Serco juggernaut set to continue

With the government's Comprehensive Spending Review behind us, now is an opportune moment for patient investors to buy Serco's shares. The group's global presence, strong cashflows and track record ensure it should be a winner, especially in the UK government's further shift towards outsourcing.

The group manages infrastructure and services across a wide range of markets. These include running prisons; health and welfare support; air traffic control, and waste management for local authorities. Both the Julius report, commissioned by the previous UK government in 2008, and Ovum, a think tank, indicate that £100bn-worth of public services in the UK could be contracted out, though some City analysts think that figure could run to £200bn. However, so far only about £15bn-worth of work has been outsourced, so the opportunities for Serco should be huge.

True, Serco won't automatically benefit from increased outsourcing but, given the messages coming from chancellor George Osborne's Efficiency and Reform Group, we think the government is serious about fundamentally shifting the delivery of services from the public sector to private operators. In particular, the chancellor's reform group has framed "the Osborne tests" - 10 questions that will be asked of each public service. Basic queries around cost and necessity are there, but most interesting are the three questions: ‘must the government be involved?', 'could the private sector do it better?' and 'could private sector pay be based on performance?'

Besides, in an interview with Investors Chronicle, the minister for the Cabinet Office and the spending tsar, Francis Maude, told us that the UK government is serious about making a structural shift toward the private sector. On a local level, the shift is already apparent; for example, Suffolk County Council aims to cut 90 per cent of its staff over 10 years, to chop costs by 30 per cent and become solely an "enabler." Brighton & Hove and Barnet councils have each made a similar pledge. More are likely to follow because, according to analststs at investment bank Merrill Lynch, only 37 local authorities have ever sealed "large" outsourcing deals, yet in the UK there are 152 metropolitan, city or county councils and 238 district authorities.

So why do we reckon Serco will profit? For starters, its exemplary track record and win rate of taking half the contracts it bids for. In addition, its diverse operations mean it can bundle some contracts into one deal, undercutting rivals. What's more, despite fears for public spending since June's budget, Serco has continued to win important contracts; in particular, a £415m deal to run Belmarsh West prison and a £650m agreement with Sandwell Metropolitan Council for environmental services.

There are also plenty of deals in the pipeline. Serco already runs the Department for Work & Pensions' "Pathways to Work," so it should be in a strong position to win additional work when the department makes further tenders, worth £2-3bn, early next year. In addition, three prisons are expected to be outsourced in 2011; yet just 13 are managed privately out of a total of 160.

Granted, there is likely to be a lull in new contracts following the details of the spending review, while the collapse of Connaught has highlighted the shortcomings of some outsourcers. True, Serco has a good record of converting accounting profits into cash, but even its reputation would not escape a major contract failure and its share are already rated well above those of other outsourcers at 16 times forecasts of underlying earnings for 2011.