Serco offers exposure to the growing role of governments

Serco acts as a wingman to governments around the world, offering a wide range of outsourced services from military satellite communications to helping the unemployed back to work. Governments have needed all the help they can get during the past 18 months as the pandemic has raged. Serco has benefited.

Almost unilaterally, governments shut down economies to tackle the threat of Covid-19. This decision to protect the public healthcare systems also forced governments to provide cash to protect the financial health of their citizens. In the case of Australia and the UK, this came in the form of wage subsidies, while in the US unemployment benefits tripled. Last year government spending as a percentage of gross domestic product (GDP) was at its highest level since 1970 in the US, Australia and the UK, according to data provider Trading Economics. Citizens now find themselves more dependent on governments than at any other time in the 21st century.

Victim of its success

Serco’s half-year results to the end of June showed just what a boon this period has been for the group. Its revenue was up 19 per cent while underlying trading profit was ahead by 58 per cent. A key contributor to this success was its £332m test and trace contract, which contributed 17 per cent of sales.

But investors are now preparing for leaner times. The valuation based on the next-12-month (NTM) price/earnings (PE) ratio is the lowest it has been in three years. Meanwhile, based on enterprise value (market cap plus net debt) to LTM sales, the rating is bumping around the bottom third of the three-year range.

While we feel the shares could prove a bargain, it is important to appreciate that there are clear reasons for the lack of enthusiasm. As well as the potential for the group to lose Covid-19-related work as life becomes more normal, in March the company lost a contract to run the Dubai Metro. Meanwhile, its joint venture managing the UK’s nuclear arsenal was recently taken back in-house by the Atomic Weapons Establishment (AWE). And profits for the rest of 2021 will be weighed on by set-up costs associated with a new £350m contract to find jobs for UK unemployed. Consensus forecasts are for earnings to drop back in 2022.

Sentiment will also not be helped by painful memories of the woes experience by the outsourcing sector – Serco very much included – during the 2010s.

However, by focusing on these short-term issues, investors risk losing sight of the significant improvements that have been made to the business over the recent year, Serco’s growing success in winning orders and international growth prospects.

“The new management team has been ultra-client-focused since they assumed control in 2014, as witnessed by the 90 per cent contract retention rate, and has invested significantly in internal processes and systems to manage the contracts more effectively,” said Chris Field, deputy manager of Edinburgh Investment Trust, which counts Serco as one of its holdings.

Haunted by the past

Since 2014, when Serco announced four profit warnings in a year, made a £1.5bn writedown and repaid £69m after overcharging on a contract to provide electronic tagging for offenders, it has made a steady but impressive recovery. This progress has been led by chief executive Rupert Soames, who arrived in 2014 and has since put a lot of emphasis on contract management.

The reason why outsourcers such as Serco and Interserve, which went into administration in 2019, where taking on such low-margin contracts was because governments often selected the lowest-price bidder regardless of the quality of service. This left little room for error, and error is always possible when implementing large, complex, multi-year projects.

By being more discerning about the contracts it takes on, there was a danger Serco’s top-line growth would slow. However, its £3.9bn of revenue at the end of 2020 was 23 per cent higher than at the end of 2015 and broker consensus is for it to be £4.3bn at the end of the 2021.

Two of the most promising aspects of Serco’s recovery are its operating margin and balance sheet health. The reason Interserve went into administration two years ago was because it had wafer-thin margins, just 3.4 per cent for 2018, and a weak balance sheet; its net debt was 4.6 times greater than its cash profit. Serco is currently in a much healthier position. Its operating margin has improved from 2.6 per cent in 2015 to 5.7 per cent in its recent interim results.

Net debt at the half-year stage was just one times its cash profit, despite the company spending £40m on buybacks and £249m on acquisitions in the period. This debt ratio is well below its covenant requirements of 3.5 times.

The balance sheet strength is built on its success over the past three years in turning its profit into cash increasingly effectively. Its underlying cash conversion for the first half of 2021 was 137 per cent, up slightly from the 136 per cent in 2020. But in 2018 its cash conversion was just 48 per cent before rising to 96 per cent in 2019. A sharp drop-off in the use of provisions related to bad contracts has been a key factor in the improvement. This is also reflected in a jump in free cash flow last year from £62m to £135m. Back in 2016 Serco reported a free cash outflow of £33m.

Beyond the pandemic

Serco may have benefited from Covid-19-related spending, but that should not distract from the fact it has a diverse business that provides it with multiple opportunities for future growth. In the first half, it won almost twice as many orders as the work it billed customers for (the so-called book-to-bill ratio stood at 190 per cent) and the order book rose from £1.35bn to £1.41bn.

Defence is its biggest division, accounting for 32 per cent of last year’s revenue. This was followed by citizen services (30 per cent), justice and immigration (17 per cent) and health (9 per cent).

While Serco currently appears to be the go-to service provider for UK government, its business is geographically diverse. It is also significantly more profitable in overseas markets.

In 2020, excluding income from joint ventures, UK & Europe contributed 46 per cent of sales. But with a margin of just 3.9 per cent, this geography accounted for only 32 per cent of trading profit. Thanks to a hearty 9.5 per cent margin, the Americas was the largest contributor to trading profit at 46 per cent of the total despite accounting for just 27 per cent of sales. The next largest geography was Asia Pacific, which was 19 per cent of sales and 15 per cent of profit.

The group is keen to expand outside of the UK, and particularly into the high-margin US market. To that end, in February it purchased WBB, a provider of engineering and advisory services to the US military for £215m – its biggest deal to date. In January, it acquired a facilities maintenance service in Australia for £44m.

New Covid-19 variants and stop-start reopenings also mean Serco’s pandemic boon could last longer than is currently expected, especially when considered in relation to consumer businesses. The US Census Bureau reported that US retail sales in August fell 1.1 per cent compared with July, worse than the 0.3 per cent decline expected by Bloomberg’s economist survey. In the same period, the Office for National Statistics reported that retail sales in the UK were down 2.5 per cent.

Where now?

It’s reasonable to assume the pandemic-related tailwind Serco has recently enjoyed will die down. But there are grounds to think following several years of restructuring, it is a more impressive business and has better prospects than the share price currently suggests.

“[The] concerns miss the point,” says Field. “Serco is being hugely successful in winning significant new contracts. [It has] a very high win rate of over 65 per cent. The new business pipeline is up 40 per cent year on year at £5.8bn. This is as a direct result of their highly efficient platform and customer focus. We believe Serco is able to grow its top line by mid single digits over the medium to long term, which will be supplemented by more targeted acquisitions. Debt levels are low, cash generation is strong and with low capital intensity, returns on that capital are strong.”

With a forecast free cash flow yield of over 7 per cent and with an enterprise value of less than half LTM sales, there is the potential for good upside as investors start to look further out into a post-pandemic world.