I’ve always considered the outsourcing business as akin to a ‘picks and shovels’ investment — whoever is doing best at the sharp end, those providing services should continue to prosper. But today isn’t a good day for the sector…

Profit warning

Shares in Capita (LSE: CPI) were down by more than 30% at one stage this morning, and despite a slight rebound we’re still looking at a 27% fall to 696p as I write. The reason? A surprise profit warning, which dropped the previous pre-tax profit consensus of £614m to somewhere “in the range of £535m to £555m for the full year to December 2016“.

That’s a big drop, but does the reaction seem a bit overdone? Well, it’s pretty late in the year to be coming up with such a hefty downgrade, and a lot of people must be thinking of the often-true idea that profit warnings tend to come in threes.

And the firm did say that its new profit estimate “excludes the cost of potential restructuring actions and is subject to the satisfactory resolution of our dispute with the Co-op Bank,” with a contractual dispute in progress over the latter and a risk of litigation hanging over it.

Capita says it will be hit by a one-off £20m-£25m cost relating to its London congestion charging contract after delays in the implementation of new IT systems. On top of that, a slowdown in its IT Enterprise Services division looks set to knock around another £30m off the bottom line.

After today’s fall and accounting for revised expectations, the shares are on a forward P/E of probably around 11, so is the fall overdone? Well, the uncertainty over that possible Co-op litigation would keep me away from the shares — and I fear the curtain is a long way from falling on the final act of 2016.

Sympathy fall?

Fellow engineering services outsourcer Babcock (LSE: BAB) also saw its shares fall today, by 4% to 1,041p. With no adverse news around, I can only think the fall is a sympathetic one in response to Capita’s troubles, with some investors assuming the whole sector must be in trouble.

Current forecasts indicate a 9% rise in EPS for Babcock this year, putting the shares on a forward P/E multiple for the year to March 2017 of 13. That’s with a dividend yield of 2.7%, and there was net debt on the books of £1.2bn at the last year-end — though that was falling and is expected to reduce even further this year.

Babcock’s recent update in July suggested there’s still some Brexit uncertainty, but the firm reckons it’s in good shape with strong pipeline visibility — 85% of anticipated 2016/17 revenue is already in place, it seems, followed by 56% for 2017/18.

Babcock’s house broker Shore Capital has chosen today to tell us it still expects to see 6% revenue growth this year. While enthusiasm from a firm’s own broker should be treated cautiously, it does suggest that Babcock doesn’t have any shocks for us in the pipeline — and it provides a bit of feedback while we await first-half results, which aren’t due until 22 November.

For me, Babcock looks a far safer investment than Capita right now.

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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.