Soaring government debt means opportunities for outsourcers.

It used to be claimed that there were only two certainties in life; death and taxes. Based on recent government profligacy, and large dollops of quantitative easing we now have a third; public spending cuts.

Budget deficit levels are unsustainable and will have to be reduced. This can only be achieved by massive reductions in public expenditure. As with all major change programmes, there will be victims and there will be winners. Recent announcements from official sources suggest that the winners could include investors who get to grips with outsourcing, and its investment implications.

Outsourcing reduces costs

Outsourcing means an organisation identifying business activities which could be more efficiently undertaken by an external provider. The activities are then bundled into a contract with the provider for a number of years at an agreed price — usually substantially lower than the previous in-house cost.

Publicly quoted companies have been successfully undertaking outsourcing studies, and awarding contracts for at least fifteen years.

Outsourcing will boom in central government

To a certain extent, the public sector has also embraced the notion of outsourcing. High profile examples would include Serco (LSE: SRP), last year being awarded the contract to run new prisons in London and Liverpool in a deal worth £600 million, together with running parts of the Welfare to Work initiative for job seekers.

And of course anyone unfortunate enough to drive through central London is only too well aware of the fact that outsourcing giant Capita (LSE: CPI), and more recently IBM, manages the congestion charges.

But these are very much peripheral activities. An announcement from Essex County Council in December indicates how contracts may progress.

Based on their success in saving “billions of dollars” for the Canadian government, IBM was awarded an eight-year contract to review, manage and provide public services for Essex County Council. The reason is brutally simple; the Council could save 20% of its annual £1.2 billion budget within three years. In total, the deal could be worth up to £5.4 billion.

Playing politics

Cameron and Conservative party chairman Eric Pickles have made no secret of the fact that they are delighted with the initiative, and other Conservative authorities are following suit.

All this is no surprise from the Tories. However, Gerry Grimstone — chairman of Standard Life (LSE: SL) and Candover (LSE: CDI), and architect of 1980s privatisations — has been working for Gordon Brown and Alistair Darling looking at the possibilities of extending outsourcing into the very core of central government, privatising aspects such as HR, payroll and pensions, for example.

Admittedly, in this case, one objective is to establish and sell off public sector outsourcing and property companies, but the message is clear from both parties; government will shrink, and much of this will be achieved by outsourcing.

This is no cyclical trend. This is a secular change in the way government is managed and there are two FTSE 100 companies that are well positioned to exploit this market. As you would expect, neither is cheap, but both have delivered outstanding shareholder returns.

Capita

Capita is one of the leading outsourcing providers in the UK and is very active in the public sector. Despite losing the London congestion charging contract to IBM, 90% of its revenues are completely immune from weakness in the economy; a fact illustrated by the fact that organic growth was about 5% to 8% in 2009.

Capita released an upbeat interim management statement in November, where the company announced it was happy with 2009 forecasts and expected profit before tax to increase by over 10% in 2010.

Trading on a prospective P/E ratio of 19.8 and a forecast yield of 2.2%, the shares are not cheap, but the rating has eroded over the last nine months following the ‘dash to trash’. I reckon government contracts are going to dry up until the election and this may well mean some negative short-term news. Any associated weakness in the share price should be exploited with a buy.

Serco

Serco is one of the most consistent growth companies in the FTSE, doubling earnings from 2005 to 2009.

An impressive 90% of Serco’s business involves outsourcing for the public sector. The visibility this gives the management and investors is astonishing; 86% of 2010’s revenues are already in the bag and so are 72% of 2011’s.

What gives Serco added spice (and risk) is the major acquisition in 2008 of SI International. This gives it a foot hold in America, where outsourcing is less well developed, but where pressures on government spending are identical.

Like Capita, it sits on a lofty prospective P/E of 19, but it has a lower forecast yield of 1.1%.

Source: http://www.fool.co.uk/news/investing/investing-strategy/2010/01/04/why-outsourcing-is-set-to-boom.aspx