Today I want to look at two stocks from a sector that’s faced a string of embarrassing problems over the last few years. Things are now improving, so I’ve been asking if this could be the right time to buy.
The first company I want to consider is FTSE 100 outsourcing group G4S (LSE: GFS). Last week’s half-year results triggered an 11% share price slump. But I think critics are too quick to dismiss this business.
Increasingly profitable
The group’s two main businesses are cash handling services and security solutions, such as prisoner transport and facilities management. It operates in about 90 countries and has around 560,000 employees — security is generally quite a labour-intensive business.
Under chief executive Ashley Almanza, the firm is seizing on opportunities to introduce more technology to its business and reduce headcount. This is a long-term project and won’t happen overnight. But when paired up with more selective contract bidding and efficient management, it’s helping to make G4S more profitable.
Its operating margin has risen from 3.7% in 2014 to 6.4% in 2017. Although that’s still relatively low, the business generated a return on capital employed (ROCE) of 14% over the last 12 months. That’s a big improvement on the 2014 figure of 7.3%.
Only one concern
My only real concern is that net debt is high, at £1,566m. This total fell by £41m during the first half, but G4S’s ratio of net debt-to-earnings before interest, tax, depreciation and amortisation (EBITDA) was unchanged at 2.7. That’s well above my preferred maximum of two times EBITDA.
I believe more progress is needed on debt reduction. But this aside, I’d say the stock looks reasonably-priced for income buyers, on a forecast P/E of 13 and with a prospective yield of 4%.
A small-cap alternative
Housing and care services provider Mears Group (LSE: MER) reported its half-year figures this morning. Revenue at this £350m company fell by 8% to £435.3m during the period, but pre-tax profit was 1% higher, at £12.9m.
Like G4S, Mears is focused on improving its profit margins rather than growing at any cost. Today’s figures show that the group generated an adjusted operating margin of 4.7% during the half year, up from 4.1% during the same period last year.
A tale of two halves
Mears employs around 10,000 people across two divisions, Care and Housing.
The Care business provides in-home care services for more than 15,000 elderly and disabled people. Housing provides maintenance and repair services, mainly for social housing landlords.
Margins are constantly under pressure in both businesses. But what concerns me the most is a new initiative where the company borrows money to buy properties and do them up, before selling them to long-term investors who rent them out. Mears typically gets the maintenance contract for these properties.
Management says this enables the firm to win new work it might otherwise miss out on. But it seems to me that the company is taking on extra risk on behalf of its clients, without much clear reward.
Property purchases like these helped lift the group’s average daily net debt from £96.4m to £114.4m during the first half of this year. This resulted in a leverage ratio of 2.5 times EBITDA.
The shares trade on 11 times forecast earnings and offer a 3.9% yield. This could be an attractive entry point, but I’d rather put my money in G4S.
