock market or for M&A prospects.

The Writer's view are their own, not a representation of London South East's.