Smart Investor: G4S is not as bad as you may think

The farcical events in the run-up to London 2012, where G4S (GFS.L) was unable to provide the required number of security staff for the Olympic Games, appear to have left a rather bad taste in mouth of officials in Whitehall.

A recent tender for a prison contract saw the company knocked out before the final round and it is not difficult to imagine why. Indeed, the debacle came just over a year after the fiasco involving the company’s takeover of ISS, where it claimed to have shareholder backing before making a sharp u-turn after shareholders complained about the terms of the deal.

So, the past 18 months has not been a smooth ride for G4S and, you could argue, it is surprising to see chief executive Nick Buckles (pictured) remains in his post.

Of course, the company’s track record is impressive, with a net profit being made in each of the past five years. However, whilst 2007 to 2010 saw net profit growth of 14.9%, 2011 was a disappointing year, with net profit slipping from £223 million in 2010 to £181 million. This was at least partly due to the company having spent £55 million on its failed takeover bid as well as another £137 million spent on several successful acquisitions.

Still, return on equity was 12.1% last year and averages 12.9% over the past five years, both of which are acceptable and show that the company is both resilient and reasonably profitable during challenging economic times.

In terms of income, the shares currently yield 3.5% from a payout ratio of 66%. Dividends per share have increased in each of the last five years; rising from 4.96p in 2007 to 8.53p in 2011; an annualised gain of 14.5%. This compares to an average yield in the FTSE 350 of 3.6%, so G4S is at least a contender for income orientated investors.

However, the company continues to carry too much debt. The debt-to-equity ratio stands at 145%; up from 120% in 2010, and affords the company too little headroom when making interest payments, with interest cover of just 3.6. As for an economic moat, the services it offers are likely to be demanded in perpetuity but there remain question marks as to the ease of entry into the markets in which G4S operates, as well as how great the fallout will be from the Olympics fiasco.

With shares priced yesterday at £2.46, G4S trades on a price to earnings* ratio of 18.8 and a price to book ratio of 2.3. Both of these figures are too high, especially when the company’s debt levels and their impact on ROE are taken into account. In other words, ROE should be far, far higher than it is when a company is leveraged to the extent which G4S is.

Overall, G4S is not an attractive investment opportunity. Sure, it offers a resilient track record and an acceptable yield, with dividends having grown at a brisk pace over the years. However, its debt levels, ROE, management strategy, valuation and, perhaps most crucially, its perception among potential clients is sub-standard and not worthy of a place in your portfolio.

I last wrote about G4S on 8 July 2011. Since then, shares have delivered a negative total return of -9.6% versus the FTSE 350’s total return of 1.3% over the same period.

*For the P/E ratio I used diluted earnings per share for 2011 from continuing and discontinued operations of 12.9p