Join our community of smart investors

Serco's road to recovery

Outsourcer Serco has been through a rough patch, but we think it may now have hit the bottom, which would provide substantial recovery upside for the shares
September 24, 2015

Following some extremely torrid years, we can see light emerging at the end of the tunnel for outsourcing giant Serco (SRP). And with the company trading at a rock-bottom valuation compared with forecast sales, we think the time has come for brave investors to buy into the group's recovery potential.

IC TIP: Buy at 103p
Tip style
Speculative
Risk rating
High
Timescale
Long Term
Bull points
  • Much reduced net debt
  • Sold lossmaking businesses
  • Return to trading profit
  • Historically low enterprise value to trough forecast sales
Bear points
  • Revenue decline forecast for two years
  • Dividend payments temporarily halted

Following a £555m rights issue in March 2015 and the £250m disposal of an Indian business process outsourcing (BPO) operation earlier this month to Blackstone, Serco's balance sheet looks as though it's out of the woods. Indeed, even before the recent BPO sale net debt stood at £290m and following the disposal borrowings should drop to less than the group's expected cash profits for the year.

Meanwhile, although revenues are falling due to the company's decision to withdraw from problem contracts, analysts expect sales to bottom out next year at about £3.3bn. Serco's current enterprise value (market cap, plus debt, minus cash) represents just 0.43 times these forecast trough sales (EV/sales). This valuation is very low compared with the 10-year historic range based on consensus next-12-month sales forecasts. Indeed, there is over 60 per cent upside to the 10-year median valuation of 0.69 EV/sales and 50 per cent upside to a bottom quartile valuation of 0.63.

With balance sheet concerns fading, we think there are two key issues that need to be addressed for the shares to re-rate, which are stabilising sales and rebuilding decimated profitability (as reflected in the very high PE ratio). We believe the tough action taken since Rupert Soames, former Aggreko chief, took the helm should pave the way for these improvements. Mr Soames has overseen an exit from lossmaking contracts, the sale of non-core businesses and a tightening of the group's focus on public sector contracts.

 

 

And, importantly, end markets are still growing. Government spending on outsourcing almost doubled under the coalition government, according to figures from the Information Services Group consultancy. What's more, separate research from OC&C Strategy Consultants predicts outsourcing could rise by a third under the current government, driven by population increases and the need to make cost savings. A streamlined Serco, with a renewed focus on public sector contracts, could stand to be a key beneficiary of this. Serco is now focusing on bidding for work in five core public sector markets - defence, justice and immigration, transport, health and citizen services.

In conjunction with this, the group is in the process of selling off its non-core and lossmaking operations. Admittedly, the group incurred a total £70.1m in charges on its assets held for sale during the first half. However, streamlining the business is creating a significantly sturdier balance sheet, and prior to the BPO sale management was guiding towards trading profit of £90m for the full year. This may not seem awe-inspiring, but it compares with a £632m loss in 2014, which included a near-10-fold increase in provisions to £578m, much of which represents expected future losses on problem contracts.

The overly aggressive attitude towards bidding in the past has led to the group exiting contracts such as the Colnbrook immigration centre, Docklands Light Railway, National Physical Laboratory, Suffolk Community Healthcare and National Citizens Service. While contract attrition is expected to push 2016 sales down by 10 per cent or £350m, it also helped the group take operating cost savings to £200m in the first half. What's more, Serco is now taking a more cautious approach to the work it undertakes. At the time of its first-half results Mr Soames told the IC that the outsourcer's processes for assessing the risks as well as the upside of contracts are becoming increasingly rigorous. "Once bitten and twice shy, and we've been bitten quite a few times," said Mr Soames.

SERCO (SRP)

ORD PRICE:103pMARKET VALUE:£1.13bn
TOUCH:108.9-109.1p12M HIGH / LOW:260pLOW: 101p
FORWARD DIVIDEND YIELD:NILFORWARD PE RATIO:NA
NET ASSET VALUE:33p*NET DEBT:80%

Year to 31 DecTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20124.9127842.610.10
20134.2822036.010.55
20143.96-669-131.03.10
2015**3.45553.3nil
2016**3.35553.1nil
% change-3+1-6-

Normal market size: 10,000

Matched bargain trading

Beta:0.64

*Includes intangible assets of £626m, or 57p share

**Numis Securities forecasts, adjusted PTP and EPS figures