G4S: bad business or buying opportunity?

Last week it was Barclays; this week, it's the turn of G4S and its chief executive to hog the front pages.

The company has made a huge mess of its Olympic security contract; no doubt about it. And its share price has plunged accordingly.

But does this mean that G4S is a bad business beyond repair? Or could this be a classic buying opportunity?

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Make no mistake, reputation is important in the outsourcing industry. After all, you're pitching to run part of someone else's business here. It's important that they trust you.

That's why this Olympic disaster is likely to cost G4S a lot more than the £50m loss on the contract itself. The damage in terms of contracts not renewed, or future bids not won, could be much more significant. This is especially true for the UK, which is one of the company's key markets, and accounted for 20% of its £7.5bn of revenues in 2011.

It's hard to see why the UK government would want to give G4S any more business after this. And will corporate customers want to face the reputational risk of having G4S work for them?

Those are the big risks on the side of the sell' case.

But let's look at the buy' case for a moment. If you take a step back and look at the numbers, G4S has been a very successful business. It is the world's top provider of security services to businesses and governments.

As well as providing security at sporting events, it also manages prisons, does back-office work for police forces, and provides security for big infrastructure assets such as airports, oil fields and ports. It also has a cash handling business. It performs tasks such as transporting cash, managing cash machines and looking after retailers' cash management functions.

Whilst outsourcing has a bad name in some parts, companies and governments have embraced it with open arms as they have looked to save money. G4S has been very successful at exploiting this trend and has grown strongly by tapping into the underlying growth and buying other companies.

Dividends have grown by 75% in the last five years as the company has generated lots of surplus cash. Even better is that the money invested in the business has produced very satisfactory returns. Profit margins of 7% and a return on capital of over 14% (see chart below) are the hallmarks of a fairly decent business. Even more so if they can be maintained.

(Source data: G4S annual report)

What's the future for G4S?

No one really knows. Its biggest shareholders failed to back management in its bid tobuy Danish cleaning business ISS for £5bn last year. So big deals are probably off the agenda for now.

However, the company remains confident that it can spend £200m a year buying smaller companies to help it grow. Throw in the fact that the outsourcing trend is not yet dead - and flourishing in emerging markets (where G4S has 30% of its sales) - and the company reckons that it can grow its net profits by 10% per year going forward. Dividends will grow in line with profits.

That sounds pretty reasonable. And at 247p, the shares trade on just 9.8 times 2012 forecast earnings and offer a prospective dividend yield of 3.7%, which all looks pretty cheap if it can live up to its promises.

You've no doubt formed a view on G4S and outsourcing over the last few days. If you don't like what the company stands for, then you probably won't go near the shares. But if outsourcing doesn't worry you, and you believe the damage to the company's reputation is only temporary, then popping a few G4S shares in your portfolio will probably pay off in the long run.